With Quiver Quantitative’s recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in Hawkins Inc. (NASDAQ:HWKN). Firms such as Charles Schwab Investment Management, Citadel Advisors, and Renaissance Technologies have all recently added to their HWKN positions. Most notably, Charles Schwab Investment Management increased shares held by 2.37% (as filed on 9/30), bringing their total HWKN holdings to 233,193 shares worth around $16.4 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on Hawkins Inc.

In November, Hawkins Inc. reported earnings results for the second quarter of FY24. During the quarter, Hawkins reported record quarterly gross profit of $53.9 million dollars (16% YoY increase), which contributed to a record quarterly operating income (EBIT) of $33 million dollars (25% YoY increase). YTD diluted EPS was recorded at $2.22/share, growing 24% over the prior year. Additionally, the business added six water treatment facilities (a business segment they have been focused on growing), via the acquisitions of Water Solutions Unlimited and The Miami Products & Chemical Company. CEO and President Patrick H. Hawkins had this to say about the quarter, "We are pleased with our strong year-over-year performance in the second quarter, with our bottom line growing 29%, following our strong first-quarter growth of 19%. Our Water Treatment group once again led the way with revenue growth of 17% and operating income growth of nearly 70%. We continue to see profit growth within this segment, as we execute on our strategy to grow both the legacy business and the businesses we have acquired over the last few years. Although our Industrial group sales declined year-over-year, operating income was up 2%. In addition, the year-over-year second quarter sales decline in our Health and Nutrition group slowed to about half of what it was in the first quarter, showing signs of improvement." With these earnings results in mind, we believe that Hawkins Inc. is a compelling investment opportunity trading at an attractive valuation. 

Hawkins Inc. is a leading specialty chemical and ingredients company, renowned for its expertise in formulating, distributing, blending, and manufacturing a wide range of products for diverse sectors including Industrial, Water Treatment, and Health and Nutrition. The company generates revenue through its three primary segments: the Industrial Segment, which provides a variety of chemicals and services to industries such as agriculture and pharmaceuticals; the Water Treatment Segment, specializing in chemicals and solutions for water treatment needs; and the Health and Nutrition Segment, offering ingredient solutions to manufacturers in the food, health, and wellness sectors. Hawkins Inc. is distinguished by its specialized sales staff, quality products, and comprehensive services, positioning itself as a vital player in its served markets, with a strong presence primarily in the central United States and national distribution for certain products.

Hawkins Inc. operates in a highly competitive specialty chemicals and ingredients industry, where it contends with numerous producers, distributors, and sales agents. Despite the presence of larger competitors, Hawkins differentiates itself by providing quality products, outstanding customer service, and value-added services, including product formulation, to maintain a competitive edge. The company relies on a broad network of suppliers, including major chemical producers in the United States and a variety of domestic and international vendors for health and nutrition ingredients. Hawkins maintains robust relationships through distributorship agreements and supply contracts, ensuring a consistent supply of raw materials, though the availability of these materials is subject to market dynamics. The company's ability to leverage long-standing supplier relationships helps in navigating supply chain challenges, securing competitive pricing, and maintaining product availability, even when supplies are limited.

Management is solid, and their capital allocation priorities do a great job of creating long-term shareholder value. Hawkins’ Board of Directors previously authorized up to 2.6 million shares of common stock to be repurchased in the open market or in privately negotiated transactions. In FY21, FY22, and FY23, management repurchased 166,088, 240,501, and 181,657 shares of common stock, respectively. As of April, there remained 1,129,348 authorized shares for further share repurchases. Management largely uses these repurchases to offset the dilutive effects of share-based compensation, ensuring that shareholders aren’t diluted. In addition to share repurchases, Hawkins also offers dividends. In fact, the business has 38 years of continued dividend growth. Usually, we don’t like to see compounding businesses like Hawkins pay out dividends, as these dividend payments often take away from earnings that could be used for reinvestments into the business’ growth. However, with a payout ratio of only 18.3% (meaning that Hawkins pays outs 18.3% of net income to shareholders in the form of dividends), the business has plenty of additional earnings capacity (81.7% of net income) to use for reinvestments, debt pay downs, and other business needs. As we can see, management’s repurchase of common shares to reverse the dilutive effect of share-based compensation and long-term dividend growth (while keeping the dividend payout ratio low) do a great job of creating long-term shareholder value, while also allowing for a large chunk of earnings to be reinvested back into the business.

In terms of management incentives, management is incentivized well, with a compensation structure that does a great job of aligning shareholder and management interests, while also doing a great job of retaining executive talent over the long term. The compensation structure includes a base salary, annual non-equity compensation, and annual equity rewards. The annual non-equity compensation awards NEOs based on predetermined performance threshold benchmarks. In FY23, these performance thresholds were based on EBT (earnings before income tax) and an industrial group operational performance measure. One unique characteristic of this bonus is that 80% of the threshold must be met at a minimum to receive any of the annual cash incentive payment. Therefore, these thresholds are almost always met, and often exceed 100% of the target threshold (showing how incentives lead to outcomes). The annual equity award is paid out via PRSUs (performance-based restricted stock units) that vest over two years. As we can see, the annual equity incentives do a great job of aligning shareholder and management interests, while also retaining executive talent. With a large part of their salary coming from equity rewards, management is incentivized to maximize total shareholder return, much to the delight of passive shareholders. Additionally, with these rewards being vested over time, management is incentivized to stay on board. It’s hard to grow a business over the long-term if management is a revolving door.

