Friday, April 12, 2013

Is The Market Being Too Complacent Over ConAgra?

Good investing often lies somewhere between the extremes of rigidly sticking to preset ideas and following the latest investing fashion. Quite often one of these things works against you in order to suddenly make you realize the underlying risk that you actually took on. In the case of ConAgra Foods $CAG I would argue that investors may be buying both ends of the aforementioned extremes at the same time!

The market seems wedded to the idea that food stocks are defensive, and they are also fashionable thanks to Warren Buffett's recent actions.

ConAgra Stock a Buy?

Don’t get me wrong. I like the stock and held it for a long while in 2012. That holding was part of a desire to balance a portfolio with a food stock, and I felt its mix of value brand, private label and evaluation made it a stock with an attractive risk/reward proposition. Indeed, ConAgra has performed very well since then in generating growth with its commercial foods sector and wringing every last piece of performance out of its consumer foods. Its underlying cash flow is very strong and it has been correctly using it to make growth-enhancing acquisitions.

Its consumer foods segment saw sales up 7%, but this was largely driven by acquisitions. Organic volume actually declined 3% with favorable movements in pricing fully offsetting this decline. Going forward, pricing will not be so easy to take because it is lapping previous increases and some of its competitors are reducing marketing efforts in favor of pricing and promotional activities.

Commercial foods revenues grew a paltry 1%, but comparable yearly profits were up an impressive 18%. The big contribution in this quarter came from its milling operations. Indeed, there should be more to come as ConAgra recently announced the creation of a joint venture (to be called Ardent Mills) that will combine its milling operations with Horizon Milling in partnership with Cargill and CHS. The transaction is expected to complete later this year.

ConAgra’s Growth Opportunities

If the ConAgra story in 2012 was about generating operational efficiencies, making acquisitions and competing in tough markets, then 2013 looks like it will be more of the same.

The key operational event will be the integration of the private label business (Ralcorp) that it recently acquired. In theory, private label business should be flourishing in this environment, but as investors in Treehouse Foods (NYSE: THS) will tell you it is a difficult industry even at the best of times. I’ve followed European white label producers before, and the pattern seems to be the same. A company like Treehouse will report some great quarters, investors pile in, only to be disappointed when market conditions change. The truth is that US consumers continue to want to trade down and favor buying if there are promotions and coupons. These shifts in sales channels caused Treehouse a lot of disruption in 2012, and I think it is just a facet of the industry. Will ConAgra run into similar problems with Ralcorp?

All of which leads me to wonder why investors continue to bid up the sector? Obviously the Buffett/Heinz (NYSE: HNZ) deal has sparked a lot of interest, but my reading of that situation is that Heinz clearly has some powerful brands, of which it wasn’t releasing the full value, and the team partnering with Buffett looks set to go about doing it. Their emerging market expertise is going to be very useful in growing revenues in the key markets for the company.

Ever since that deal the market has fallen even more in love with food stocks, and it has taken ConAgra up with it.

Where Next for ConAgra?

This is going to be a busy year for the company. Integrating Ralcorp will obviously demand management resources and its consumer foods markets remain highly competitive. ConAgra’s reaction to tough end markets has been to increase marketing recently; while its competitors seem more interested in discounting and promoting their way to volume growth. It remains a tough market. Moreover, the stock is no longer good value and there is little margin for error in its performance within difficult end markets.

On a risk/reward basis I think the stock is no longer great value, and any company that is seeing increased marketing costs while volume growth is weakening is hardly flourishing. On a more positive note the company has executed well over the last year. The questions are can it continue to do so and what evaluation are you willing to pay in order to bet on it?