ConAgra Foods, Inc. (NYSE:CAG), one of the largest packaged foods companies in North America and the subject of this research report, has very many appealing attributes. The company's business itself, for one, is attractive, especially in the prevailing slow-growth environment, since the food industry is relatively insensitive to the vagaries of economic cycles. This reality is evident in the fact that the 95-year-old concern has been consistently, predictably, and solidly profitable through most of its history. That's not all, excluding a four-year stretch in the second half of the past decade (reviewed in greater detail below), per-share earnings have risen year after year for a good part of the last 30 years, at least. This has allowed the company to increase the annual dividend payout in 29 of the past 30 years; it should be noted, however, that the one exception is significant, in that the quarterly distribution was cut from $0.273 to $0.18 in the spring of 2006, a reduction from which the recovery remains incomplete.
Also appealing is the issue's depressed valuation. The stock market, as represented by the Dow Jones Industrial Average and Standard & Poor's 500 Index, is once again making forays into new territory as investors anticipate and discount the economic vitality and vigorous earnings growth that has been elusive for so many years. Food sector equities too have soared of late, lifted by the bidding war that engulfed several components, notably Pilgrim's Pride (NYSE:PPC), The Hillshire Brands (NYSE:HSH), and Tyson Foods (NYSE:TSN). ConAgra shares certainly haven't participated in the rally, though, trading at a roughly 23% discount to the market, on a six-month trailing and six-month prospective basis. The prevailing 14.2 price/earnings ratio is also well below many of its sector peers, and today's closing price is 12.0% below the 52-week high of $37.28 set last August. The stock's comparative weakness most likely reflects Wall Street's lowering of earnings expectations as the company copes with both the absorption of a recent, relatively large acquisition that already had some problems and other operational challenges.
We think the current quotation amply discounts the challenges, noting that the company is not only solidly profitable, the challenges notwithstanding, but also probably posted its fifth consecutive bottom line record in the just-concluded fiscal year (ended May 25th). Moreover, our expectations are that share-net advances will accelerate in the years ahead as ongoing efforts to increase revenues, improve cost-efficiencies, and expand profit margins bear fruit. The better integration of the aforementioned acquisition ought to help, too, with the potential for considerable synergistic benefits. Moreover, the bottom line should be augmented by the implementation of management's plan to aggressively pay down debt, a task that will be facilitated by the company's prolific cash flow. The improving earnings picture we envision, meantime, will probably be accompanied by an increase in the P/E multiple. All things considered, we think CAG shares will generate mid-teens annual total returns over the next three to five years, buttressed by an above-average dividend yield; the mid-point of our three-to-five year price targets is $55.
ConAgra Foods, Inc. is one of the largest packaged food companies in North America, with branded and private-label products found in 99% of America's households, sold through grocery, convenience, mass merchandise, club, and drug stores. The Omaha, Nebraska-headquartered concern also has a robust commercial foods business, supplying frozen potato and sweet potato products, as well as other vegetable, spice, bakery, and grain products to restaurants, foodservice operators, and commercial customers globally. Its balanced portfolio of products include well-recognized consumer names, such as Chef Boyardee, Egg Beaters, Healthy Choice, Hebrew National, Hunt's, Orville Redenbacher's, PAM, Peter Pan, Reddi-wip, Slim Jim, and Snack Pack. As well, the January 29, 2013 acquisition of Ralcorp Holdings, Inc. made ConAgra the largest provider of private label packaged food in North America, with annual sales of approximately $4 billion.
The history of the company begins in 1919, when it commenced operations in Nebraska as a flour milling enterprise. A seemingly never-ending series of acquisitions, divestitures, and organic developments have transformed ConAgra over the past 95 years. The current business composition includes three reportable segments - Consumer Foods, Commercial Foods, and Private Brands - that are supported by some 34,840 employees, most of them in the United States. Mass discounter Wal-Mart Stores, Inc. (NYSE:WMT) was its largest customer in each of the past four fiscal years (ended last Sunday in May), accounting for 17%-18% of consolidated net sales, mostly in Consumer Foods and Private Brands. In fiscal 2013, the last year for which final results have been reported, sales to foreign customers totaled a relatively modest $1.9 billion, or 12.3% of aggregate worldwide revenues.
ConAgra faces stiff competition in all major markets for most of its principal products, which compete with other widely advertised, well-known branded merchandise, as well as with private brand and customized products. Competition is waged on the basis of quality, value, customer service, brand recognition, and brand loyalty. Seasonality is not a huge factor, but demand for certain products is influenced by holidays, changes in seasons, and other annual events.
