Campbell Soup's Too Hot

Cost-Cutting Wise, but Might Not Have the Legs the Market Expects Campbell set a course last year to shed some excess fat from its operations, and it appears these efforts are yielding improvements. Through the first nine months of fiscal 2016, Campbell's adjusted gross margins climbed 240 basis points to 37.4%, and its adjusted operating margins increased nearly 300 basis points to slightly above 19%. However, we don't believe that all of the factors presently propping up margins will persist in the longer term, although the market seems to disagree. We think the potential for more pronounced commodity cost inflation, increased investment behind brands in an effort to withstand intense competitive pressures, and a mix shift toward the lower-margin natural and organic channel and away from the highly profitable soup category are poised to hinder material margin gains from recent levels.

We think efforts to extract costs and drive efficiencies have accounted for around 45% of the firm’s enhanced profit levels of late. Campbell aims to realize $300 million in cost savings over a three-year period, up from its initial $250 million goal, and these savings are slated to be incremental to the 2%-3% in productivity savings it targets generating annually. This equates to around 4.5% of its cost of goods sold and operating expenses when excluding depreciation and amortization expense and runs in line with the 3%-7% earmarked at other domestic packaged food manufacturers.

We believe a portion of these savings are ensuing from extracting some low-hanging fruit: reducing unnecessary spending on travel, rationalizing IT infrastructure and consolidating vendors, and reducing the use of consultants. However, the firm is also working to drive increased efficiency across its supply chain and manufacturing network. Campbell closed five manufacturing plants (around 15% of its global network) and eliminated more than 700 positions (about 4% of its global workforce). In addition, it has been working to rationalize the number of packaging sizes and formats in order to remove complexity from its operations and simplify its manufacturing process while enhancing its leverage over suppliers. However, Campbell is just over a year into its current three-year cost-efficiency program, and supply-chain savings tend to be more back-end loaded, supporting our contention that other factors are contributing to its recent profit gains.

Even before its recent efforts, Campbell maintained a cost edge that, combined with entrenched retail relationships, forms the basis of our wide economic moat rating. Campbell’s current efforts should ensure that its cost edge is unwavering. We still believe that Campbell’s cost advantage should support further investments in product assortment and retail relationships to a greater degree than new entrants with limited budgets, ultimately creating a barrier to entry. When we strip out customer acquisition costs to compare the go-to-market cost structures of companies across the consumer staples industry, it is evident that Campbell’s scale, particularly in North America where the firm derives around 80% of its sales, affords a vast network over which to leverage fixed costs. When adjusted for expenses not directly linked to production and distribution, Campbell’s profitability and costs per employee run in line with or are superior to those of other global packaged food operators.

Commodity Cost Inflation Could Eat Away at Plumped-Up Profit Despite Campbell's pronounced margin gains through the first nine months of fiscal 2016, we see several headwinds that could stall this recent trajectory over the next few years. For one, although lower commodity costs have aided profitability (contributing around 15%-20% of recent margin gains, by our estimate), raw material prices have proved volatile over longer time horizons, and we don't anticipate that recent deflationary trends will persist. Campbell's largest exposure to raw materials includes inputs such as carrots, grains, sweeteners, cocoa, meats, and aluminum cans, and the prices of these inputs are likely to ebb and flow based on supply and demand in the longer term.

As such, we believe that bouts of unfavorable weather combined with heightened demand for commodities around the world will prompt accelerating raw material inflation at a mid-single-digit rate annually during the course of our 10-year explicit forecast horizon, weighing on Campbell’s profit in the longer term. While Campbell’s diversified commodity basket includes raw materials that aren’t actively traded, we examined the futures exchange market (CME) for input prices of grains, such as wheat, corn, and oats, which generally point to indicate higher prices through December 2017. This supports our stance that recent commodity cost deflation is unlikely to persist in the long term.

We don’t think Campbell will be able to offset these pressures (and ultimately maintain its margins) merely by raising prices, as volume could be constrained, especially during economic periods when consumers are highly selective in their purchase decisions. Brands can be a significant advantage for consumer product firms, but in our view, branded manufacturers should be able to garner value from their portfolio mix and pass through inflationary pressure to customers. We believe Campbell has fallen short in its efforts, failing to price in excess of inflation. Campbell’s price/mix, adjusted for inflation (as measured by the consumer price index), has averaged nearly negative 2% during the past three years, the weakest performance in its peer set.

