Conagra Looks Appetizing

Conagra CAG has made many changes to improve its growth and profit margin profile since Sean Connolly stepped in as CEO in 2015. Significant portfolio reshaping has improved the company’s weighted average category growth to 2.4% from about 1%, by our estimate, while more-effective innovation practices have increased the level of incremental sales generated from new products to 17% of total sales from 9% despite a similar level of investment. In addition, the company’s total category-weighted market share increased to 29.0% from 27.4% the last four years, while adjusted operating margins improved to 16.5% from 10.8% over the past six years. We think the pandemic accelerated Conagra’s turnaround efforts, as the health crisis resulted in four and a half years of incremental new buyers and saved the company hundreds of millions of dollars in customer acquisition costs, according to management.

Conagra has significantly improved the effectiveness of its innovations by shifting its market research efforts from consumer surveys (which aren’t always predictive of purchasing patterns, although this is still a common practice in the industry) to more reliable behavioral data. The company also improved the efficiency of its marketing investments by shifting from traditional media to digital, which is more relevant and effective.

We expect 2% annual organic sales growth, which we think is underappreciated by the market. We also expect Conagra to realize over $1 billion in cost savings through fiscal 2022, with over $300 million in synergies from the Pinnacle Foods acquisition and over $700 million in supply chain efficiencies. These savings should drive a 250-basis-point improvement in operating margin to 19%.

We think investors fail to appreciate the improvements Conagra has made and perceive the company as continuing to operate in slow-growing categories with outdated brand-building efforts. The stock has materially underperformed the consumer defensive sector over the past three years and has experienced price/earnings multiple compression over this same time frame despite materially improved fundamentals. But Conagra is managing well in the current environment fraught with labor shortages, supply chain disruption, and inflation. We think the stock offers investors a healthy potential total return, as it trades 20% below our fair value estimate and yields 3.8%.

A Moat Remains Elusive

Conagra maintains market-leading brands in several categories, making it an important partner for retailers. And we acknowledge many positive changes implemented in recent years, which have improved the growth and profitability of the business. However, Conagra’s commitment to maintaining below-average investments in marketing (4.2% of revenue compared with the 5%-plus peer average) and research and development (0.6% of revenue compared with 1.3% for peers) weakens our conviction that Conagra can maintain its preferred status with retailers over the next 10 years, as required for a narrow moat designation. As such, we think Conagra has failed to secure an economic moat.

In addition to moats rooted in intangible assets such as brand strength or entrenched relationships with retailers, consumer products companies can also secure a competitive edge based on a cost advantage. However, we do not see evidence to suggest that Conagra has secured a moat based on this. We suspect Conagra’s numerous divestitures have helped the company simplify its operations, as it now participates in fewer, more focused categories. While we think these efforts enable Conagra to operate more competitively, we do not think it has led to an advantaged cost position.

When a company consistently reports economic profits (returns on invested capital in excess of its weighted average cost of capital), it suggests quantitative evidence of a competitive advantage, in our view. In the past six years since it spun off the Lamb Weston business, Conagra has consistently reported economic profits. Conagra’s ROICs including and excluding goodwill have averaged 8.9% and 21.1%, respectively, both in excess of our 6.5% estimate of the company’s cost of capital. However, the 2019 acquisition of Pinnacle Foods has caused Conagra’s consolidated ROICs including goodwill to fall from 10% to around 8%, given the lower returns of the legacy Pinnacle business and the addition of goodwill. Over the next five years, we expect Conagra’s ROIC including goodwill will average 7.8%, which is only 130 basis points above our 6.5% WACC estimate. The relatively low spread reduces our confidence in Conagra’s ability to report consistent economic profits going forward, supporting our no-moat rating.

Competition and Acquisitions Bring Risk

The packaged food industry is highly competitive, with many of Conagra’s peers having significant resources. Over the next five years, we expect Conagra’s investments in marketing and R&D will lag peers’. As such, we think it will be difficult for Conagra to keep pace with its categories over time.

Conagra has increasingly relied on acquisitions for growth, which could drive multiples higher, increasing the chance that it may overpay for assets and destroy shareholder value. Furthermore, integrating acquisitions comes with additional risks and can be complicated by differing cultures, systems, and processes. Acquisitions that are not integrated effectively can be disruptive to business, straining the company’s relationships with customers and distracting management from strategic priorities.

Walmart represented 26% of Conagra’s revenue in fiscal 2020 and 2021. If the retailer makes a material shift in its product offerings--to more natural selections, for example--to align itself with evolving consumer preferences, Conagra could lose valuable distribution.

Conagra’s most pressing environmental, social, and governance risks are related to food safety, the healthfulness of its products, and carbon emissions regarding the energy used for the company’s freezer-heavy supply chain. But as these risks are well managed by the company, with no material outstanding controversies, we do not expect any meaningful impacts to the company’s valuation.