A Perpetual Work-in-Progress
ConAgra began its corporate life as a flour-milling enterprise, as noted above. It subsequently entered other commodity-based business, and was a low-margin provider of commodity-type products through a good part of its long history. Its business composition changed dramatically in the past decade or so, though, with the divestiture of commodity-based businesses and systematic acquisition of value-added brand name products, such as Banquet, Chef Boyardee, PAM, Marie Callender's, and Alexia. The poultry, beef, and pork businesses were jettisoned in the latter half of the past decade, as were operations that included dehydrated garlic, onion, capsicum, and fresh vegetables. Asset sales generated cash proceeds of more than $4 billion in the past decade, while acquisitions cost a few billion dollars more. Recent additions include Unilever PLC's (NYSE:UL) Bertolli and P.F. Chang's Home Menu frozen meals businesses. They also include Del Monte Canada and National Pretzel Company. That said, the most significant was the January 2013 purchase of Ralcorp Holdings, Inc. for $5.1 billion. The relative newcomer manufactures private brands of products, including: ready-to-eat and hot cereals; nutritional and cereal bars; snack mixes, corn-based chips, and other snacks; frozen and refrigerated dough products; dry pastas and frozen pasta meals; and many others.
The changing portfolio of businesses, essentially a moving up on the food chain, has produced a notable improvement in profitability. Indeed, operating margins have expanded considerably over the past several decades, moving up from the 4% neighborhood in the 1980s, 6% and 7% in the 1990s, barely in double-digits last decade, to the low teens in recent years. On the downside, the many changes have also resulted in a variety of special items - capital gains, restructuring charges, and impairment charges, etc. - that have obscured year-over-year earnings comparability. Of note, too, in the second fiscal quarter of 2014, management announced that it had implemented organizational changes, due to the Ralcorp acquisition, that resulted in the three reporting segments detailed above, as opposed to the four that had existed previously.
Looking forward, reported results in fiscal 2015 will reflect the recent formation of Ardent Mills, a joint venture with Cargill, CHS, and HM Luxembourg that began operations on May 29th. With a 44% equity interest, ConAgra will be entitled to JV earnings, but results of the Commercial Foods segment will no longer include the roughly $1.8 billion top line contributions from what was the ConAgra Mills division. Factoring in about $450 million in cash proceeds that will be used to be repay debt, the bottom line impact from this transaction will probably be very modest, perhaps dilution of a penny or two in the current fiscal year. (Note: The exclusion of the low-margin milling business will result in higher operating margins.)
Consumer Foods (41.7% of revs. in 2014's first three quarters; 51.1% of op. profits)
The Consumer Foods reporting segment includes branded food products, which are sold through various retail channels, mainly in North America. The products include a variety of categories (meals, entrees, condiments, sides, snacks, and desserts) across frozen, refrigerated, and shelf-stable temperature classes. Major brands include: Alexia, ACT II, Banquet, Blue Bonnet, Chef Boyardee, DAVID, Egg Beaters, Healthy Choice, Hebrew National, Hunt's, Marie Callender's, Odom's Tennessee Pride, Orville Redenbacher's, PAM, Peter Pan, Reddi-wip, Slim Jim, Snack Pack, Swiss Miss, Van Camp's, and Wesson.
Segment sales for the third quarter of fiscal 2014 were $1.87 billion, a decrease of $68.6 million compared to the third quarter of fiscal 2013. For the year's first three quarters, sales were down 1.7% to $5.54 billion. Results for the three quarters reflected a 2% decrease in volume from the base businesses, with price/mix essentially flat, and an immaterial impact from foreign exchange rates. Volume was hurt by promotional activity by competitors. Additionally, significant slotting and promotion investments related to new product launches weighed on pricing/mix. Sales of Bertolli, Hebrew National, Libby's, Reddi-wip, Ro-Tel, Slim Jim, Swiss Miss, and Wolf increased in the third quarter of fiscal 2014 as compared to the third quarter of fiscal 2013. On the flip side, sales of the following key brands declined: ACT II, Andy Capp's, Banquet, Blue Bonnett, Chef Boyardee, Crunch 'n Munch, DAVID, Healthy Choice, Kid Cuisine, La Choy, Manwich, Orville Redenbacher's, PAM, Parkay, PF Chang's, Rosarita, Snack Pack, Van Camp's, and Wesson. Operating profits, meantime, increased nominally (to $266.3 million) in the third quarter, while slipping modestly for the three quarters (from $730 million to $722.3 million).
