Conagra Not All That Appetizing Right Now (NYSE:CAG)

It’s been a hard slog for Conagra (NYSE:CAG) shareholders for a while. Though there have been attractive pullbacks that have created good investment opportunities (particularly late 2018), long-term investors don’t have a lot to show for their patience, as the returns have lagged the S&P 500 by a pretty significant amount over the last five, 10, and 20 years. The performance has been better relative to packaged foods industry and consumer defensives sector, but still not exceptional.

Unfortunately, I don’t see much evidence that the trend is likely to change in investors’ favor any time soon. Concerns about brand equity seem at least partly valid, and while initiatives like modernizing plants would likely pay off down the road, it’s hard to see much reason to pay up for the shares and today’s price looks quite fair.

Core Weakness To Close The Fiscal Year

Conagra’s reported earnings weren’t bad relative to published sell-side estimates, but the quarter was made by an unexpectedly large positive contribution from the Ardent Mills business. While there is some countercyclicality here and I’m not saying the contributions should be ignored completely, the reality is that core Conagra results were lackluster.

Revenue rose just under 7% in organic terms, coming in just a bit shy of sell-side expectations. Volumes declined more than 6%, while price/mix contributed more than 13% to growth. Foodservice was the strongest segment (with 22% growth), and the only segment to beat expectations, as Refrigerated/Frozen (up more than 4%) and International (up 2%) missed, and Grocery/Snacks (up 7%) met.

Gross margin fell 140bp, as the company’s pricing actions haven’t completely offset cost inflation and some consumer trading-down has been evident. Operating income rose almost 14%, missing by about 3%, with operating margin rising 100bp to 15% (missing by 30bp). The operating result was helped by a 39% cut in advertising and promotional spending, something that will be tougher to replicate as Conagra wasn’t a big spender on that line item.

Mirroring the revenue performance, segment-level performance was mixed. Grocery/Snack profits were up 17% (with a margin of 22%), while Refrigerated/Frozen was down 6% (margin of 15%), and International was down 26% (margin of 8.7%). Foodservice was up 54%, with a margin of 10.1%; Foodservice was the only segment to beat expectations on margins.

Volume Erosion Is A Worry As Costs Remain High

One of the more concerning takeaways from the quarter is the 6% volume decline for Conagra’s brands in the quarter. While Campbell Soup (CPB) and McCormick (MKC) were in the same ballpark (and Kellogg (K) was worse, as per NielsenIQ data), it was still notably worse than recent trends for companies like General Mills (GIS), J. M. Smucker (SJM), and PepsiCo (PEP).

One of the main bear theses on Conagra is that the company has weak brand equity and that the company really doesn’t have much pricing power as a result – customers will simply leave Conagra brands for others if the prices go up too much. Making matters worse, the nature of Conagra’s business is such that it typically sees the impact of input cost inflation before some of its peers, as many of its inputs (chicken, dairy, etc.) are harder to offset than inputs like grains (where there are liquid futures markets).

Pricing is also a concern as Conagra’s brands tend to skew stronger to lower-income consumers. While some food demand is relatively inelastic, there has been a shift in mix as customers try to cope with double-digit price increases across the packaged food sector.

Looking at management’s guidance for FY’23, 4% to 5% organic revenue growth and “low teens” price leverage suggest worsening volume erosion, and I do have concerns about whether there will be some longer-standing share loss here.

Limited Levers To Offsetting Pressures

Unfortunately, there’s not a lot that ConAgra can do to offset pricing pressures and other operational challenges. Sourcing inputs like chicken and metal cans has been an industry-wide challenge, and there really aren’t many alternatives other than to pay what it takes to get the inputs – reformulating recipes is a long-term option, but often alienates at least some consumers.

Management has likewise talked about looking to introduce automation into its plants, but that takes time and capex spending and it won’t produce benefits for a couple of years. Cutting back on promotional spending has helped some, but Conagra was never a big spender (at least relative to some names), so I think this is a relatively shallow well to tap for earnings leverage over the next 12 to 24 months.

Likewise, there are some items below the operating line that will pressure reported earnings next year, including higher interest expense (more borrowing at higher rates to support working capital needs) and a higher discount rate on the pension.

As far as positives go … well, while the volume situation has been worse than some, it hasn’t been that far off the industry-wide trends, so I think the bear concerns about weak brand equity may be at least a little inflated. I also like the drive to automate, as I believe that could produce some solid gross margin benefits down the line. In the meantime, though, what Conagra could really use is some bulletproof brands that skew to higher-income consumers that are relatively less sensitive to cost inflation, but that’s true for most packaged food companies and it’s not something that Conagra has been especially good at it over its recent history.

The Bottom Line

“Modeling is hard” is a complaint that generally falls on deaf ears, but it’s relevant to mention in this case, as the impact of inflation on the outlook is significant. I expect prices to start easing in 2023, and I think Conagra is likely a low-single-digit grower on a core revenue basis, with maybe some upside to the lower end of the mid-single-digits.

I do expect cost pressures to ease over time, and I do think there are opportunities (like automation) to drive sustainably higher margins over time. That said, I don’t think Conagra can drive its free cash flow margins much beyond 10% on a sustained basis unless it can fundamentally change its brand equity for the good (desirable brands that can support wider margins). Even so, I expect core FCF growth on the lower side of the mid-single-digits.

Between discounted cash flow and return/margin-driven EV/EBITDA (12x, or $36), I think Conagra is basically fair valued. While Conagra does look cheap within its peer group by some metrics, I don’t think that alone makes for a compelling “buy” case, as there are some “cheap for a reason” counterarguments. A slide toward $30 might lead me to reconsider this as a value/recovery name, but at this point, I just don’t see a compelling story for either bulls or bears.