ConAgra Foods (NYSE:CAG), a company that holds honorable repute in the North American processed and packaged food industry, was unable to meet the top line projections during the second quarter of the fiscal year 2015. This may have shattered the investor's confidence for now in this stock. However, the company is trying to cover up its current loss through active investment in high growth business areas like its potato business. In this article, I will analyze the potential return that the company's investment can generate and the nature and persistence of the company's underperformance.
Investment Appraisal Of Potato Processing Expansion
ConAgra witnessed positive sales and income growth in its foodservice brand, Lamb Weston, during the second quarter of the fiscal year 2015. This was achieved as it continued to diversify and fortify its customer base resulting in increased market share and greater investments in assets abroad. Keeping in view the profit potential that this business segment upholds, the company has decided to increase its investment in this high growth generator.
The company's Lamb Weston foodservice brand has recently teamed up with Meijer Frozen Food in Netherlands to expand its potato processing operations in the country. The joint venture will make an investment of $150 million to achieve the planned expansion for making chips and other frozen potato products. Being a one-time strategic investment today, it will start contributing revenues from mid-2016.
I have conducted an investment appraisal of the company's investment decision in order to determine the return generation capacity of the respective production plant. To begin with, a joint venture between the two companies shows that both parties will be contributing half of the total investment required i.e. $75 million each. I have applied the sector's asset turnover "ttm" to ConAgra's share of the asset size to derive the expected revenue addition from the installation of this production plant. Staying conservative, I have assumed the capacity utilization of the plant to be 25% in the year of commencement of operation, increasing to 60% in the following year and 100% thereafter. I have applied the EBITD margin "ttm" of the company to the incremental revenue to calculate EBITD and then, the effective tax rate of 35% to derive free cash flows. The terminal value has been determined by dividing the revenue of 2018 by the required return, assuming no further growth as the plant is already operating at 100% capacity.
Weighted average cost of capital "WACC" has been calculated by multiplying the cost of equity and cost of debt with the proportion of equity and long term debt on the company's balance sheet. Cost of debt has been computed by annualizing the interest expense of the recent quarter and dividing it by the long term debt reported at the end of the second quarter of the fiscal year 2015. An effective tax rate of 35% was applied to derive the after-tax cost of debt of 2.80%. Cost of equity was determined by using the Capital Asset Pricing Model "CAPM". Risk-free rate is assumed to the prevailing 10-year Treasury yield and the market risk premium used is 8%. This gives cost of equity of 6%. Plugging these figures into the formula, WACC is derived to be 4.05% which was used to calculate the discount factor.
The present value of free cash flows has been computed using the discount factor to assess the feasibility of the investment undertaken. Netting off the investment, the net present value "NPV" is $140 million. The positive NPV is a green signal for the shareholders that the undertaking of this plant expansion will create value for them.
Recent Operational Performance Summary
Top Line Story
ConAgra's top line has witnessed a decline of 1.70% during the second quarter of the fiscal year 2015 compared to the corresponding period a year ago. The company's two segments i.e. Consumer Foods and Private brands experienced negative sales growth. Only the Commercial Foods segment was able to post positive sales growth where the respective divisions' sales increased by 1.90% as the company gained new business in the home market. On the contrary, the Consumer Foods segments' sales dropped by 1.90% due to an equivalent decline in volume and price mix whereas sales in the Private Brands division plummeted by 4.80% owing to the negative growth in volumes sold by 6%.
Bottom Line Snapshot
Source: Company s Press Release
Ostensibly, the company's bottom line performance seems to be depressing. However, delving into the detail shows that the company had charged goodwill impairment with respect to its underperforming Private Brands segment and is non-recurring non-cash in nature. Hence, for analytical purposes, I have adjusted the diluted EPS which shows that the company's performance has actually improved by 8.93%.
The company is investing in its high growth segments to cover up for the slower than expected recovery in its private brands segment. On the premise of the company's recent investment decision and adjusted financial performance assessment, ConAgra Foods makes an attractive investment choice.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.