Campbell’s deteriorating brand intangible asset partly stems from category issues, in our view. Ready-to-serve soup has fallen victim to increased competition from other simple meal categories, and global category growth has languished, holding about flat on average over the past five years. As the leading player in the space, Campbell has not been immune to these headwinds. For instance, after two consecutive years of U.S. soup sales declines (2% in fiscal 2012 and 6% in fiscal 2011), Campbell posted a 5% increase in fiscal 2013, but it has yet to prove this increase is sustainable, with lackluster sales in fiscal 2014 and 2015.

This degradation in its brand intangible asset has also manifested itself in market share losses over the past few years. Campbell still operates as the leading soup manufacturer on its home turf but now has just less than 59% share, down from 63% five years ago. While the share held by private-label players has held relatively stable over that time at around 12%-13%, the major winners in this share shift have been niche manufacturers--including General Mills GIS and other natural and organic firms that have taken advantage as consumers have sought out fare they perceive as healthier--with other branded manufacturers’ share soaring from 24% to nearly 29% between 2011 and 2016.

Lower Brand Spending Has Bolstered Profits, but May Erode Competitive Edge A reduction in promotional and advertising spending has also boosted Campbell's bottom line; we estimate this accounted for around 10%-15% of recent profit gains. Campbell's advertising spending slipped to less than 5% of sales in fiscal 2015 from more than 6% historically and below peers' 6% average. However, management claims this reduction is occurring only in select categories, including U.S. beverages, which continue to struggle as new products have fallen flat with consumers. We expect Campbell will ultimately ramp up its brand spending, which would constrain its margin expansion over time but could stem further material erosion in its brand intangible asset.

We agree that aligning innovation with consumer tastes and preferences needs to occur before brand marketing will prove beneficial. However, even value-added new products can fail if consumers don’t know about them, so we view marketing spending as essential, particularly in the highly competitive packaged food landscape. Given that we don’t expect intense competitive pressures will subside, we think maintaining or even increasing brand spending will be crucial in sustaining brand awareness and ensuring Campbell’s competitive edge and leading share position don’t meaningfully deteriorate further. However, marketing alone won’t be enough to prevent an eroding competitive position and languishing sales performance. We suspect that when Campbell brings new products to market that are more aligned with consumer trends, it will ratchet up promotional and advertising spending in an effort to drive trials of its new offerings.

As a result, our forecast calls for marketing to tick up to 5.7% of sales on average over the next 10 years (versus less than 5% in fiscal 2015) and research and development to approximate 1.6% of sales (about $150 million each year, or about 20 basis points above fiscal 2015). Whether this will be sufficient to offset competitive pressures and ensure products win with consumers, both at home and abroad, is debatable.

Although Campbell operates with a higher cost of goods sold than industry peers, our 10-year forecast shows its selling, general, and administrative expense, at less than 8% of sales, is already below the more than 9% of sales its peers spend, which indicates that Campbell doesn’t possess significant excess fat to shed beyond current restructuring plans. In addition, we expect that Campbell will resume investing a commensurate level of sales behind its brands (relative to its peers) in R&D and marketing, at around 1.5% and 6% of sales, respectively. As a result, we forecast that Campbell’s operating margins will only modestly trail those of its packaged food peers, averaging nearly 18% over the next 10 years versus nearly 20% for its peer set.

If Campbell instead chooses to operate with reduced brand spending for the longer term to bolster profitability, its competitive position could deteriorate. We believe that effectively spending behind R&D and marketing serves to enhance the stickiness of Campbell’s retailer relationships and is an aspect of its intangible asset moat source. Trusted manufacturers like Campbell that maintain a product set spanning the grocery store (including soup, sauces, beverages, and snack bars) have amassed high switching costs in the eyes of retailers, which are reluctant to risk costly out-of-stocks with unproven suppliers. All else equal, we suspect retailers would rather do business with an established vendor with whom they have a long-term relationship, but these relationships could be jeopardized if Campbell were to instead opt to inflate its profit levels.

