Since publishing my previous article on Conagra Brands (NYSE:CAG), I continued to write put options that were (and are) slightly out of the money. The option premiums are quite appealing, and I’d be happy to initiate a long position in the company as the strong financial results reduce the balance sheet risk.
Anyone expecting a post pantry-stocking blues was wrong
As I explained in the October article, Conagra’s financial performance in the first quarter of FY 2021 (which ended in August) remained pretty strong. Some readers thought this was mainly due to the pantry-stocking frenzy right after the outbreak of the COVID pandemic (Conagra’s Q1 runs from June to the end of August), but I’m happy to see the company’s Q2 performance confirms the trend. The revenue remains very strong while lower interest expenses help to increase the net income.
Source: SEC filings
As you can see in the image above, the H1 FY 2021 revenue came in at just over $5.67B, an increase of almost 9%. Meanwhile, the COGS increased by just 6% which means the gross profit (revenue minus COGS) came in at almost exactly $1.7B compared to $1.46B in the first half of FY 2020. The SG&A expenses also decreased although this was pretty much reverted during the second quarter. All in all, Conagra performed very well and thanks to the continuous effort to reduce the net debt and the lower yields on the debt markets, the interest expenses decreased by about 10% compared to the first half of 2020. The bottom line shows a net profit of $709.3M of which $707.8M was attributable to the shareholders of Conagra Brands. This works out to be approximately $1.45 per share.
That being said, my main investment thesis in October was based on the free cash flow rather than the net income, so I was very keen on checking up on Conagra’s free cash flow profile. After all, those incoming cash flows are more important than the paper profits to reduce the net debt as fast as possible.
Conagra reported an operating cash flow of $541M, but we still need to take the working capital changes into consideration. The total net investment in the working capital was approximately $400.7M. Adding this back to the reported operating cash flow results in an underlying adjusted operating cash flow of approximately $942M. I am also deducting the $13M in ‘payment of intangible asset financing arrangements’ and end up with $929M in operating cash flow.
Source: SEC filings
The total capex in H1 FY 2021 was about $282M. Much higher than the $184M in the first half of the preceding financial year, but even after taking the higher capex (which currently is trending at 1.5X the depreciation expenses) into account, the free cash flow result of $650M is quite impressive.
The current share count is just under 489M shares which means the free cash flow result is approximately $1.33 per share. That’s lower than the reported EPS, and that’s entirely attributable to the high capex which is substantially higher than the depreciation expenses. Conagra is still investing in growth which should result in additional operating cash flows going forward.
It’s also important to note the free cash flow guidance issued by Conagra includes growth capex, this was confirmed during the Q2 conference call.
Source: Press release
As the free cash flow guidance for FY2022 includes growth capex, the sustaining free cash flow will likely come in at in excess of $3/share.
What did Conagra do with the cash?
As Conagra still needs to focus on its balance sheet, it shouldn’t come as a surprise that’s what most of the cash inflow was spent on. First of all, while the underlying free cash flow was $650M, but a big chunk had to be reinvested in the working capital where the inventory build-up required a working capital investment of $247M.
This means Conagra’s net debt didn’t decrease by too much. As of the end of November, Conagra had $68M in cash, $980M in current debt and almost $8.3B in long-term debt for a net debt position of about $9.2B. That’s high, even for a company generating $2.6B in EBITDA using a trailing twelve month basis. This represents a debt ratio of just over 3.5 and that’s well within Conagra’s expectations.
Also keep in mind that as the investments in the working capital position are being released, the net debt will decrease again, so there will always be some seasonal fluctuations. In FY 2020 for instance, we saw a $230M investment in inventory levels during the first semester, but in the second semester there was a total $390M release from these inventories due to this seasonality.
The market still seems to be underestimating Conagra’s underlying performance. The official guidance for FY2022 calls for a free cash flow per share of roughly $2.70 while filtering out the growth capex indicates an underlying free cash flow result exceeding $3/share. Rather than just writing put options, I will likely also just buy the stock on the open market while continuing to write put options. A P30 expiring in June for instance, has an option premium of $0.70, which I think is quite generous for a resilient company like Conagra Brands. Writing a similar P30 with an expiry date in January 2022 (the year wherein the reported FCFPS will be around $2.70 and the underlying FCFPS will exceed $3) would get you an option premium of in excess of $2.50, and I think that’s just too good to pass up on.
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