January Stock Talk V

Hansen Natural (HANS) develops alternative soft drinks, including natural sodas, fruit juice drinks and energy drinks. It is best known for its Monster brand energy drink, which is the second-most popular brand of energy drink and has helped the company’s shares become one of the best investments of the last decade.

Hansen now has to prove whether it can extend its momentum to new products and markets. We all now know what John Edwards thinks of leading energy drink Red Bull, and it’s probably not a stretch to think that many others feel similarly about the newer concoctions.

Still, that hasn’t stopped the market from growing exponentially over the past several years. The question keeps getting asked whether the growth can continue, and the answer so far has been affirmative. What’s more, the past improvement seems sufficient to justify holding the name even if growth slows substantially.

For example, over the past 12 months, Hansen generated free cash flow (cash from operations less capital expenditures) of $98 million. Based on its $3.4 billion enterprise value, this equates to a 2.9% free cash flow yield. With the market turmoil having pushed five-year Treasury yields below 2.5%, Hansen is now yielding a premium to Treasuries despite offering substantial growth opportunity — more than 40% sales growth in 2007 and another 30% or more expected in 2008.

By contrast, PepsiCo (PEP) offers a more generous 4.3% free cash flow yield but is expected to grow just 7.5%. Meanwhile, Jones Soda (JSDA) is expected to grow a similar 30% in 2008 (though off less impressive 2007 growth), but its cash flow from operating activity over the last year has been negative.

If Hansen grows as expected this year, its free cash flow yield (relative to the current enterprise value) would approach Pepsi’s. Any additional future growth would be a bonus from that point, and there seem to be many opportunities for the growth to continue.

For example, last February, Hansen entered a distribution agreement with Pepsi-QTG Canada. This gives Hansen its first real crack at international sales, which increased from 2.6% of the total in the first nine months of 2006 to 4% in the same period for 2007. Its domestic distribution has also been enhanced by deals with Anheuser-Busch (BUD) . To incorporate earnings quality, I calculated an accrual ratio for Hansen, which describes how much of a company’s earnings (in this case, over the preceding 12 months) are explained by cash flows rather than accounting choices.

Hansen Natural Accrual Ratio
Click here for larger image.
Source: Zacks’ Research Wizard, compiled by William A. Trent

The closer to 100%, the better, and Hansen’s accrual ratio has been much less volatile than I would have thought for a company growing so fast. (Rapid growth typically requires cash outflows that aren’t reflected in current earnings.)

Operating profit margins were lower in the first nine months of 2007, but this was primarily due to the legal and accounting expenses surrounding an investigation of stock-option-granting practices and the costs associated with terminating existing distribution agreements as the company enhanced its relationship with Anheuser-Busch.

The biggest risk for shareholders is probably Hansen’s choppy record with regard to earnings expectations. The company reported earnings below consensus expectations in two of the last four quarters, and, since a miss in November, the shares have shed more than 40% of their value. A two-year chart reveals a similar situation in mid-2006.

In hindsight, that 2006 selloff proved to be a terrific buying opportunity. Based on Hansen’s current valuation, I think the current one may prove to be the same.

Hansen should be able to maintain its current free cash flow yield as long as the company keeps growing, which suggests potential upside in line with the 30% growth rate this year. Unless the growth rate slows substantially, it looks like a keeper.

Kentucky youths may have to turn to another source for their morning caffeine jolt if the state’s legislature passes a bill introduced Friday that would ban energy drink sales to minors.

Beverage and convenience store industry professionals say the proposed bill unfairly targets energy drinks and would create an undue burden on convenience stores. But State Rep. Danny Ford (R-Mt. Vernon) said he introduced the bill “for the safety of the children.”

Energy drink companies target sales at 18-30 year-olds; teens often drink them as well.

Ford said a student from Brodhead, Ky., inspired the bill when he related his experience with an energy drink for a contest called “It ought to be a law.”

“This young man bought an energy drink on the way to school one morning,” Ford said. “He had a situation that his heart started beating rapidly and he had a bad experience with it.”

If passed, the law would join a series of political and regulatory actions concerning energy drinks worldwide.

California’s Office of Environmental Health Hazard Assessments is considering forcing companies to label energy drinks as potentially harmful if used in excess, and both Denmark and France have long banned Red Bull.

Ford said he researched energy drinks and found that some contained as much as three times the caffeine as a cup of coffee. Tom Davis, technical director of Hansens Beverage Company, the makers of Monster, disagreed with Ford’s findings.

“Coffee – especially the coffee that’s sold in any store – has more caffeine per ounce… than a Monster energy drink does,” Davis said.

Davis, a professor of pharmacology at the University of Arizona College of Medicine, said one 12 oz. cup of Starbucks coffee can contain as much 3-4 cans of Monster.

“If they want to legislate caffeine, they should start with coffee,” Davis said.

Jeff Lenard, the vice president for communications for the National Association of Convenience Stores, said the bill would place a greater burden on convenience store clerks.

“Convenience stores are already conducting more age-verification checks than probably any other channel,” Lenard said.

Tyler Benedict, president and CEO of Source Beverages, makers of Burn energy drink, said the bill’s definition of “energy drink” could create an additional burden for clerks.

The bill defines an energy drink as “a carbonated beverage that exceeds a caffeine content of 71 milligrams per 12 oz. serving and contains taurine and glucuronolactone,” which would fail to include juice-based energy drinks, and energy drinks without taurine or glucuronolactone. Benedict said that would leave clerks to determine which drinks are not covered by the law.

Ford said that definition could be subject to change as the bill proceeds through the Kentucky General Assembly.

Currently, he said, it has been introduced and assigned to the health and welfare committee, but has yet to be heard there.