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Saturday, December 18, 2010

1-800-Flowers.com (FLWS): Is "Moat" Shallow, Shrinking, or Nonexistent?

We've made our stance on 1-800-Flowers.com (FLWS) fairly apparent during 2010, starting with our Which Way from Here? video presentation in January followed by our February post, Many Funds Can't Buy FLWS Right Now; But, We Can Because We Can Wait.

More recently, in our Nestlé Kit Kat series, we alluded to the strength of 1-800-Flowers.com's growing chocolate business, Fannie May. We'll soon share more on Fannie May, but in the meantime we recommend reading this 11/27 AP article:
  • The Associated Press — CHICAGO — A half-dozen years ago iconic chocolatier Fannie May, loved by Chicago candy devotees who passed down their affections for mint meltaways, caramels and vanilla buttercreams from generation to generation, was all but finished.
While somewhat counter to our Weight Watchers (WTW) thesis and general emphasis on healthy living, we're not shy in recommending Fannie May chocolates because we like the product and believe quality is high. Some of our favorites:

- Mint Meltaways
- Mint Meltaways
- Pixies®
- Pixies®
- Trinidads®
- Trinidads®

But, let's cut to the chase here. In October, we shared (click link):
In that post, we emphasized the company's ability to generate free cash flow for owners. Subsequently, a friend and former colleague posed critical questions after his brief review:
  • Seems like revenues and EBITDA have been pressured... So, it begs the question of how sustainable that free cash flow stream really is and also questions the sustainability of any remaining "moat" around the business. A rising tide will lift all boats for sure, but the company seems to have struggled long before the financial/consumer spending downturn.
Our response was essentially (with a few additions):
  • Please note that the company had pretty solid results through Fiscal 2008 until the recession took hold -- see operating income history for Fiscal 2007 and Fiscal 2008 following the inclusion and growth of new business units -- from Google Finance (GOOG), click to enlarge:
  • We also recommend reviewing the Fiscal 2008 Annual Report for more perspective - here's a summary snapshot of financial results (click to enlarge):

  • No question, since Fiscal 2008, the Consumer Floral segment has been especially hard hit and competition intensified as all stripes of consumer businesses fought (and continue to fight) for market share through the recession. Yet, we believe the company still has number one market share (*formerly around 20% -- uncertain of latest share data) and the "flowers.com" business drives tremendous Web traffic to the company's other branded businesses, including cookie and chocolate businesses (Cheryl's Cookies, Fannie May and Harry London).
  • The cookie and chocolate segments, acquired in March 2005 and May 2006, respectively, materially changed the mix of the business. Further, both have been growing through the recession and have better margin profiles than the floral unit. Also, 1-800-Flowers.com's home grown BloomNet floral wire network, launched in January 2005, has been well received by florists over the past five years. BloomNet is now a fantastic line of business that extends the company's significant economies of scale across products and services to benefit all network participants.
  • Finally, the company is leveraging its April 2008 acquisition of DesignPac Gifts to take on Harry & David in the gift basket marketplace. Notably, 1-800-Flowers.com's brand, products, and capabilities (e.g. skills and scale) provide a strong springboard for growth in this category. For reference, we recommend this 12/22/09 NYTs article, Bringing Bouquets and Gift Baskets Together. Like the floral segment, the wholesale basket business (e.g. sales to large retail stores like Target/TGT) suffered over the past two years as consumers retrenched, but the company should soon face easier Y/Y comparisons on the wholesale side and the retail 1-800-Baskets.com business should begin to contribute more meaningfully to the revenue mix over time. Harry & David -- which admittedly has a great brand -- remains under pressure, with revenue for the September 2010 quarter down 13% Y/Y. We see potential for 1-800-Flowers.com -- via 1-800-Baskets.com -- to garner meaningful market share.
  • HENCE, the key is to understand how the mix of 1-800-Flowers.com's business shifted over the past five years, both via acquisition and organic initiatives. The result is a more stable and durable franchise capable of reasonably consistent excess cash generation.
  • Some offerings from Cheryl's:

For insight into recent results, the shifting business mix, operating strategies, and future direction, we recommend reviewing 1-800-Flowers.com's recently released Fiscal 2010 Annual Report. The letter to shareholders provides a worthwhile summary and details management's plans to grow the business and enhance shareholder value. Summary financial snapshot (click to enlarge):

Also, for reference, January 2010 commentary from President Chris McCann on customer relationship management:

Importantly, rather than a shallow, shrinking, or non-existent moat, we see a strengthening moat for the business and believe our core thesis holds (from our January presentation):

Accordingly, we've been purchasing more shares in the company in recent months. We'll try to share a bit more in the coming weeks. As always, we welcome questions and alternate viewpoints.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long FLWS, WTW.
© 2010 Jeffrey Walkenhorst
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