Natural and Organic Expansion Stands to Stifle Profits We think a shifting business mix is also poised to hamper Campbell's profit levels in the longer term. Campbell has acting to extend its reach in the natural and organics space following the acquisitions of Bolthouse Farms (a domestic seller of fresh carrots and superpremium beverages) in July 2012 and Plum Organics (a U.S.-based manufacturer of premium organic foods for babies and children) in May 2013.

In our view, the motivation behind Campbell’s expansion into the natural and organic channel is the more attractive mid- to high-single-digit growth prospects the category is expected to see over the next decade. In addition, this increased presence in the natural and organic space could offset the languishing core soup business, which we expect to approximate a low-single-digit growth rate as the category has been losing out to other simple meal alternatives. However, we don’t believe this faster-growing product set stands to improve Campbell’s margin profile or competitive positioning.

Campbell Fresh (where the firm houses the bulk of its lower-margin natural and organic lineup) now accounts for 11%-12% of the firm’s consolidated sales base, but with operating margins in the mid- to high single digits, it contributes just a mid-single-digit percentage to overall operating income. This stands in contrast with the higher-margin Americas simple meals and beverages assortment, from which the firm derives just more than half of its sales (down from more than 60% historically) but more than two thirds of its operating profit. We estimate that soup, which boasts operating margins in the mid-20s, accounts for around one third of Campbell’s total sales and 60% of the revenue generated by its Americas simple meals and beverages segment.

We don’t think Campbell’s natural and organic margins are artificially low; rather, we believe they are commensurate with other industry peers. While we forecast that margin expansion will ensue at both Hain HAIN (a manufacturer of natural, GMO-free, and organic products across several food, beverage, and personal-care categories) and WhiteWave WWAV (a firm focused on natural and organic food and beverages, plant-based milks and protein products, coffee creamers and drinks, and organic packaged salads and produce), our forecast calls for operating margins of 13.5% and 12%, respectively, which materially lag the high teens margins we forecast for Campbell Soup on a consolidated basis. As such, we believe the change in Campbell’s business mix could also constrain its ability to expand profitability at its recent pace in the longer term.

We also don’t believe that the price premium afforded to organic fare supports a brand intangible asset or is a sustainable source of competitive advantage. In our view, the pricing power that the organic aisle seems to possess may wither if supply catches up with demand or if consumers lose confidence in the quality of organic products--a possibility if the designation transcends too wide and deep to be well regulated. As a result, we fail to perceive Campbell’s increased presence in the natural and organics channel as enhancing its competitive prowess.

Improving Margin Profile Fails to Address Lagging Sales Despite improving margins, Campbell's top line has remained tepid, as consolidated sales have ticked up just 1% annually over the past two years. However, with more focused brand spending, we think Campbell stands to drive low-single-digit sales growth over our 10-year explicit forecast. This lagging performance has been particularly bleak in the firm's Americas simple meals and beverages segment, which houses its U.S. soup, sauces, and simple meals, as well as its North American beverage lineup: Its sales have held flat or declined at a low-single-digit rate each of the past two years. Campbell changed its reporting structure just over a year ago, which has distorted our ability to garner a greater historical perspective based on the firm's current segment breakdown.

In addition, we think Campbell has fallen victim to lackluster innovation over the past few years as it sought to renovate its product set by taking sodium out of its soup rather than bringing appealing new flavor profiles to market, leading to disinterest from its customer base--a particular challenge, given the minimal switching costs in the consumer products space. While we think Campbell’s renewed focus on innovation with more impact, as opposed to its prior strategy of bringing a rash of new products to market, stands to drive accelerating sales growth relative to the recent past, we don’t expect the firm will achieve the mid-single-digit sales gains it achieved historically.

As such, we forecast around 2% consolidated sales growth over the next 10 years, in line with management’s 1%-3% annual long-term sales target, with nearly 60% resulting from increased volume and favorable mix and the remainder from higher prices. We expect foreign currencies to hinder sales growth in fiscal 2016, but given the firm’s geographic concentration in North America and the impact of recent tie-ups, any negative impact from exchange rates is likely to be minimal. We don’t incorporate foreign currency impacts beyond our current-year outlook.

