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Morningstar | Despite Tepid Sales and Lukewarm Profits, the Market Warms to Campbell; Shares Still Undervalued

After just one month in the top spot, recently appointed CEO Mark Clouse held court on what could arguably be defined as a fair quarter for the struggling packaged food manufacturer. Campbell’s second-quarter organic sales were flat to the year-ago period at $2.7 billion, while adjusted gross margins compressed 430 basis points to 30.9% and adjusted operating margins sank 370 basis points to 14.7%. The pronounced profit contraction stemmed from higher inputs costs--particularly for steel cans, vegetables, resin, and aluminum--and higher transportation costs related to continued startup costs associated with its recently opened Ohio distribution facility, which management expects are largely in the rear view. However, this performance aligned with the firm’s prior guidance, as opposed to suggesting further deterioration in the business--news that the market welcomed, sending the stock up to the tune of a mid-single-digit bump. Results through the first half are tracking our full-year forecast, and as such, we see little to sway our $45.50 fair value estimate; we view shares of this wide-moat operator as modestly undervalued, trading at a more than 20% discount to our valuation.

Despite the rash of headwinds (competitive and inflationary) that seem unlikely to subside over the near term, we believe Campbell is proactively pursuing a course to extract $650 million in costs from its operations by fiscal 2022, which equates to 8% of cost of goods sold and operating expenses (excluding depreciation and amortization), in line with the 6%-9% its peers target, which we think is attainable. However, we don’t expect that the entirety of these savings will fall to the bottom line, as we think these efforts will free up funds to bolster spending behind Campbell's brand mix to differentiate its fare in this intensely competitive space and support its edge (with research, development, and marketing ticking up to 7% of sales annually from 6% on average the last three years).

At first blush, industry veteran Clouse (who most recently held the top spot at Pinnacle Foods, prior to its acquisition by Conagra earlier this year) seems intent on getting Campbell back to basics, highlighting his commitment to adequately investing behind its brands while maintaining a disciplined bent toward costs. While we aren’t blind that it will take more time for Clouse to get his hands around the business and ultimately craft the course he believes is best for the business (the likes of which should be disclosed at the firm’s investor event in mid-June), we think Campbell has already begun to take proactive steps to right the business.

For one, as announced in August, the firm has opted to sell its fresh and international operations, including the Kelsen and Arnott’s brands, which in aggregate generated $2.1 billion in fiscal 2018 sales (about one fifth of its consolidated base), a process that is expected to be completed by the end of fiscal 2019 (July year-end). We still think Campbell lacks the scale and reach beyond its home turf to profitably win with local consumers. We previously posited that expanding into natural and organics would aid in its efforts to diversify away from the stagnant center store. But in light of the challenges that Campbell has faced (particularly as it relates to carrot farming), we view its decision to operate with a more focused portfolio as prudent, especially given the intent to direct any proceeds to the paydown of debt, with leverage sitting at nearly 6 times at the end of fiscal 2018.

In addition, and unlike its ill-fated purchase of Bolthouse Farms, we still maintain that Campbell’s integration of Snyder’s-Lance is better suited to leverage its expertise. In our view, snacking is a business that Campbell knows and understands well (particularly with its Pepperidge Farms and Goldfish brands), and we expect that it will be able to leverage this insight and distribution clout, enabling it to take advantage of consumers’ penchant for convenient, healthy fare. However, we also posit the combined entity could bolster the spending behind its brand mix to support its entrenched retail relationships and withstand intense competitive pressures. This underlies our outlook for Campbell to chalk up 2%-3% annual segment top-line gains longer term in a space that stands to account for about half of its mix as well as our outlook for marketing to tick up to 5.4% of sales on average over the next 10 years versus 4.8% on average the last three years.