ConAgra Splits Its Menu, but We're Not Hungry

In less than 18 months at the helm of ConAgra, CEO Sean Connolly has charted a new course. After selling the private-label and spice operations, management has split the consumer foods (

Like others that have pursued a similar course--including Kraft, Ralcorp, Sara Lee, and Fortune Brands--management says this strategic endeavor stands to unlock material value, an opinion we struggle to share. For one, we don’t believe ConAgra can enhance its brand intangible asset, given that its mix consists of second- and third-tier brands that lack pricing power. Further, we don’t think the firm will post operating margins on par with the high teens to low 20s of its peers, given its lagging brands and the inherent complexity in its supply chain (it sources 90% of its products from just one location).

It is hard to deny the benefits of uncoupling, which in some instances has led to an improved competitive positioning. We didn’t see substantial synergies between Sara Lee’s domestic retail meat business (Hillshire) and international beverage operations. We also saw little benefit for Fortune Brands to continue operating its home security and alcoholic beverage units under one consolidated leadership group. We didn’t think the former Sara Lee business, which operated with a disparate portfolio of brands, had an economic moat. However, after the separation, we believed Hillshire had a narrow economic moat based on its portfolio of well-known brands in categories with low private-label penetration, which afforded the firm some clout with retailers that depend on leading brands to drive traffic in their stores. Similarly, while we assigned narrow economic moats to both the former consolidated Kraft business as well the current North American grocery operations (now named Kraft Heinz KHC after the July 2015 tie-up), we believe Mondelez MDLZ--the global snack business of the former Kraft operations--has garnered a wide economic moat thanks to its solid brand portfolio and the economies of scale that result from its global distribution network. However, we don’t believe ConAgra Brands stands to bolster its competitive edge now that Lamb Weston is split off.

Beyond an enhanced competitive positioning from the division of differentiated businesses, these more-focused consumer product operations realized improving financial prospects. Both Mondelez and Kraft have expanded margins since 2012. ConAgra’s operating margin held relatively flat at around 10% between 2012 and 2014, while between fiscal 2012 and fiscal 2014, Kraft’s operating margin improved more than 200 basis points to nearly 18%, and Mondelez’s operating margin edged up 100 basis points to nearly 12%. We forecast Kraft Heinz’s operating margins to expand to the mid-20s over our 10-year forecast--about 500 basis points above the 21.5% the firm generated in fiscal 2015 and in excess of the mid- to high teens its peers boast. We expect Mondelez’s operating margins will amount to around 19% by fiscal 2025 (650 basis points above fiscal 2015’s level). While we believe that ConAgra is poised to bolster its profitability as well, we forecast operating margins in the midteens over the next 10 years, lagging the high teens to low 20s of its industry peers.

The advantages of previous breakups didn’t stop at a strengthened competitive position and improving financials. Over the course of its independent life, which began in June 2012 and ended in August 2014, Hillshire chalked up a 24% annualized return over and above the appreciation in the S&P 500 before being bought out by Tyson Foods TSN for $8.6 billion on an enterprise basis (which equated to 16.7 times EBITDA, a 97% premium to our stand-alone valuation for Hillshire at the time). Fortune Brands Home & Security FBHS has generated a nearly 20% excess return over its four years as an independent firm. Overall, we think consistent cash flows, solid dividend streams, and speculation about further consolidation have acted as a floor for valuations in the consumer defensive space, which trades at a price/fair value of 0.99.

Pricing Power Remains Weak Mission number one for ConAgra centers on beefing up its brand intangible asset. Management has admitted that a lackluster brand mix and an overreliance on promotions (rather than new products) have plagued its operations in the past. In our assessment of brand strength, we found that relative to its packaged food peers, ConAgra lacks brand prowess, particularly given its muted pricing power and slim market share position across its categories.

Although simply comparing pricing across product categories may seem appropriate, this ignores the follow-on effect of volume in the economic equation. If a firm is able to raise prices only at the expense of volume share over an extended period, the implied brand strength is actually quite weak. Rather, we believe stronger brand portfolios should lead to higher long-term top-line growth as a result of better pricing power versus competitors and stable or improving volume share positions. While ConAgra has historically refrained from providing the contribution from price and volume, its gross margins have tended to trail its peers. A portion of this differential could reflect the composition of its product mix and, as a result, its commodity cost basket, but we don’t believe this sizable gap is entirely due to mix. Instead, we think this highlights the lack of pricing power the company has been able to amass, given its past focus on bolstering volume at the expense of price.

The company has more recently called out significant volume degradation, particularly in its grocery and snacks and refrigerated and frozen businesses. For example, in the first quarter of fiscal 2017, ConAgra’s grocery and snack volume tumbled 6% after a 1% benefit from higher prices and favorable mix, and volume in refrigerated and frozen slid 11% on top of a 3% price increase. This backs up our stance that ConAgra Brands has yet to exhibit much pricing power.

