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.

General Mills Offers Defensive Growth Prospects

General Mills $GIS is an interesting defensive stock that appears attractive because it offers a few key plus points. I’ve listed a few of them in bullet form below

• Defensive end markets of food and yogurt
• Good exposure to lowering commodity prices
• Strong dividend yield currently around 3%

So is General Mills an attractive stock to buy?

General Mills is ubiquitous name in the US Households through its cereal brands, healthy snacks, ready-made meals (Pillsbury etc), Haagen-Dazs ice cream and Yogurt (Yoplait) offerings. The last of which is growing quicker than the other products and, accordingly, the co is busying acquiring the international business of Yoplait. Next year will be about General Mills increasing pricing in order to benefit from the retention of market share that they fought for (via promotions, discounts etc) in previous years. However, the co is predicting that media spending will track sales growth so the management are unlikely to generate any operating efficiencies there.

This type of stock will always appeal to fund managers and investors because it provides good income and helps balance risk in a long only portfolio. I like the potential for future margin expansion coming from exposure to commodity prices coupled with its defensive nature. Indeed, over the last five years General Mills has grown operating profit every year (CAGR of 7% over the period) and EPS every year (CAGR of 12% over the period).

General Mills Q4 and Full Year Results

General Mills recently gave results and they were pretty good, however the outlook was weaker than the company had previously forecast. The good news is that the market had largely priced this in because the main cause is commodity price inflation. All of which suggests that if these prices continue to moderate-in line with the tightening attempts in many emerging markets-that General Mills could see some ‘upside surprise’ to gross margins. I’ve outlined historical cost inflation and gross margins for General Mills below

General Mills Estimates(%)	2007	2008	2009	2010	2011	2012
Input Cost Inflation	4	7	9	-3	4	10 to 11
Gross Margins	35.9	35.1	36.4	39.7	39.4	Lower

It is easy to see the inverse relationship between gross margins and input cost pressures. Moreover, this year’s cost inflation push is even more pervasive because commodities are up across the board and from relatively weaker comparables. In fact, the company is predicting lower gross margins as well as a low adjusted EPS growth of only 5% for next year.

Delving deeper into the results reveals that US retail sales were down 2% but international sales (constant currency) were up 16% respectively. This should provide little succour to shareholders because US retail sales still make up over 76% of segmental operating profits but international is only 10.7%. US retail sales were down but this is largely due to less price discounting and promotions. Accordingly, overall, full year operating margins expanded from 15.1% in 2010 to 16.6% in 2011.

General Mills Evaluation

Listening to the conference call, the management are predicting a tough time in 2012 and, gross margins are seen as being lower. Similarly, the forecast adjusted EPS growth of 5% (261c from 248c) is not particularly attractive. However, I think the co could beat this guidance with lower commodity costs; however, my concerns are with the stock’s evaluation and sales growth.

At $37.26 General Mills has a market cap of $23.81bn and an EV of $30.17bn which, in my opinion, is a bit rich for a company which has generated $878m in free cash flow. In addition, the co is forecasting $670m in capital spending next year against $649m in 2011. Given that EPS is predicted to rise by 5% only, then this suggests that next year’s free cash flow generation could be similar to this year’s. A forward PE of (37.26/2.61)=14.3x and FCF/EV of around 3.2% is not particularly exciting for a company with low single digit sales and EPS growth.

In addition, the free cash flow barely covers the dividend which suggests that long term dividend growth will be tough for General Mills. I think there are better ways to play a correction in commodity prices. The bulk of General Mills products are hardly high growth so whilst it is a fine investment for investment managers looking to park cash in a defensive manner, it will not attract GARP focused investors. I took a pass.