As a student of the stock market, I pay close attention to trends.
Investing into an established trend is a time-proven way to find success. When two or more trends merge, it creates a high-potential stock market investment.
An excellent example of a major societal trend is the one toward healthy eating. Organic fast food and low-fat dining have become the hot new things among the masses. We see successful restaurant chains like Chipotle (NYSE: CMG) riding the organic, healthy fast food trend.
Another major trend is the growth of pet-ownership spending in the United States. According to the American Pet Products Association, total pet spending in 2010 hit $48.35 billion. This number has been growing steadily and is expected to hit $62.75 billion in 2016 with $27 billion being attributed to food products.
Combining these two seemingly unrelated trends pointed me toward the organic pet food market. As pet ownership trends higher, wholesome food-oriented consumers seek to provide their pets a similarly healthy diet.
The leading company in the wholesome pet food business, Blue Buffalo Pet Products (Nasdaq: BUFF), is riding these two trends with great foresight and skill.
Let's take a closer look.
Founded in 2002, Blue Buffalo is a $5 billion market cap pet food company headquartered in Connecticut. The company has developed markets in the United States, Canada, Japan, and Mexico.
Its products include multiple brands and types of pet food. These names include the BLUE Life Protection Formula, BLUE Wilderness, BLUE Basics, BLUE Freedom, and BLUE Natural Veterinary Diet lines. Also, the company has branched out from pet food by offering a cat litter under the BLUE Naturally Fresh line.
Blue Buffalo boasts a 6% share of the overall pet food industry but feeds only 2-3% of the 164 million pets in America. The company is focused on rapidly acquiring additional market share.
Performance in the second quarter of 2016 was stellar with net sales increasing by $32.9 million, or nearly 13%, to just under $287 million, driven primarily by volume growth.
Net sales of dry foods ramped higher by $22 million, or 10.6%, to $228.8 million while net sales of wet foods, treats, and other products increased $11 million, or 23%, to $58 million.
Gross profit exploded higher by 27.6%, to $127 million and gross margin was 44%, up 510 basis points from 39% in the second quarter of 2015. The increase in gross margin was driven primarily by supply chain efficiencies including the ramp-up of the new Heartland production facility and lower input costs, favorable mix, as well as a benefit from net pricing.
Net income increased $14.0 million, or 61.8%, to $36.6 million in the second quarter of 2016, as compared to $22.6 million in the second quarter of 2015. Adjusted net income, which excludes litigation expenses and costs incurred in public offerings, increased $12.0 million, or 45.7%, to $38.3 million in the second quarter of 2016, compared to $26.3 million in the second quarter of 2015.
What I like most about Blue Buffalo, however, is that it is always innovating and expanding its capacity.
The focus on expansion is evident in the company's beginning construction of an 89-acre facility in Richmond, Indiana. Chairman and Founder Bill Bishop stated, "This is a very big day for Blue Buffalo. This new, state-of-the-art addition to our manufacturing network will complement our facility in Missouri. We expect to further increase our internal production capacity and now will have two of the most modern manufacturing facilities in the pet food industry. Additionally, we plan to open a state-of-the-art R&D facility on our premises. We are also very proud of our plan to create over 160 full-time jobs and look forward to being an upstanding partner in the Richmond community."
The company's innovative spirit is crystallized in the recent hire of Gregory Reinhart, Ph.D., who will spearhead the research and development team. Dr. Reinhart brings his 30-plus years of experience in nutrition and therapeutic diet development to maintain Blue Buffalo's position on the cutting edge.
In addition to the quantifiable trends that Blue Buffalo is riding, I have also noticed another non-quantifiable trend. As the popularity of pets increase, more and more owners are viewing their pets as members of the family rather than just an animal. Treating pets as humans brilliantly plays right into the marketing strategy of the company, as evidenced in Blue Buffalo's slogan, "love them like family, feed them like family."
CEO Kurt Schmidt added to this sentiment by stating his company has benefited by the "humanization of pets," and Blue Buffalo continues to expand domestically and internationally.
For the rest of fiscal 2016, the company is projecting net sales in the range of $1.14 billion to $1.15 billion with a gross margin of 44%.
It expects adjusted earnings per share (EPS) in the range of $0.74 to $0.76, which excludes costs related to litigation and the company's secondary public offering.
Risks to Consider: In September, shares plunged due to a secondary offering but quickly rebounded. Third-quarter numbers will be released on November 10 and investors need to be on guard for volatility around this date.
Also, the company is currently trading at a P/E ratio of just under 60, much higher than the 31-plus average for the industry.
Finally, although it shows no sign of waning, the high-end pet food market remains dependent on expansive economic times. Despite company claims to the contrary, a recessionary cycle will likely hurt growth.
Action to Take: Buy now in the $25.38 per share zone on the pullback. Our target price is $34.00 per share, and initial stops are suggested at $23.93 per share.