ConAgra - Fully Valued Packaged Food Transition Play

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About: ConAgra Brands, Inc. (CAG), Includes: LW
by: The Value Investor
Summary

ConAgra continues to transition the business, and 2018 will be another challenging year in which investors need to have patience.

Shares trade at a full adjusted multiple and leverage is reasonable, but growth prospects continue to be dire, just like the rest of the industry.

Despite a recent pullback from $40 to $35, I am not finding the stock appealing yet. I would only start buying at around the $30 mark, provided that sales stabilize soon.

ConAgra Foods (CAG) praises itself for being an adaptable business, and that is what the business will need to be in this challenging packaged food environment. Over the past twelve months, ConAgra has wound down its bulk discounting practice - which has reset sales but provided a boost to margins - as it gradually aims to transform the business to be more active in growth areas.

That being said, ConAgra trades at 20 times current adjusted earnings, which is a steep multiple for a business that is expected to post (albeit smaller) revenue declines again this year, with margins close to reaching their target. Given this steep multiple, modest long-term revenue growth target (probably realistic), and lack of real margin improvements from current levels, I am not a buyer. This is even as shares have recently fallen from $40 to $35 per share.

On a historical basis, ConAgra is not cheap yet; shares have enjoyed a multi-year momentum run over the past decade. Appeal can only be found around the $30 mark in my opinion, as management has a lot to prove and has a daunting task with regard to creating shareholder value.

The Business

ConAgra has been in business for nearly 100 years. The company started out as an agriculture business and became a diversified conglomerate in the 1970s, and now it has become a pure play on branded food products.

Following the spin-off of the Lamb Weston (LW) business, ConAgra is a $8 billion business which mostly focuses on grocery and snacks (40% of sales) and refrigerated & frozen products (35% of sales). The company has a foodservice business that is responsible for 15% of sales, with the remaining 10% of sales generated abroad.

Some 90% of sales are derived from branded products which include a range of brands including Marie Callender´s, Chef Boyardee, Bertolli, P.F. Chang's, and SlimJim, among many others. Strong categories include frozen meals, tomato products, cooking sprays, microwave popcorn, whipped toppings and hot cocoa mix, among others. Besides the core business, the company, of course, has a stake in the Ardent Mills joint venture which recently has regained some operational momentum again.

ConAgra´s CEO Sean Connolly has admitted before that food conglomerates, including ConAgra, long benefited from synergies and scale, yet many have turned into bureaucracies over time. This results in complexity, lack of clarity and lack of decision making. To make ConAgra more nimble, the company is cutting complexity/costs and it is obsessing about growth again and brand strength as it aims to adopt the ¨founders' mindset¨ again. The company traditionally focused on discounting which boosted volumes, but this has resulted in operating margins lagging that of the wider industry by 3-5 points.

To deliver on the changes and higher margins, ConAgra has cut its headcount by 2,000 positions in 2015 and 2016 and implemented pay-for-performance practices. The company further aims to focus on value-creating brands which gain traction with millennials, in part by focusing on M&A deals that can aid the company in its transition. To learn more about this transition, the company discusses more strategic directions to change its business in this 259 page presentation!

What About The Business Performance?

Despite the good intentions about transforming the business, investors simply care about a good positioning in the future and current growth. But what about this growth? When can investors actually see it?

In December of last year, ConAgra posted its second quarter results, which revealed a 11.5% decline in sales to $2.09 billion. Adjusted for the sale of the commercial food business, which contributed $119 million in sales in Q2 in the year before, sales were down still nearly 7%. Excluding the impact of FX movements as well as divestments, underlying sales were down 5.5% on the back of less promotional activity and the wind down of lower margin businesses.

