Investors in Campbell Soup (CPB) hardly reacted to the first quarter numbers which revealed solid growth in terms of volumes and sales, as the strength of the dollar will limit growth of sales and earnings into the rest of the year. The sales growth and operating cost control was quite encouraging I must say, as the company clearly believes that this operational excellence is not sustainable into the year, given the lackluster full year guidance.
Following a fair valuation, a very modest track record in terms of operational growth, and a fairly leveraged balance sheet, I continue to display caution.
First Quarter Highlights
Campbell reported healthy sales trends for the first quarter of its new fiscal year. Revenues were up by 4.2% to $2.25 billion, driven by a 5% jump in comparable sales. Sales growth exceeded expectations by the investment community, which anticipated sales to rise to levels around $2.22 billion.
While the sales numbers were solid, Campbell did face some margin pressure with gross margins being down by 120 basis points to 34.7% of sales on the back of cost inflation and higher supply chain related costs, among others. Of course cost inflation are reasons why margins were up, as pricing power to increase prices has been quite weak as well. In the conference call, management stresses that the gross margin compression was disappointing.
The company did a great job offsetting these costs headwinds in other areas. Marketing expenses fell to 11.0% of sales, a whopping 110 basis points reduction compared to the year before. One interesting factor, Campbell already spends a quarter of its advertising efforts on digital media. Administrative expenses fell by 80 basis points to 6.0% of sales as the company did not have to incur restructuring charges during the quarter while Campbell benefited from past cost saving programs as well.
As a result of the strict cost control in terms of operating expenses and overall sales growth, Campbell managed to grow its earnings by little over 36% towards $234 million. Amidst a constant share base, this resulted in earnings increasing by twenty cents to $0.74 per share, coming in two cents ahead of expectations by the investment community.
Growth, Driven By Simple Meals
The reported revenue growth largely resulted from the improvements at the simple meals business at which sales were up by 8% to $928 million, being entirely the result from a better mix and higher volumes on the back of strong soup sales. The introduction of the Slow Kettle varieties have been a key driver behind the growth as well as the introduction of new sauces varieties. Profitability of the largest segment was up 15% to $242 million, for a contribution margin of 26.1% of sales.
The baking and snacking business posted a modest 3% increase in sales to $627 million on the back of a 5% jump in volumes which came on the back of a 3% impact of promotional spending. Despite the increased promotions, profit contributions were up by 15% towards $90 million, resulting in margins improving to 14.4% of sales.
Bolthouse and foodservice sales were up by 4% to $343 million. Despite the modest sales growth earnings have been taking a beating. Earnings have been down by 29% to just $22 million, resulting in relatively poor margins of just 6.5% of sales on the back of quite some compression in terms of gross margins.
The smallest two divisions of the business have been struggling. Sales at the international simple meals and beverages unit were down by 2% to $189 million as earnings plunged by a fifth to $16 million. Adverse currency movements and a soft performance in Latin America were the drivers behind the disappointment. US beverage sales were down by 3% to $168 million, but despite this sales shortfall earnings improved by 8% to $26 million.
In general the impact of deals and currency moves has been limited for most of the subdivisions with overall sales growth matching comparable sales growth. This has not been the case of the international simple meals business which saw sales fall by 2% as reported due to divestitures and adverse currency movements, as organic growth for the unit actually came in at plus 5%.
CFO Anthony DiSilvestro was pleased with the first quarter performance, but warns for currency headwinds creating a greater headwind throughout the remainder of the year. Cost inflation which ran at a rate of 4% in the quarter, is seen at 3-4% for the entire year, which is quite significant. Following this cost inflation, gross margins are seen down 50 to 100 basis points this year.
As a result, Campbell already has to cut the full year guidance, although he stresses that adjusted for currency moves, Campbell is maintaining its guidance. Currencies will now hurt sales by roughly a percent and earnings by three cents per share.
Consequently, full year adjusted sales are seen flat, or could potentially increase by 2%. Adjusted earnings are seen flattish as well, expected co come in between $2.42 to $2.50 per share, with the company previously anticipating earnings of $2.45 to $2.50 per share. Despite the fact that Campbell lowered the low end of the earnings guidance, the midpoint still matches expectations at $2.46 per share. As discussed above, the guidance which essentially calls for flat adjusted earnings and sales appears to be a bit disappointing given the solid start to the year.
Fair Valuation, Keep An Eye On The Leverage Position
At the end of the quarter, Campbell held some $239 million in cash and the company's debt load came in at $4.07 billion, resulting in a net debt position just north of $3.8 billion. This debt position is quite sizable with the company having posted trailing EBITDA of some $1.3 billion, resulting in a 2.9 times leverage ratio based on reported EBITDA, a sizable ratio. In terms of net earnings the debt position comes in around 5 times GAAP earnings, which simply is a sizable ratio.
With some 316 million shares outstanding currently, and those shares trading at around $44 per share, equity in the business is currently valued at around $14 billion. This results in a valuation for the business, including the net debt holdings, of roughly 2.1 times trailing sales of $8.3 billion. The company is furthermore valued at a steep 13-14 times EBITDA multiple as the equity trades at an anticipated 18 times earnings for this year.
Updating On The Business And Environment
In the summer of this year, Campbell Soup last held its big investor day. CEO Denise Morrison stressed the challenging consumer environment, cautiousness displayed by households as well as general economic uncertainty. The company stressed the continued emergence of value chains while consumers at the same time demand more transparency, as well focus more on their health and well-being.
The company furthermore clearly stressed the pressure on the middle-class in terms of real income developments, all being clear negatives for the business. At the same time the global middle class is expanding, driven by Asia becoming more affluent.
To operate in this difficult environment, Campbell continues to focus on cost initiatives and productivity efforts, dealing with the ¨new normal¨ for the food industry as it calls the current operating environment. The company has already reshaped the business by divesting the simple meals business in Europe which for a long time has been a troubled child, moving into Asia and Mexico instead. These moves have not had a great impact yet on the reported sales for instance, but they do improve the growth profile of the business.
Additionally, I must say that traditional soup out of cans doesn't really resonate with the millennials, who often opt for fresh soups or other innovations in key areas in which Campbell focuses itself.
Thoughts For Investors
Campbell remains a very defensive income play as the company has grown the business by just 10% since 2005 in terms of sales, not even keeping track with inflation over this time period. Net after-tax profit margins have largely ranged between 9-11% of sales, as the company has used cash to be returned to its investors. Of course this modest past growth all relates to the difficult economic times which the middle class in the US and in major other parts of the world have seen over this time period, having seen their discretionary income being severely pressured.
Investors in Campbell currently receive a 2.8% dividend yield, which over the past decade has been accompanied by sizable and continued share repurchases, with the company having repurchased roughly 25% of its share base over the past decade. This has resulted in the debt load increasing quite a bit over the past few years.
Following the focus on return of capital through dividends and share repurchases, the performance in terms of the share price has been very modest over the past decade, although shares trade at the high end of the long term trading range. Trading at market equivalent multiples of around 18 times earnings, the valuation is full enough already in my eyes.
While the dividends are appealing, the lack of current and historical growth, combined with a fair bit of leverage on the balance sheet, are my main reasons to remain cautious. Furthermore, note that predictable cash flow companies like Campbell in this low environment are seen as a combination of a bond and equity-like investment, making shares probably vulnerable to rising rates. Yield investors should keep a close eye on the yield difference versus Treasuries.
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