Commercial Foods (34.4%; 34.9%)
The Commercial Foods segment principally includes commercially branded and private brand foods and ingredients that are sold primarily to foodservice, food manufacturing, and industrial customers. The segment's primary products include: specialty potato products, milled grain ingredients, and a variety of vegetable products, seasonings, blends, and flavors, which are sold under brands such as ConAgra Mills, Lamb Weston, and Spicetec Flavors & Seasonings, as well as frozen bakery and ingredient products. The recent formation of Ardent Mills will lead to the deconsolidation of ConAgra Mills Products from ConAgra's results.
Segment sales were $1.46 billion in the third quarter of fiscal 2014 and $4.56 for the first three quarters of fiscal 2014. By comparison, they were $1.47 billion and $4.46 billion in fiscal 2013's comparable periods, respectively. The $108.1 million year-over-year improvement for the three-quarter stanza reflects a 4% boost from the acquisition of the frozen bakery business of Ralcorp. This was mitigated by a 6% slump in sales volume, due to adverse industry trends and poor weather. Operating profits fell 12.2% (to $163.5 million) in the February period and 8.9% (to $493.8 million) in the first three quarters.
Private Brands (23.9%; 14.0%)
The Private Brands reporting segment principally includes private brand and customized food products that are sold in various retail channels, predominantly in North America. The products include a variety of categories, including: cereal products; snacks, sauces, and spreads; pasta; and frozen bakery products. The segment is newly created, and includes a significant portion of the results of the former Ralcorp businesses and the store brands results that were previously part of the Consumer Foods segment. The addition of Ralcorp made ConAgra the largest private label packaged food company in North America, with annual private brand sales of about $4 billion. Private label or brand (sometimes called "store brand") products often are less expensive than competing goods, which can increase their appeal to cost-conscious consumers.
Private Brands' net sales were $1.06 billion in the third quarter of fiscal 2014, an increase of $635.4 million compared with the third quarter of fiscal 2013. They were $3.17 billion for the first three quarters of fiscal 2014, an increase of $ 2.39 billion over the figure for the first three quarters of fiscal 2013. The huge increases reflect the timing of the Ralcorp acquisition, which render the year-over-year comparisons meaningless. It is important to note, however, that sales and profits for Private Brands continue to be softer than expected, due in part, to issues that pre-dated the acquisition. Management continues to focus on rectifying the situation, working on improving sales force coverage, pricing strategies, customer service levels, and plant efficiencies. As well, the company has made pricing concessions to protect volumes as the challenges are being addressed. In the meantime, the segment posted operating income of only $198.1 million for the year's first three quarters, reflecting a profit margin of just 6.3%. By comparison, the Consumer Foods and Commercial Foods segments reported operating margins of 13.0% and 10.8%, respectively.
An Ongoing Restructuring Program
ConAgra is engaged in a broad-based restructuring program that's geared towards generating operational improvements essentially throughout the company. Some of the initiatives derive from a plan that was approved by the board of directors in early 2011 related to optimizing the performance of its manufacturing and distribution infrastructure, which calls for, among other things, the disposal of certain manufacturing facilities and other underutilized assets. Others include the continuation of activities that were initiated by Ralcorp's management prior to ConAgra's acquisition of the business. All in all, the restructuring program is designed to generate sales growth and boost profit margins through enhanced marketing and innovation strategies; reduced costs in the supply chain and general and administration functions; and fine-tuning of the business portfolio. The initiatives to improve SG&A outlays alone are expected to result in at least $100 million of annual cost savings by the end of fiscal year 2016. As well, the ongoing integration and restructuring of Ralcorp is expected to yield some $300 million in synergistic and cost benefits.
Unexciting but Consistent Profitability
As of February 23, 2014, ConAgra's balance sheet was debt heavy, with long-term and total debt totaling $8.8 billion and $9.5 billion, respectively, compared with cash of just $239 million and equity of $5.6 billion. Long-term indebtedness soared $6.0 billion in fiscal 2013, reflecting mainly the Ralcorp transaction. Interest expense in fiscal 2014's first nine months totaled $286 million. The relatively steep financial leverage isn't too worrisome, however, given both the recession-resistant nature of the company's businesses and its lengthy history of year-after-year profitability. Indeed, other than a four-year stretch that began in the middle of the last decade, earnings per share moved mostly upwards during at least the past 30 years; results in 2005 to 2008 were hurt by a plethora of challenges, including significant inflation in fuel, transportation, warehousing, and packaging costs; and a financial crisis that triggered a near-depression and froze consumer spending. It's important to also note that the company was profitable in each of the four "difficult" years, earning a total of $2.5 billion during those years; the worst performance during that period was in 2008, when net income totaled $519 million.
