Since I wrote my bullish piece on Hawkins Inc. (HWKN) a little over 2 ½ years ago, the shares are up about 41% against a gain of 17% for the S&P 500 over the same time period. A stock that’s trading at $46 is by definition more risky than one that was trading at $35, so I thought I’d look in on the name to see if it’s still worth holding this company. I’ll try to make that determination by looking at the stock as a thing distinct from the actual business. As is frequently the case, I’ll recommend an options trade here.
For those of you who are pressed for time, I’ll come right to the point. This is a great company that has done very well during the pandemic. Management continues to treat shareholders well by increasing the dividends, and the firm has remained consistently profitable for years. The problem is that the shares are not excessively cheap, nor are they overly expensive. I think it would be wise to avoid the name for the moment until the valuation becomes more compelling. That said, there’s a great short put trade here that represents a 5% yield over 8 months.
In my estimation, the financial history here is superb. Specifically, since 2014, revenue has grown at a CAGR of about 6.5%, and net income has grown at a CAGR of 6.6%. With the exception of 2018 when profits cratered as a result of a $39.11 million goodwill write-down, the firm has been consistently profitable for years. This has allowed the company to grow dividends per share at a CAGR of about 3.4%. Furthermore, the company has cleaned up its balance sheet greatly since 2018, with long-term debt declining from just over $100.6 million that year to $75.7 million at present.
What I’m most impressed by is the fact that this is one of those rare companies that actually saw improvements in 2020 relative to the same period a year ago. Revenue was up slightly from the same time last year, and net income was up just under 26%. The firm achieved this result in spite of a 27% uptick in income tax expense, and a 5.4% increase in SG&A expenses. Notably, interest expense was ~50% of what it was the previous year, and the mysterious “other income” grew by 462%. Whatever the causes, though, I think we’d agree that a company that is doing better now than in 2019 is a rarity.
I think investors would be interested in buying this name for the dividend, so I think it’s important to write briefly about the strength of the dividend here. First, the payout ratio has dropped from the low 40s in the 2014-2016 period to about 21 today. The dividend only represents about 17% of cash flow from operations. Both of these measures suggest that there’s much room for relatively painless growth of the dividend. Second, the company’s revolving credit facility matures in 2023, suggesting that the company has few obligations over the next few years. Thus, investors shouldn’t be worried about any crowding out effects from other cash obligations.
Given that I think the dividend is reasonably secure, and the much-improved balance sheet, I’d be very happy to buy more of this business at the right price.
Source: Company filings
The phrase “at the right price” is of critical importance, in my view because there’s a negative relationship between price paid and future returns. For that reason, I need to look at the stock as a thing distinct from the underlying business. When I buy stocks, I want them to be cheap because I consider those to have both the highest return potential and the lowest risk. They’re low risk because much of the bad news is already “priced in”, and thus more disappointment won’t be too shocking to the market. At the same time, cheap stocks offer great return potential because when a stock that’s perceived as a “dog” reports surprisingly good results, the shares often pop dramatically higher in price.
I judge whether a stock is cheap or not in a few ways. First, I compare the ratio of price to some measure of economic value, like earnings, or free cash flow. Obviously, the more an investor pays for $1 of future economic benefit, the more risky the investment. In particular, I want to see a company trading at a discount relative to both its own history and to the overall market. On that basis, I think Hawkins is relatively inexpensive, per the following:
In addition to looking at the ratio of price to some measure of economic value, I want to try to understand what the market is currently assuming about a given company’s future. In order to do this, I turn to the methodology described by Professor Stephen Penman in his book “Accounting for Value.” In this book, Penman walks investors through how they can use a fairly standard finance formula and high school algebra to work out what the market must be thinking about a given company’s future. We do this by isolating the “g” (growth) variable. Holding all else constant, this model suggests that the market is currently assuming a long-term (i.e., perpetual) growth rate of ~ 6.7% for Hawkins. I consider this to be a fairly optimistic forecast. Based on this, and the relatively low PE ratio, I’m actually fairly neutral on the current valuation. I’d recommend neither buying more nor selling at this point.
Options As Alternative
Just because I can’t recommend buying more shares of Hawkins at the moment doesn’t mean there’s nothing to be done to enhance returns here. As my regular reader-victims know, I consider short put options to be “win-win” trade, and I think they’re particularly good in this case. In particular, my preferred options trade here is the June 2021 puts with a strike of $35 which is currently bid-asked at $1.80-$2.60. If the investor simply takes the bid on these and is subsequently exercised, they’ll be obliged to buy at a net price about $33.20, which is about 29% below the current market price. Holding all else constant, at that price the dividend yield would jump to 2.9%. If the shares remain above that price, they will simply pocket the premium and move on. That’s never a bad thing.
I have a confession to make, dear readers. One of my many odious traits is that I sometimes like to get people’s hopes up, only to then dash them. Now that you’re hopefully excited about the potential of short put options, it’s time to do just that by going through the boilerplate discussion of risks. Short puts come with risk. The nature of the world is such that we must choose between a host of imperfect trade-offs, as there’s no “risk-free” option. Short puts are no different in this way. We do our best to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. The risks of share ownership should be obvious to readers on this forum.
I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money, and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.
Puts are distinct from stocks in that some put writers don’t want to actually buy the stock – they simply want to collect premia. Such investors care more about maximizing their income and will, therefore, be less discriminating about which stock they sell puts on. These people don’t want to own the underlying security. I like my sleep far too much to play short puts in this way. I’m only willing to sell puts on companies I’m willing to buy at prices I’m willing to pay. For that reason, being exercised isn’t the hardship for me that it might be for many other put writers. My advice is that if you are considering this strategy yourself, you would be wise to only ever write puts on companies you’d be happy to own.
In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day.
I’ll conclude this rather long discussion of risks by indulging my tendency toward tedious repetition, and I’ll use the trade I’m currently recommending as an example. An investor can choose to buy Hawkins today at a price of ~$47.00. Alternatively, they can generate a credit for their accounts immediately by selling put options that oblige them, under the worst possible circumstance, to buy at a net price about 29% below the current price. Buying the same asset at a near ⅓ discount is the definition of lower risk, in my estimation.
This is a wonderful business that has performed very well for me. I really like the way management has treated shareholders, and I really like the fact that Hawkins seems to be thriving in 2020. That said, investors don’t buy companies, they buy stocks. Stocks are sometimes (often) disconnected from the fundamentals of the underlying business, though. While it’s not egregious in this case, I don’t think these shares currently represent compelling value. For that reason, I won’t be adding to my position. That said, I think the short puts described above represent great value. If the shares remain above $35 over the next several months, the investor will simply pocket the premium. If the investor is exercised, they’ll access this wonderful business at a truly great price. For that reason, I consider this to be a “win-win” trade. If you’re uncomfortable selling puts, dear reader, I think the best thing for you to do would be to sit on the sidelines here.
Disclosure: I am/we are long HWKN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I’ll be selling 10 of the puts described in this account.