Time to Buy ConAgra?

ConAgra Foods  shareholders have had a hard time stomaching its earnings and outlook statements in the last couple of years. The company has disappointed across all of its segments, and its acquisition of Ralcorp has been fraught with unexpected difficulties. With that said, the stock now stands at a valuation discount to peers like Treehouse Foods and Kraft Foods  , but does this make it the value play in the sector? It's time to look more closely.



ConAgra Foods in charts
Sometimes a chart tells you a lot of what you need to know about a stock. For example, ConAgra's price chart reveals that after every disappointing earnings report, the value hunters move in on the expectation that it will sort out its difficulties in due course.

CAG data by YCharts.

Unfortunately, the latest setback has taken the stock price almost back to where it was in February when it last guided expectations lower. However, don't be surprised if the value players and activist investors start sniffing around the stock, because on a relative value basis, the stock is starting to look cheap.



ConAgra's acquisition of private-label food company Ralcorp is intended to enable the company to sell both branded and private-label foods into its customer base. The idea is that ConAgra can generate synergies in the process and take advantage of offering a range of products to the same retailers. With this in mind, Fools should keep an eye on its valuation versus Kraft (branded foods) and Treehouse Foods (primarily a private-label company).



Enterprise value (market cap plus debt) to free cash flow is used, because ConAgra took a $681 million non-cash impairment charge in the recent fourth quarter, which reduced its net income for the full year to just $315 million. In addition, ConAgra, Treehouse, and Kraft all contain significant, but varying, amounts of debt.

CAG EV to Free Cash Flow (TTM) data by YCharts.

There is no doubt that ConAgra looks like a good relative value, but is it?


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ConAgra Foods has Much to do

Investors in food company ConAgra Foods must have breathed a sigh of relief over the company's latest earnings results. They weren't particularly good, but the company has had a series of issues over the past year. In other words, any results that don't indicate any more deterioration will immediately switch investors' focus to how cheap the stock is compared to peers like General Mills and Kraft Foods. Is it now time to see ConAgra as the value play in the sector?

ConAgra's problems
Going into its third-quarter results, ConAgra was reeling from a number of issues, covered in detail in a recent article. Unfortunately, ConAgra had difficulties in all three of its segments (consumer foods, commercial foods, and private brands), while its acquisition of Ralcorp has also disappointed, and the regulatory review process overshadowed the creation of its Ardent Mills joint venture with Cargill and CHS.

 

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What ConAgra Needs to do to Convince Investors

Investors in ConAgra Foods  must wonder what on earth will come next. The company's update in February outlined a litany of problems that ran though its existing operations, through its acquired businesses, and even to the future formation of a joint venture. Value-seeking investors may ask whether these problems mark the trough of ConAgra's difficulties, and if the stock offers good value.

ConAgra's list of problems
Many of the company's problems don't indicate anything new, rather they show a failure to rectify ongoing issues. For example, in a previous article in July, readers learned of the three big risks associated with the stock. In short, ConAgra struggled to generate sales growth in its consumer-foods division. Moreover, its acquisition of private-label manufacturer Ralcorp produced results that came in below expectations. Finally, it lost a major customer from its Lamb Weston (potato operations) unit within its commercial-foods segment.

Fast forward to the recent February update and the company faces these issues:

 

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Buy ConAgra on the Dip?

It's been a pretty dismal summer for investors in ConAgra Foods (NYSE: CAG  ) , with the stock currently down 18% from its high at the start of August. Essentially, the market got a little bit too excited by the company's purchase of private-label food manufacturer Ralcorp.

 

Furthermore, the stock price reflected a significant amount of optimism over the company's prospects within a difficult economy for food retailers. Unfortunately, ConAgra managed to miss estimates for the first quarter in FY ending 05/2014, and the market punished the stock accordingly. Is now the time to take advantage of this?

 

ConAgra disappoints

First, in order to put the following discussion into context, here's a look at each segment's operating income for the quarter.

 

source: company accounts

In a previous article, I discussed the three big risks with the stock, and it's time to assess them again. In its recently reported first quarter, ConAgra disappointed with the first risk factor by failing to generate organic volume growth in its consumer-foods division.

