Sunday, August 12, 2012

Campbell Soup Company Analysis

Theoretically, the Campbell Soup Company $CPB should be the perfect stock for this kind of economically uncertain environment. The idea, at least, is that its end demand is relatively stable and even if there is a global slowdown in growth, it could expand margins through lower cost inflation. In addition, it generates large amount of cash flow and pays a big dividend.

Of course, that’s the theory. In practice, the latest results create almost as much uncertainty over its prospects as the global economy does over the market in general!

Campbell’s main problem is that with ongoing sluggish US growth, consumer trips to stores are down and spend per visit is down. Moreover, consumer purchasing habits have changed and more groceries are being bought from dollar stores. Unfortunately, this means that consumers are more inclined to trade down to private label options and/or require greater promotional spend in order to be induced into buying the product. This leaves the consumer goods companies in a tricky situation.

Raise Prices, Lose Sales

Procter & Gamble $PG is one of those companies whose traditional company model has been challenged by the harsh realities of the current protracted slowdown. It is a company known for retaining pricing during a slowdown in order to keep margins up when the recovery comes. It doesn’t appear to be working.

In fact, PG has had to announce price cuts across certain lines. Similarly, with Campbell, it tried to increase pricing (mainly to pass on cost inflation) in its core soup category but it also had to increase advertising and consumer promotional spending. Meanwhile, Campbell reduced trade promotion. The result?

Sales declined in US Simple Meals (soup) segment by 2% and earnings were down 14%.  In fact, operating earnings were down in every segment this quarter.
Segment details for Campbell in this table here.

Gross Margins declined 160bp to 38.8% in the quarter. The company was quick to blame the decline on cost inflation and increased promotional spending. However, promotional spending is supposed to drive top line growth. Indeed, promotional spending was higher than expected in the Baking and Snacking segment, but with little end result. Similarly, the company invested in US Beverages in order to keep market share, but this helped to push earnings down 10%.

Industry Challenges

I think there is a good case for the industry suffering from a protracted game of ‘swings and roundabouts’ with market share. In other words, companies like Campbell and its rival Heinz $HNZ seem to be stuck in an ongoing saga of increasing pricing, losing market share, then increasing promotion and advertising to get it back -- volumes go up, margins go down and then they might try to increase pricing and, back to square one they all go.

If this is the case, then management initiatives are really only going to be effective over a short-term basis and the real problem is structural.  In fact, if you look at the choppiness of Heinz’s results over the last few years, it certainly seems to bear this out.

However, Heinz does something better than Campbell. It is much more aggressive in expanding in emerging markets and its prospects look better there. This is a key distinction because if cost prices are being driven by emerging market consumer demand growth for commodities, then it is helpful if you can sell to that hungry consumer with your end product! Heinz is expanding its emerging market business strongly, whilst Campbell is stuck with high input costs and trying to pass much of them onto the stretched US consumer.

Neither is Campbell able to leverage its brand in the same way that another US company with a Scottish name can. Simply put, McDonald’s $MCD sells an iconic piece of Americana to the world. Campbell sells soup and, despite Andy Warhol’s paintings, this is simply not going to be the kind of product that invokes any kind of emotional or inspirational attachment.

Whilst McDonald’s is able to offer a low cost ‘trading down’ option to developed markets, it is also able to offer a desirable product to poorer Chinese moving into the middle classes. It is a similar story with Yum Brands $YUM which has made expansion in China the lynchpin of its growth strategy.

My point here, is that whilst Yum and McDonald’s can make operational changes and see a related change in return on investment -- because they have variable end markets to play in -- I think Campbell is much more constrained by strategic considerations. If I am right, this would make it very hard for Campbell’s management to generate a meaningful change to the company's performance.

What Next For Campbell’s Stock?

The stock is cheap, generates a lot of cash flow and pays a very good dividend. It will attract many dividend-seeking investors but it will need to demonstrate that it can reverse the declines in US soup sales. Moreover, generating some traction from management initiatives will restore confidence and take away the nagging feeling that canned soup is a food category that is in a sustained decline in popularity.

It is hard to make a case for those conclusions, given the trends in the latest results and, therefore, I would be cautious before concluding that Campbell is a company worth getting too excited about as a dividend play.

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