Sovos Brands: Business Remains Strong But Valuation Is Rich Now (NASDAQ:SOVO)

Summary

It has been a while since I gave an update about Sovos Brands (NASDAQ:SOVO). The last time I wrote about this business in October. I believe SOVO is a business with a decent moat stemming from its portfolio of key brands, and a clear growth strategy that has been repeatedly executed successfully in the past. Previously, I expected a long-term IRR of 10% at that valuation (around 23x forward PE), and it would’ve been better if valuations were lower at the low 20s PE level. For the good or the bad, the stock price has risen by more than the 10% IRR target, returning shareholders with ~22% return since last October. I believe the valuation is now too rich and I am changing my recommendation to a hold. However, I still think this is a business that is worth monitoring for the long-term and I am sure there will be buying opportunities sometime down the road. In particular, the Rao brand continues to demonstrate impressive momentum, both within its core sauce portfolio and in its expansion categories. I believe as SOVO continues to focus on its Rao brand to continue launching products to the market to stay relevant and maintain consumer mind share, it should be able to pivot its product lines to its frozen portfolio easily (as the brand becomes more of household name). A combination of these factors, along with some sane approaches to pricing and inflation, should result in healthy top-line growth over the next few years.

Rao

The SOVO story is mostly about Rao, which represented around 2/3 of the top line. How Rao develops will be the key driver to SOVO business and stock. I believe Rao will become an even important driver for the company where the company has leveraged its Rao’s brand to enter categories, which I expect to improve increasing items per store, awareness, and household penetration. This is a virtuous cycle as one leads to another. SOVO needs to innovate and increase the number of items to gain awareness, which will lead to further purchase/household penetration. Then, this cycle repeats itself as SOVO now has more awareness in household, which gives them justification (easier to estimate demand and draw feedback) for more innovation and products (in other categories).

The momentum for this brand is not showing signs of slowing down either with Rao’s Sauce growing 23% in the latest quarter. To me, this is a clear indication that the brand remains under-indexed in terms of household penetration, awareness, and distribution. I.e. There is still a lot of room to penetrate as demand is clearly very strong. If we look at the numbers, total Rao brand has less than 13% household penetration but Rao’s Sauce has less than 7%. If we assume that Rao’s Sauce can reach the consolidated average over the next 5 years, this means that growth can continue to stay in the mid-teens CAGR for 5 straight years (7% x 2 = 14%, double over 5 years is around 14/15% growth a year).

Extension to adjacent categories

I believe management will capitalize on the widespread belief that Rao “is a good brand” among consumers to propel the company’s expansion into adjacent markets. In particular, I call attention to the fact that the TAM for categories other than sauce is over $50 billion. I think Rao’s success in expanding into new product categories can be attributed to the company’s strategic decision to position itself as an Italian food brand rather than just a pasta sauce manufacturer. This opens the door for Rao to permeate the entirety of Italian cuisine, including but not limited to pizza, pasta, and all manner of sauces. SOVO, which initially released pizza at just four stores, will expand nationwide beginning in 3Q23. Keep in mind that the pizza industry is a $7 billion one. Though I expect positive results in the long run, they won’t show up anytime soon because SOVO needs to strengthen its distribution channels and guarantee the quality of its products before it can launch aggressively.

Valuation

Using back the same DCF model I used previously, the IRR is now less attractive, mirroring the return that S&P could give (S&P historically has an IRR (total return) of 8% a year). The biggest difference between my model this time round is that SOVO is now trading at 28x forward PE which means it will face multiples compression over the next 10 years, representing a headwind to shareholder returns. However, the reality is multiple compression might come in earlier than expected, which means the headwind to returns could be larger. For instance, if multiples were to compress from 28x forward earnings to 23x in 2 years, that is a 9% headwind per year. As such, I think the valuation today is no longer attractive.

Conclusion

SOVO has demonstrated strong growth and momentum, largely driven by its Rao brand. The brand’s potential for increased household penetration, awareness, and distribution presents significant opportunities for continued growth. The company’s strategic expansion into adjacent categories, such as pizza, further enhances its prospects. However, despite its positive trajectory, the current valuation of SOVO is no longer attractive. Trading at 28x forward PE, the potential for multiple compressions poses a headwind to shareholder returns. While SOVO remains a business worth monitoring for the long term, I am changing my recommendation to a hold due to the rich valuation.