 

The second risk was also somewhat disappointing. The Ralcorp integration is proceeding as planned, but Ralcorp sales have been below management's expectations for the second quarter in a row. Last time around, ConAgra argued that the problem was short term and fixable, but this time around it blamed the soft retail market.

 

The third issue is that ConAgra still hasn't replaced the revenues given up when it lost a key customer for its Lamb Weston (potato operations) brand earlier in the year.. Aside from declaring that it was "very confident" in making up these sales going forward, there wasn't any significant announcement on the issue. Accordingly, the commercial-food segment saw sales flat, and operating income decline 7%.  

 

Tough markets, tough decisions

Focusing on the issue of organic growth in consumer foods, you shouldn't be surprised to see ConAgra's weak results. The consumer market remains challenged, and particularly so in the food category. Consequently, the leading players have been forced into an ongoing cycle of raising prices only to lose market share, then discounting/marketing/promoting in order to take back share, and then the tough cycling begins all over again.

 

The fact is hard-pressed consumers have become highly sensitive to price. Even a company that has been doing relatively well, like General Mills (NYSE: GIS  ) , is having to invest in order to generate growth. In it's latest quarterly results General Mills outlined how its' advertising spending grew at a higher rate of 7% compared to its operating profit growth of 6%, and its organic sales growth of 3%. Sales growth doesn't come easy in this environment.

 

Unfortunately, it isn't getting any better. In fact, in August -- and one month into the previous quarter -- ConAgra reported that conditions were favorable, but conditions must have significantly deteriorated through the quarter. The company finished the quarter with a 3% organic-volume decline in consumer foods. Having declared that it felt a turning point had been reached thanks to the 3% organic-sales increase in the previous quarter, this result must have been disappointing. However, as noted at the time, ConAgra had increased advertising and marketing spend by 15% in the previous quarter in order to get this growth. See what I mean by a tough cycle?

 

Indeed, it isn't just ConAgra. Kellogg (NYSE: K  ) gave results at the start of August, and promptly stated that "sales growth was lower than expected." A dosage of -- you guessed it -- increased advertising spending was immediately proscribed. Moreover, the only real growth is coming via acquisitions. Kellogg acquired Pringles, General Mills invested in Yoplait, and ConAgra bought Ralcorp.

 

Ultimately, it proved to be a quarter categorized by intensive pricing competition. Going forward, ConAgra's plan is to increase merchandising efforts, with the aim of taking back market share

 

What's Next for ConAgra?

Despite the gloom, there are reasons to be optimistic!

 

First, if the consumer market really is categorized by heightened consumer-price sensitivity, then ConAgra's merchandising efforts should lead to a pick up in volumes again. Second, the Ralcorp acquisition is going largely as planned, and management confirmed that it still expects $300 million in cost savings by 2017. Third, any announcement of a contract win for Lamb Weston's frozen-potato operations will provide some upside to the stock.

 

However, while ConAgra's operational performance can get better, its valuation still looks stretched.  The mid-point of its 2014 earnings-per-share guidance ($2.36) puts it on a forward P/E ratio of around 13 times. This looks good, but its implied free-cash-flow guidance is for around $1 billion this year. In other words, it's around 4.4% of its current enterprise value. 

 

Recall that ConAgra has around $8.6 billion in senior long-term debt, and few people are expecting rates to fall. Moreover, with debt repayment a priority, it's hard to imagine the dividend can increase for a while yet. All told, the recent pullback still hasn't made ConAgra's shares attractive enough on a risk/reward basis.

ConAgra Foods Earnings Analysis

ConAgra Foods(NYSE: CAG) stands out as a winner in the food industry over the last few years. Its mix of value brands in the consumer division, expanding private label business and, a commercial foods division (which has been expanding profits strongly over the last few years) has stood it in good stead to deal with a challenging environment.

In summary, I think the company is well-positioned to do well, but a lot of its prospects depend on believing the management can execute successfully.

