While narrow-moat Conagra's (CAG) legacy business continues to track in line with our expectations (roughly flat organic sales and high-20s gross margin year to date), these results were largely overshadowed by concerns about the underlying health of Pinnacle (acquisition closed at end of October), which posted 11% operating margin, versus a midteens average over the last few years, on $259 million of sales (11% of revenue this quarter). Both sales and profitability fell short of Conagra's expectations, leading management to revise its 2018 estimates below Pinnacle's internal targets. We attribute this to lackluster innovation that failed to respond to evolving consumer tastes, leading to share and shelf space losses and, consequently, heightened promotional activity. In our view, the inability of these brands to command pricing power and speed at which they lost distribution supports our contention that Pinnacle lacked the brand assets or entrenched retail relationships needed to form an edge on a standalone basis.
Conagra's outlook now calls for Pinnacle to be dilutive by 40 basis points to consolidated fiscal 2019 gross margin, with Pinnacle's adjusted gross margin expected to hover around 27%, below the 29% in its last fiscal year and our above 30% estimate. We plan to trim our $37.50 by a high single-digit percentage as we temper our near-term sales and profitability forecast for Pinnacle, although we aren't anticipating any material changes to our outlook for Conagra's legacy business. Over the long run, we still view low-single-digit sales growth and midteens average operating margin (on a consolidated basis) to be feasible, as management strengthens innovation and execution within Pinnacle's brand set, though we wouldn't be surprised to see further erosion over the next few quarters as these efforts may take time to yield improvement. Shares pulled back by a high-teens percentage on the announcement and look undervalued even relative to our expected revisions.
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Sonia Vora does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.