This allowed adjusted gross margins to improve by a full 250 basis points to 31.1% of sales. Underlying sales declines improved to minus 4.8% in Q3, while gross margins were up 180 basis points. Last week ConAgra posted the results for the final quarter of the year. Underlying sales declines improved to minus 3.6%, while adjusted earnings topped the initial guidance of $1.65-$1.70 per share, as final adjusted earnings came in at $1.74 per share. Note that GAAP earnings are much lower at $1.25 per share, with much of the discrepancy relating to impairment charges.

The company now operates with $251 million in cash, and $3.00 billion in debt, for a $2.75 billion net debt load. As of May of 2016, the company had pension liabilities of $944 million, and we of course still have to await the current stance of those liabilities for this year, especially following the spin-off of Lamb Weston - which undoubtedly resulted in some liabilities disappearing from ConAgra´s books. Furthermore, ConAgra made another $150 million contribution in Q4 of 2017 in order to tackle the underfunded status.

Sales hit $7.8 billion this year - which, combined with margins of 15.5%, translates into adjusted operating profits of $1.21 billion. After adding back $268 million in depreciation and amortization charges, adjusted EBITDA approaches $1.5 billion, for a 1.8 times leverage ratio based on net financial debt. If we assume that pension liabilities come in at $750 million at this moment, (a conservative guess) that leverage ratio increases to 2.3 times.

With shares trading at $35, the company trades at exactly 20 times adjusted earnings. That seems like a full valuation given the pressure on topline sales, although margins are improving. Leverage is reasonable, and so is the dividend yield of 2.2%.

2018 And Beyond

Following the spin-off of Lamb Weston late in 2016, shares have risen from $35 to levels in the low forties on the back of M&A speculation, before now falling back to $35 again. Speculation was driven not just by the overhang of 3G on the entire industry, but due to rumors that the company would like to buy Pinnacle Foods (PF) in the spring of this year.

We have seen the sequential improvements in terms of organic sales throughout 2017, but the 3.6% decline for Q4 remains quite large nonetheless. Despite these declines, ConAgra sees declines flatten out to a range of 0 to -2% this year, while adjusted operating margins are expected to improve further to 15.9-16.3%, translating into earnings of $1.84-$1.89 per share for the upcoming year. Most of these anticipated earnings improvements are being driven by share buybacks, which are expected to slightly exceed $1 billion in the upcoming year. What I do not like is the progress of divesting underperforming brands. The divestiture of Wesson oil looked to be executed at a soft multiple, as analyzed in this article. After all, even underperforming assets have their value.

The long term targets (i.e., for 2020) are not that impressive: the company is targeting 1-2% organic growth and operating margins of 16.5%, which more or less translates into a $2 earnings per share target by 2019/2020. As shares trade at $35 today, the company trades at market multiples already. Leverage comes in around 2 times, and growth is not that inspiring. Furthermore, ConAgra still has to deliver on the turnaround, including a stabilization of sales.

Final Thoughts

I must say that ConAgra´s strategy to focus more on sustainable and growing brands makes sense, but the same goes for the rest of the industry. That makes it harder to grow, as acquisition targets to drive this transformation are expensive. While ConAgra has made progress in terms of margins, sales remains sluggish, as valuations have gotten quite expensive. Shares traded in the $15s ahead of the 2009 crisis - in which shares dipped to the $10 mark before starting on a multi-year run to the low $40s this year.

While ConAgra´s operating margins on a GAAP basis came in at just 10% in 2007-2011, the company was a $12 billion giant at that point. Sales are down a third from that point (in part driven by the Lamb Weston spin-off). The number of outstanding shares has been cut by some 15%, which means revenues per share are actually down, in part offset by rising margins. Nonetheless, ConAgra has not made any gains in terms of earnings per share and book value growth over the past decade, while shares have doubled or even tripled, depending on the exact time frame which you look at.

Greater margins, M&A speculation and low-interest rates have driven shares higher, but I fail to see real growth and a margin of safety for that growth from here. Appeal can only be found if shares can be bought at a discount compared to the overall market, which makes me a buyer if shares hit the low-thirties.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.