How ConAgra makes its money

I’ve broken out the recent fourth-quarter numbers, because private-label manufacturer Ralcorp hasn’t been part of ConAgra for a full year yet.

In order to properly reflect its performance ConAgra will change the way it reports by splitting the commercial foods division into a private-label segment (to reflect the addition of Ralcorp to its existing private-label business) and, a food service segment which will contain its Lamb Weston potato operations.

The three things its management needs to execute

The first question is it can continue to generate volume growth in its consumer foods division. ConAgra increased prices last year; in common with so many other companies in this slow economy, it then saw volume decreases. Consequently, it’s taken a while for ConAgra to get back to organic volume growth. Indeed, it only did so in the recent fourth-quarter results with a 3% gain. Overall, consumer foods sales were up 7%, with acquisitions contributing 5%.

ConAgra sees the organic sales growth as a turning point, but it has come at the expense of increasing advertising and promotion expenditure by 15%. Margins were up slightly thanks to strong cost savings which may not be repeated this year. This is fine but,note that the company has had to increase marketing costs in order to get volume growth. It is also spending more on supporting the launch of some new products in areas like desserts and frozen breakfasts. It is not a given that the new products will work and/or that operating margins won’t suffer next year thanks to increased marketing spending.

The second question relates to the Ralcorp acquisition. The good news was that It raised its synergy projections to $300 million by 2017, as opposed to the initial target of $225 million. Moreover Ralcorp’s profits were in line with expectations, but its sales performance was softer than ConAgra expects to see in the future. The subsequent restructuring activity was described as short term and fixable in the conference call.This is fine, but it still needs to be done.

Looking at the wider question of private label manufacturing I would issue caution. As investors in TreeHouse Foods (NYSE: THS) will tell you, manufacturing private-label foods can be a volatile business. Industry trends may be favorable right now, but Treehouse has had to deal with difficult conditions in recent years. Its customers' sales channels have changed along with the trend towards trading down.

Private-label companies are subject to the sales patterns of their customers, and while Treehouse is currently doing well with things like single-serve coffee and refrigerated dressings, it has also suffered before with categories like soup and pickles. It’s a business that requires a constant adjustment to the end market conditions of customers. Don’t be surprised if Ralcorp faces similar issues in future. Treehouse is on a forward PE of over 20 and is hardly cheap for such an uncertain business.

The third issue is that its commercial foods segment saw its potato operations (Lamb Weston) lose a major long-term customer. This will reduce EPS by $0.10 next year.The contract loss will also hit margins, but ConAgra expressed confidence that it would make up for it. Again, the management needs to deliver.

In addition, ConAgra talked of "short term challenges in Asia," which caused profits to decline for its potato operations for the quarter. Frankly, I don’t believe in coincidences, and anyone looking at McCormick’s (NYSE: MKC) latest results would note that it reported weakness from its quick service restaurant customers in both China and the Americas. Yum! Brands is a major customer of McCormick and much of its problems are company specific but the truth is that it’s Chinese same store sales growth has been falling since the first quarter of 2012.

In addition McCormick’s industrial growth has been negative for the last two quarters. Is this a short term issue or is it a deeper one relating to slowing quick-service restaurant sales growth? These types of restaurants are major customers of ConAgra's potato operations.

The bottom line

In conclusion, I think these three concerns require you to express a fair amount of confidence in the management to execute over the next year. This might be okay if the stock traded on a more attractive valuation. A forward PE of around 13 may look attractive, but recall that the company has to pay off significant amounts of debt.

Looking at these companies' current enterprise values (EV) in relation to their earnings before interest, depreciation and amortization (EBITDA) reveals that none of them are cheap. The measure helps to account for debt levels in evaluating a stock.

CAG EV / EBITDA TTM data by YCharts

ConAgra is the most expensive of the three companies above, and it's not cheap enough to compensate for the execution risk. It's a stock for the monitor list. The market may be in love with food stocks, but there is no excuse for not sticking to your valuation principles.

Is Treehouse Foods Still Good Value?