Hawkins is a very efficient business. The business currently operates at a LTM ROE of 19.3% and a ROIC of 20.2%. With the business operating at a WACC of 8.2%, Hawkins currently operates at a ROIC to WACC ratio of around 2.5x, showcasing the business’ ability to generate returns on capital far greater than the business’ weighted average cost of capital. Businesses that are able to generate high returns on capital are referred to as compounders, businesses that are able to rapidly compound earnings and intrinsic value over the long-term, handsomely rewarding shareholders in the process. Going back to ROE, return on equity is a great way to measure a company’s ability to generate shareholder value. Increasing ROE over time may suggest that a business is reinvesting its earnings wisely, so as to increase productivity and profitability. Since 2016, Hawkins has expanded ROE from 9.3% (ROE = Net Income / Shareholders’ Equity) to 19.3% today. Looking further, we can see some solid growth in EBIT within the last decade (largely due to strong top-line revenue growth and incrementally expanding EBIT margins). EBIT is a great way to measure the profitability of a business’ core operations. Since 2014, Hawkins has grown EBIT at a CAGR of 11.8%, with EBIT margins incrementally expanding from 8% of revenue in 2014 to 10.3% of revenue today.

Analyzing Hawkins’ income statement, we can see some stellar sustained growth in revenue, gross profit, and earnings within the last decade. Since 2014, Hawkins has grown revenue at a CAGR of 10.4%, with gross profit also growing at a CAGR of around 10.4% in that same time frame (gross profit margins have stayed relatively flat over the last decade, usually hovering around 17 - 20% of revenue). In terms of earnings, Hawkins has grown EBITDA at a CAGR of 10.8% since 2014, while EPS has grown 12.8% in that same time frame. This growth in EPS can somewhat be attributed to small share repurchases over the last decade. Since 2014, shares outstanding have decreased 1.4%, just enough to offset dilutive practices like share based compensation for management and other employees. It must be noted that Hawkins has a low float, with only 20.94 million shares outstanding (please note that float and shares outstanding are similar yet different concepts, where float is the number of shares available for trading by the general public).

Looking at Hawkins’ balance sheet, we can see that the business operates in solid financial health. The business currently holds nearly $11 million dollars worth of cash and equivalents on the balance sheet, with around $50 million dollars of long-term debt. The business currently operates at a net debt of around $58 million dollars, signifying a Net Debt/EBITDA of around 0.45x. Therefore, theoretically, the business could pay off its debt in less than half a year with its current EBITDA (and this ratio will only go lower, assuming that EBITDA continues to grow at the rate it has over the last decade, and the business keeps debt to a minimum). As we can see, the business has plenty of runway to pay off its debt obligations, with the business operating with little debt. Low debt is a great quality for a small compounding stock like Hawkins to have. With low debt, Hawkins can focus on initiatives that drive long-term shareholder value. These initiatives include reinvestments back into the business at high rates of return, share repurchases, and dividends (which can include increasing or offering a dividend).

Analyzing Hawkins’ cash flow statement, we can see stellar sustained growth in net income and free cash flow within the last decade, showcasing the business’ improved operational efficiency over that time period. Since 2014, net income has grown at a CAGR of 12.7%, with free cash flow growing at a CAGR of 15.3% in that same time period (calculated using 2014 FCF and LTM FCF). Hawkins, over the last decade, has had shaky free cash flow generation at best, however, that can be explained by how FCF is calculated (Operating Cash Flow - Capex) and Hawkin’s business model. Capital expenditures have risen heavily over time ($20.8 million in FY21, $28.5 million in FY22, $48.3 million in FY23, and projected capital expenditures of $40-$45 million in FY24). These capital expenditures are being used for growth in the business, specifically being used for investments into facility improvements and expansion, new trucks, safety equipment, and other additions of PP&E. This is great, as these capital expenditures will pay dividends in the future, however, at the moment, they hurt free cash flow generation. At the surface level, this may be a concern to investors, however, over time, we believe that free cash flow will stabilize as Capex stabilizes, and these current capital expenditures will help grow the business, leading to top-line revenue growth and higher cash flows. This is a great example of why you need to dig deep into the financials of a business to understand things like profitability and cash flow generation. A great example of this is Amazon. For years, Amazon was an unprofitable enterprise, however, this was only because of large R&D expenses that crippled EBIT and net income. On the surface level, an investor may think that Amazon is a bad business. However, these R&D expenses paid dividends, allowing Amazon to introduce new products and improve the customer experience, leading to strong top-line revenue growth and cash flow growth over time.

After conducting a reverse discounted cash flow analysis, we can see that Hawkins is trading at share prices that imply a -1.85% growth rate (CAGR) in free cash flow over the next decade, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 8.2% (Hawkins’ WACC). Hawkins’ is a high quality business, and despite the shaky free cash flow generation described above, we believe that this valuation is very cheap. Large capital expenditures have depressed free cash flow generation over the past few years, however, as the business grows and capex stabilizes (which we believe is evidenced by their FY24 Capex projections), we believe that Hawkins’ can turn into a cash generating machine that can continue to reinvest cash back into the business as the business continues to compound, leading to further cash flow generation. The price implied expectations of investors seem to be very low, and rightfully so given the business’ current free cash flow generation situation. However, over time, we believe that top-line growth due to current capital expenditures will drive increased free cash flow generation, making these current price implied expectations seem very cheap in hindsight. We believe a 5% free cash flow growth rate (CAGR) is a fair value for the business, which gives us an implied share price of $112.44/share and an implied return of nearly 60%. These valuations are based entirely on our proprietary models, and we encourage all investors to do their own due diligence when it comes to valuation, as it may lead to you a completely different viewpoint on the business.