Myriad Challenges are Restraining Current Results…
Each of the packaged food concern's three business segments is performing sub-optimally. Consumer Foods revenues and profits were down slightly (1.1%) in fiscal 2014's year-to-date results, with just the final three-month period left untallied, pressured on multiple fronts. Many of the important brands are struggling to simply maintain volume in a tough retail environment, which in turn, severely limits pricing flexibility. Bottom line contributions from the Commercial Foods segment were off even more in the year's first three quarters, falling 12.2%. The loss of a major foodservice customer towards the end of fiscal 2013 significantly hurt the Lamb Weston potato business. Margins were also squeezed by an unfavorable shift in the customer mix, as well as by an inferior potato crop. Last, as noted above, the recently enlarged Private Brands segment continues to generate sub-par results, struggling with both (Ralcorp) legacy and sales force and supply chain transition issues. The company has had to make pricing concessions to remain competitive and protect volumes, but the trade-off is margin erosion.
… But Share Net Likely to Remain in Uptrend for Foreseeable Future
Multiple acquisitions and divestitures over the past several years obscure top line comparisons. Significantly, though, the bottom line has risen in each of the past five reported years, with the last four tallies representing new all-time records. That's not all, despite the challenges detailed above, the company will probably report later this month (around June 24th) that fiscal 2014 was another record-setting year in terms of per-share earnings. Share net was 3.2% (or a nickel) ahead of the year-earlier figure, with just the final quarter left to be tallied, and we expect full-year earnings of $2.24 a share; management's guidance is for $2.22-$2.25, excluding nonrecurring items.
Looking ahead, we think ConAgra will earn $2.40 a share in fiscal 2015, after which our expectations are for bottom line advances to accelerate. Our optimism for the long haul is based on the following: Initiatives to expand the company's presence in international markets, particularly in Asia and Latin America, where rising standards of living provide the best growth opportunities, are paying nascent dividends, and this augurs well for the Consumer and Commercial Foods segments; Organizational, pricing, and customer service improvements in the Private Brands business ought to pay off on the bottom line too, at least gradually; Beyond the operational improvements that should derive from ongoing efforts to lift revenues, boost efficiencies, and widen profit margins, a steady and ample cash flow affords management substantial flexibility to enhance share-net gains through treasury department activities.
ConAgra has historically been very aggressive in buying back its own equity - a net 110 million (almost 21% of the shares outstanding) in the past 10 years - and additional repurchases are certainly possible in the years ahead. That said, for the next few years, we fully expect the company to allocate most (if not all) of its substantial "free cash flow," which represents the cash available after meeting capital expenditure and dividend requirements, to rapidly paying down debt and achieving a more palatable capital structure; management's debt reduction target earlier this year was $1.5 billion by the end of fiscal 2015, a figure that didn't include the proceeds from the Ardent Mills transaction that will also be applied to cutting indebtedness. As such, debt-serving outlays should trend steadily downwards in the quarters and years ahead, from the $95 million paid out in the February quarter. Net interest expense probably approximated $385 million in fiscal 2014, but should be considerably less in fiscal 2015, and lower still in the subsequent years. All things considered, our bottom line projections for fiscal 2016, 2017, and 2018 are $2.65, $2.95, and $3.30, respectively.
Broad-based operational challenges have impeded ConAgra's bottom line of late. The company's success, or lack thereof, meantime, has grounded the packaged food concern's equity, which hasn't kept pace with most other stocks. Looking forward, there's always the risk that the hurdles detailed above will prove more difficult to surmount than anticipated. All that said, the current stock price seems to already amply discount the difficulties ahead, and the current valuation and dividend yield provides a reasonably solid floor near-present levels. On the flip side, if management can successfully implement the various initiatives to improve results, as we expect, earnings growth will accelerate nicely, which, combined with a likely expansion in what Wall Street will be willing to pay for those earnings, out to fuel healthy capital appreciation out to the late decade. Factoring in an above-average dividend yield, which will pay investors to wait for the bottom line improvement, investors stand to earn very attractive total returns over the next several years.
Disclosure: The author is long CAG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.