It has been a difficult couple of years for Treehouse Foods, and the share price is only above what it was back then thanks to the recent strong run. I’m sure that part of this is due to the market’s infatuation with the food sector this year (sparked by Buffett’s move into Heinz), but it is also down to the company successfully reorganizing its activities in line with market shifts.

With some successful acquisitions contributing to revenue growth in the quarter, and more M&A activity to come, its prospects are looking brighter than they have for a while. Is now the time to pick up the stock?

Food for thought

The recent results need to be looked at in depth to ascertain the underlying conditions. On the one hand, revenue was only up 3.1%, and this was largely due to acquisitions. On the other, adjusted EPS rose 17%, and restructuring activities have created a more favorable product mix. Production efficiencies, moderating commodity expenses, and supply chain improvements (transport efficiencies) have helped operating margins.

In a sense, these restructuring efforts were essential because the company has been faced with some difficult conditions in the last few years. Theoretically, a slow consumer environment where trading is down, and promotions and discounting are the key buzzwords, should be ideal for a private label manufacturer like Treehouse.

Unfortunately, it is not that simple. Shifts in consumer spending patterns, and more importantly where they buy certain groceries, has resulted in changing outlooks for some of Treehouse’s customers. Consequently, it has needed to restructure in order to realign its retail channels accordingly. The good news is that some of these changes are now coming to fruition.

There was a $0.14 restructuring charge relating to its soup operations, and if soup is excluded from revenue, then it would have risen a more respectable 7%. The strength comes from growth in its hot beverages (particularly single serve coffee) and from acquisitions in areas like refrigerated dressings and sauces. These are measures initiated to restructure, following some below par performances, with categories like soup and pickles, over the last few years. In addition, the management was pretty clear that more M&A activity is on the cards for 2013.

What to expect this year

Potential investors in Treehouse will have to accept that its prospects are somewhat dependent on the dynamics of the food industry. The industry story of 2013 is likely to be an environment of modest volume growth, aided by moderating commodity input costs. The question is, what will the food companies and grocers do in response? Will they try to hold pricing and take margins, or will they use the opportunity to lower prices and grab volumes or market share?

We got an early taste of these kinds of dynamics with ConAgra’s latest results. Its strategy seems to be to increase marketing activities in the face of weakening volume growth. Of course, this decision is guided by the fact that it tends to have value brands and is already competitive on price. In addition, its acquisition of Ralcorp is a positive indicator for private label manufacturers like ConAgra. In fact, across the retail market, the drive toward private label in-store brands has been a key development in the last few years. ConAgra has a lot on its plate this year, with integrating Ralcorp and dealing with some difficult conditions in the service food industry. Its evaluation of nearly 30 times earnings also suggests there is little room for error in its execution.

Meanwhile, grocers like Kroger have been rolling out corporate brands in order to better compete with lower-priced stores that have been gaining market share. In looking at Kroger’s earnings, I was struck by how tonnage came back strongly when prices abated. This is a sure sign that price sensitivity is still the key determinant of volume growth. The good news for Kroger investors is that margin pressure is finally starting to ease. Commodity prices are moderating for Kroger, and given its sterling efforts to retain market share and footfall with a mix of innovation and pricing, it should now see some margin growth.

A look at Kroger's revenue and margin trends:

Putting these thoughts together, I think it is clear that 2013 will be another year of intense competition categorized by promotions and discounts. As a consequence, the shift to private label brands is unlikely to slow down, and conditions should remain favorable for Treehouse. We are not yet in an environment where customers will take pricing easily.

Where next for Treehouse?

Full year EPS guidance of $3.00-3.10 was maintained, and conditions for Treehouse look better than they have for a few years. The restructuring activities are working, and moderating commodity costs should allow for volume increases, while the trend toward private labels continues. The company appears to have sorted out its retail channel challenges.

The bad news is that, on a forward evaluation of 21 times earnings, the stock is hardly cheap, and I would argue that this sort of company usually needs to be priced at a relative discount to reflect the risk inherent in buying a company whose prospects are largely governed by its customers' trading patterns and decisions.

If you are looking for relative value (in an expensive sector), Treehouse may fit the bill. But, cautious investors may want to wait for a better entry point.