Management says this volume erosion is likely to prove short-lived as the firm works to enhance the value of its product set, including tailoring its mix to meet consumers’ evolving taste and preferences toward healthier ingredients, which have come at a higher price tag. We are a bit more skeptical. As an example, ConAgra has sought to bolster the value profile of its Banquet product line, which accounts for just 8% of total sales, but to which management has attributed the bulk of the recent volume erosion in its refrigerated and frozen segment. But because this offering has historically catered to a more cost-conscious consumer, we think efforts to trade consumers up could prove a tough slog. While 56% of Banquet’s consumers generate total income below the 50th percentile--implying that its core customer group is more cash-constrained and therefore more likely to make purchase decisions based on price rather than brand--the same metric is just 36% for Betty Crocker (a General Mills GIS brand) and 46% for Stouffer’s (a Nestle NSRGY brand). In this context, we aren’t surprised that Banquet has been the prime culprit behind volume declines in the refrigerated and frozen segment, and we don’t expect these pressures to subside over the near term. We forecast volume declines in this segment to persist at a low- to mid-single-digit rate over the next three years.

ConAgra’s mix of second- and third-tier brands has also been evident in its market share position. ConAgra garners $4.2 billion in annual sales--more than half of its consolidated total--from meals, which includes the Banquet, Marie Callender’s, and Healthy Choice brands. However, according to Canadean, ConAgra maintains just 13% share of the ready-meals category, compared with Nestle’s 33% share. We believe that firms that operate with a leading mix of brands that drive store traffic can entrench themselves in retailer supply chains, but this mix of second- and third-tier brands has limited ConAgra’s ability to do so to the extent of its peer set.

After selling its plagued private-label venture earlier this year, ConAgra allocated the $2.6 billion in proceeds to reduce its debt load. With debt/adjusted EBITDA now less than 3 times by our estimates (versus a peak of close to 5 times), ConAgra could look to refocus on faster-growing areas of the grocery store, such as natural and organics. We view expansion into this segment as more likely, given the more attractive mid- to high-single-digit growth prospects the category is expected to enjoy. Some of ConAgra’s recent new products, including Pam Organic Extra Virgin Olive Oil and Healthy Choice Simply Café Steamers (which are organic, non-GMO, natural, and contain no artificial colors, preservatives, or flavors), are examples of its efforts to bring on-trend products to market.

ConAgra’s acquisition focus supports our thinking. Over the past year, the company has added Blake’s All Natural Foods and Frontera Foods to its arsenal. While we think adding these products to the portfolio could be advantageous, given the alignment with consumer trends, we suspect that neither acquisition is large enough (probably less than 1% of sales) to move the needle on ConAgra’s financial performance or bolster its competitive edge.

We stress that this category’s faster growth doesn’t necessarily enhance ConAgra’s competitive positioning or drive improved margins (with operating margins for natural and organics in the high-single- to lower-double-digit range). Although the price premium afforded to natural and organic fare seems to support a brand intangible asset, we don’t perceive this as a sustainable source of competitive advantage. We believe the pricing power of natural and organic offerings may wither if supply catches up with demand or if consumers lose confidence in the quality of organic products--a possibility if the designation becomes too wide and deep to be well regulated.

Overall, we forecast around 1%-2% consolidated sales growth longer term for ConAgra, with slightly more than half of the increase resulting from higher volume and favorable mix and the remainder from increased prices. We expect a modest negative impact from foreign currencies in fiscal 2017, but because the firm derives around 90% of its sales from the United States, we forecast only a low-single-digit hit from exchange rates.

Slim Margins Also Present a Challenge ConAgra hasn't just been plagued by a lagging brand mix. Material profit improvement has also proved elusive, as operating margins have historically hovered in the low teens, paling in comparison with the mid- to high-teens operating margins of better-positioned peers. Management is taking steps to improve the efficiency of its operations, with plans in place to shed $300 million in costs over the next few years. Its cost-saving targets equate to about 4% of cost of goods sold and operating expenses, excluding depreciation and amortization expense, which is at the low end of the 4%-7% of savings targeted at other domestic food and beverage manufacturers.

Overall, we view these targets as prudent but unlikely to materially close the profit gap with peers or enhance ConAgra’s ability to leverage fixed costs in the longer term. For one, the competitive landscape is quite intense, and we believe continued brand spending will be necessary to ensure that a competitive edge doesn’t get eaten up. Consumer preferences are evolving at a rapid clip, and we think the onus is on packaged food manufacturers like ConAgra to ensure that new products consistently resonate with consumers. But just bringing on-trend products to market is insufficient to win in this marketplace, as even value-added new products can fail if consumers don’t know about them. We believe that maintaining--or even increasing--brand spending will be crucial to beef up brand awareness.