We forecast top-line growth in the Campbell Fresh business to approximate 3% annually on average between fiscal 2016 and 2025, which lags the mid- to high-single-digit growth that characterizes the natural and organic category, as the firm derives around 60% of the segment’s sales from commodified offerings--such as raw carrots--as opposed to faster-growing branded fare. However, this far outpaces the 1% and 2% growth, respectively, that we anticipate for Campbell’s Americas simple meals and beverages segment and its global baking and snacking segment. This outlook incorporates our view that intense competitive pressures and lagging category trends will temper the growth prospects for these businesses. The more robust growth forecast for Campbell Fresh in fiscal 2016 reflects the recent acquisition of Garden Fresh Gourmet (a leading branded manufacturer of refrigerated salsa, hummus, dips, and tortilla chips), the addition of which is propping up segment sales by 10% this year; however, Garden Fresh Gourmet reflects only about 1% of the firm’s total sales base. In addition, the global baking and snacking segment is facing a pronounced hit from foreign exchange rate pressures; in the absence of foreign exchange movements, our forecast calls for 1% segment sales growth in fiscal 2016.

Our forecast for the Americas simple meals business doesn’t depend on a robust improvement in Campbell’s soup operations. We project that soup presently accounts for about 60% of Campbell’s segment sales, and we expect it will post 0%-1% growth over the course of our explicit forecast. As a result, we forecast the remainder of the segment will chalk up annual sales growth of 2%-4% over our 10-year explicit forecast.

We don’t expect Campbell will amass meaningful share gains on its home turf in the soup aisle; rather, we expect its growth to run in line with or modestly lag that of the underlying category trend. Based on our estimates for the $5 billion domestic soup market’s growth through 2020, Campbell’s disclosures, and our estimates surrounding the contribution of U.S. soup sales to the firm’s consolidated sales base, we forecast category sales to increase by less than 1% over our 10-year forecast, in line with the 10-year historical average. Thus, our forecast implies that Campbell’s U.S. soup share will decline from around 59% to 57% between fiscal 2016 and 2025. As has been the case over the past several years, we think Campbell’s continued share losses will be to other niche branded offerings, particularly those with a natural and organic bent. This further supports our stance surrounding the firm’s eroding competitive edge. On a category basis, this outlook suggests that U.S. soup consumption edges up from 14 billion servings each year presently to just above 15 billion by the end of our 10-year explicit forecast.

Further, we don’t expect Campbell to take advantage of more favorable growth potential abroad. The company derives only around one fifth of its sales outside the United States currently--about half of which is from the mature and highly competitive Australian market--and we don’t expect this exposure to expand materially over our 10-year explicit forecast. The firm has struggled in the past to replicate its dominant U.S. share position around the world. Campbell’s efforts to expand in two of the world’s largest soup markets, Russia and China (which account for around 32 billion and 320 billion servings of soup each year, respectively, far in excess of the 14 billion servings consumed annually in the U.S.), have fallen flat. Unlike the U.S., where consumers tend to use ready-to-eat soup as a meal alternative or as a cooking aid, the bulk of soup consumption in Russia and China--which together account for around 50% of the world’s soup consumption--tends to be homemade. As a result, Campbell has failed to garner a meaningful foothold and exited Russia in 2011 after losing money in the region for more than five years. Even though Campbell was aware that the best way to penetrate these local markets was to target aiding homemade soup preparation, varying tastes and preferences proved challenging for the firm, and we don’t expect those pressures to abate.

We've Yet to Warm to Campbell's Share Price Our $50 fair value estimate incorporates low-single-digit annual sales growth, 170 basis points of gross margins improvement to nearly 37%, and nearly 300 basis points of consolidated operating margin expansion to 18% by fiscal 2025. The current market price implies that Campbell needs to generate 3%-4% top-line growth annually over the next 10 years, while operating margins would have to expand to nearly 20%, a 550-basis-point improvement from fiscal 2015. This profitability would exceed the midteens to high teens levels we model for Campbell's packaged food peers but would still trail the mid-20s that we forecast for Kraft Heinz KHC.

In light of the modest growth prospects we see for the consumer product landscape, combined with our belief that continued investments behind R&D and marketing spending will be crucial in this highly competitive environment, we think the market is putting too much weight on the firm’s recent profit trajectory. Given Campbell’s lack of pricing power and continued erosion in share position, we think the market’s expectations will prove to be a stretch.