Why Packaging Changes Could Help Campbell Soup Deal With Margin Issues

| About: Campbell Soup (CPB)
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Summary

Campbell Soup's gross margin dropped for the quarter.

Health-focused companies have increased their use of food pouches as an alternative to cans.

Food pouches could drive margin improvement for Campbell Soup.

Campbell Soup (NYSE:CPB) reported earnings on November 25 and after some fluctuation, the stock ended up higher for the week with a jump of 1.9% on Friday. While the soup company had a decent quarter, with 5% organic sales growth, it also cut its guidance. The company also mentioned two factors that were dragging down its profits, supply chain costs and currency translation issues. While it's very difficult to predict future exchange rates, the company did discuss a way to deal with rising costs on the call that could result in better-than-expected performance.

The Appeal

While Campbell Soup is a blue chip that currently offers a 2.8% dividend, the soup company currently trades at a discount to its industry. On Monday it was trading at a P/E ratio of 16, below the industry average of 20. This is much lower than the valuation of the health-focused Hain Celestial (NASDAQ:HAIN) as well, which had a 44 P/E on the same date.

However, Hain looks like the less expensive stock under another metric. Yahoo! Finance currently lists a five-year expected PEG ratio of 5.2 for Campbell Soup, much higher than Hain Celestial's ratio at 1.8. So it appears that Campbell Soup could be selling at a discount because analysts expect limited earnings growth for the company, and the guidance cut supports this argument. However, a look at why Campbell Soup cut its guidance shows that its long-term earnings could be better than investors expect, which could result in a higher valuation later.

Gross Margin

Campbell Soup cut its income expectations partially because of higher costs; its gross margin fell from 35.9% in the year-ago quarter to 34.7%. CFO and SVP Anthony DiSilvestro pointed out two reasons why Campbell's gross margin dropped on the earnings call. First, higher aluminum costs hurt the company. Aluminum prices at Kitco show a definite jump this year; while aluminum cost around $0.80 per pound a year ago, the metal now costs close to $0.90 per pound. Although the five-year price chart for aluminum shows a longer-term downtrend, a reversal of that would be a negative for Campbell. According to the company, the rise in aluminum prices did not affect costs for its soup containers, since they are made out of tin-plated steel, but Campbell does use aluminum in beverage containers. Second, freight and production costs were also important factors for the company's margins this quarter, according to the company. In addition to these cost issues, Campbell has to deal with the perception of its products as well.

Health Focus

Companies with health-focused brands like Hain Celestial have been showing rapid growth recently. This has raised the prominence of health-focused companies and driven acquisitions in the industry; for example, General Mills (NYSE:GIS) bought Annie's (NYSE:BNNY) in September, and Campbell Soup bought Bolthouse in 2012 and Plum Organics in 2013. One way for food manufacturers to create a healthier image for their products is by packaging them in food pouches; an article by Carmen Lobello at The Week explains that food pouches provide the impression of freshness, which appeals to millennials. Monica Watrous, at Food Business News, explained that Hain expanded its product line in this area when it bought British food manufacturer Tilda, which offers rice pouches. Companies that successfully brand their products as healthy, such as Hain and Annie's, can also charge premium prices for their products. Campbell's recent purchases show that acquisitions play a part in its growth strategy, so there is a risk that General Mills, Hain Celestial, or other food companies will buy up the targets first.

Campbell's Strategy

Campbell Soup could address its gross margin issues and improve its competitive position by offering more food pouches. Lightweight plastic containers could help Campbell deal with fluctuations in costs for tin-plated steel and possibly reduce its freight costs. In addition to this, food pouches could fetch higher prices from shoppers who want fresh food, and Hain Celestial's recent acquisition indicates consumer demand in this market. Campbell Soup could have room to expand in this area. The article in The Week included a quote from an AP interview which explained that food pouches didn't make up a large portion of Campbell's soup sales a year ago. However, on the earnings call, CEO Denise Morrison discussed the company's move away from canned broth toward broth in aseptic containers, so the company has successfully changed its food packaging before. In addition to this, Plum Organics offers baby food pouches, so the company's current food pouch lineup includes more than just soups.

Conclusion

While the guidance cut is a definite negative for Campbell Soup in the short term, supporting its discount to its industry, there could be an opportunity here. The company clearly pointed out margin weakness as a source of its income weakness, and it could address that with food pouches. Watch for any announcements from the company about expanded food pouch offerings. That could set Campbell Soup up for higher margins and possibly lead to the company beating earnings estimates later.

Disclosure: The author is long HAIN.

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.