To put ConAgra’s brand spending and our forecast into perspective, we compared the percentage of sales we expect ConAgra to earmark for cost of goods sold, selling, general, and administrative expenses, marketing, and research and development over our 10-year explicit forecast with a group of its industry peers. Despite its cost-efficiency efforts, we forecast that ConAgra will continue to apportion more toward cost of goods sold as a percentage of sales than others in the industry (at 69% versus 61% on average for its competitors). In addition, we expect ConAgra will edge up its brand reinvestments slightly from the 4.2% and 0.7% of sales it spent on marketing and R&D, respectively, in fiscal 2016, but at just 4.7% and 1.0% on average over the next 10 years, this will still lag other packaged food operators, which spend closer to 8% of sales in total on marketing and R&D. Even with this lower level of brand spending, we forecast that ConAgra’s operating margins will trail peers’, averaging around 15% over the next 10 years versus nearly 20% for its competitors.

Even though we forecast ConAgra’s profitability to lag other industry players, we don’t think the firm will take additional steps that stand to cut into muscle. Management has said that firms in the highly competitive packaged food arena don’t benefit by trying to cut their way to growth, recognizing the importance of effective spending behind R&D and marketing as a means to enhance the stickiness of its retailer relationships (one aspect of an intangible asset moat source). We view brand reinvestment as even more crucial now than several years ago, given the rise of e-commerce, which has enabled smaller, niche operators to gain a leg up in amassing proof of concept as they aren’t constrained by the limits of costly physical distribution. However, if ConAgra were to do an about-face and opt to ratchet back that spending in an effort to inflate its profit levels, we think its retail relationships could become more severely impaired.

Overall, our forecast calls for operating margins to jump 340 basis points over our 10-year explicit forecast to more than 16%, with enhanced profitability across ConAgra’s segment mix. We forecast that the grocery and snacks (up 280 basis points to 23% by fiscal 2026) and refrigerated and frozen (up 210 basis points to 17%) businesses will boast sizable gains.

We don’t believe a bloated cost base is the only issue; we also see structural challenges that are unlikely to abate. Relative to others in the industry, ConAgra operates with a more complex supply chain network, as 90% of its mix is produced in only one location. This has resulted in higher mileage per shipment than its peer set (900 miles versus 600-650), and given the lack of synergies in the product portfolio, the ability to materially narrow this gap is limited.

We Don't Think Long-Term Investors Should Indulge in ConAgra We think the market's outlook for ConAgra is a bit too rosy, particularly in light of the intensely competitive landscape. The market fails to share our stance that ConAgra's lagging competitive position is likely to hinder top-line growth and margin gains longer term. Our $28.50 fair value estimate incorporates low-single-digit annual sales growth, 220 basis points of gross margin improvement to just more than 31%, and around 340 basis points of consolidated operating margin expansion to slightly north of 16% by fiscal 2026.

Part of the market’s favor could reflect speculation that ConAgra is poised to become an acquisition target down the road, particularly as consolidation in the space persists. However, while several companies that have slimmed down, like Hillshire, have been swallowed up by larger peers, we don’t think this will prove to be ConAgra’s fate. For one, Hillshire’s brands were leaders in the meat aisle; in contrast, we believe ConAgra lags its peers because of its portfolio of second- and third-tier brands, which lack pricing power, as evidenced by gross margins that have historically hovered in the 20s versus the 30%-40% generated by other leading packaged food peers.

Further, we think that the size of a tie-up combined with the muted potential for supply chain synergies because of the complexity of ConAgra’s network would probably turn off interest from its peer group. Past deals in the packaged food space have seen buyout multiples ranging from 8 times to more than 20 times on an enterprise value/EBITDA basis. Our analysis incorporates our expectation that ConAgra would only muster a valuation around the median of this historical range (about 12 times on an enterprise value/EBITDA basis), given its lagging brand equity combined with its more muted profitability, which would equate to a buyout price of around $32 per share, a 12% premium to our stand-alone valuation.

Although we fail to see much value in ConAgra’s shares, we believe the market is still underestimating the prospects for chicken producer Pilgrim’s Pride, whose shares trade at an approximate 35% discount to our valuation. Our Pilgrim’s Pride forecast calls for sales growth of about 3%-4% annually in the longer term, exceeding the 1%-2% we forecast for ConAgra. We expect Pilgrim’s Pride will capitalize on rising fresh food and meat demand in North America. Further, low corn and soybean meal prices have coincided with strong demand for chicken, conditions that we believe will benefit Pilgrim’s Pride’s balanced portfolio while providing investors with a steadier near- to mid-term outlook than large bird-focused producers if commodity tailwinds abate. While we fail to find much value in the packaged food space, we’d suggest long-term investors looking to gain exposure to the industry consider building a position in Pilgrim’s Pride.