One of our favorite top US food producers ConAgra (CAG) will be reporting third quarter 2011 earnings on March 24th. We thought it might interest readers to show them what indicators and clues our dual cash flow and accrual model was telling us about CAG.
Before we begin, investors should be aware that the biggest challenges facing packaged food makers in this environment are sky-rocketing commodity prices, intense competition and brand loyalty.
Protecting market share in this business comes at a great cost, usually extracted in margin erosion or a hit to equity from write-downs or charges. Consumers enjoy the luxury of walking into a grocery store and finding at their fingertips a tremendous range of options, brands and prices to choose from.
The grocery stores for their part, realize how important it is to have you in their store and they want you to come back...again and again. Grocers (with exception of niche players such as Whole Foods (WFMI), Trader Joe's, etc,) scramble just to generate 2-3 cents of profit margin for every dollar-of-sales. It’s one of the lowest margin businesses we know of.
Downstream on our farm-to-fork journey are the many companies that produce and market all the products that consumers want or need. Before a consumer even steps inside a store, the grocer, distributors and the vendor(s) are busy cutting deals for shelf space, price concessions, rebates, you name it.
We venture to guess that 3 out of 5 shoppers probably have no idea about the events that occur to get food in their refrigerators. Investors though, need to focus on those producers who are skilled at leveraging their brand recognition and quality to a defiantly price conscious consumer.
An investor should also be watchful to potential disruptions in the food chain, such as weather related effect on commodity supplies, contamination, product recalls, etc.
ConAgra is a stock we have owned for many years. It is also an example, in our view, of a well managed company operating in a fiercely competitive industry. We also admire its ability to navigate very difficult economic conditions and generate healthy cash-flows to support earnings.
Notice that CAG’s dual cash flow trend (below) has been improving in recent periods. A look at the balance sheet shows consistency with inventory, receivables, days –sales-outstanding, etc.
(Click charts to expand)
One critical observation is the bump in accounts payable and 18% increase in other current assets during Q2. There is also a decline in Q2 operating cash flow (as a % of sales), but offset by a similar change in balance sheet cash flow. These changes if isolated are not a concern, but we will keep an eye on this going forward.
A greater concern is rising input costs as evidenced in Q2 declines in pre-tax, operating and net margins. CAG reports gains/losses from commodity hedges in the period in which the underlying item being hedged is recognized in cost of goods sold.
As you can see in the revenue metrics image above, the increase in Q2 COGS is only modestly higher than the average COGS for the seven previous periods. It is impossible to predict future commodity prices with any certainty, but we believe CAG is managing input price risks appropriately.
Accruals: CAG tends to be conservative with accounting and the accrual trend for the previous seven quarters (above) bears this out. This tells us that for the most part, treatment and reconciliation of adjustments to net income is fairly represented.
Operationally, management did cite disappointing Q2 promotional results. We like the fact they were up-front about this and we believe consumer sentiment will improve as the economy firms.
Goodwill / Intangibles: Goodwill levels as a % of assets and equity did rise modestly in Q2, but remain within median average(s) in the seven periods reviewed. The recent acquisitions of Elan Nutrition (Q4 2010) and American Pie, LLC (Q1 2011) added about $118m to goodwill, of which $51m is deductible for income tax purposes.
Given the strength of CAG’s product portfolio and anticipated synergies from acquisitions, impairment risk is likely minimal. We believe this is due in large part to the restructuring efforts and renewed focus on branded foods since CEO Gary Rodkin joined the company in 2005.
Summary: Based on dual cash-flow and accrual analysis for the seven periods through Q2 2911, we are maintaining an earnings quality grade of B+ for ConAgra. We are also encouraged that debt-to-asset levels declined to 27.8% in the latest quarter, a 220 basis points reduction from the avg. 30% for all periods.
Dividend: Pay-out ratio on CAG’s dividend is 54% of earnings versus an industry average of 33%. We believe the current $0.92 annual distribution rate is sustainable based on the 6.94% earnings yield and company’s history of generating solid operating cash-flow. Management has also shown proficiency at recycling capital.
If you own CAG shares presently, the attractive 4% yield pays you well to hold them. Investors looking for an entry point might want to consider waiting for a pullback to $21 or under. CAG shares are currently trading 7% above our estimated fair-value of $21.65.
Takeover appeal: We agree with other analysts that ConAgra could be a potential target of private equity. The $28-30 price target we’ve heard mentioned appears reasonable with the lower end of that range a more likely scenario in our view. The LBO scene is heating up with food related companies (Arby’s is one). You can view our full analysis of CAG here. (pdf)
Disclosure: I am long CAG.