EUR 850.00 For Business Accounts Only

Morningstar | While Cost Pressures Persist, Investors Warm to Campbell's Efforts to Improve

We don’t expect to materially alter our $45.50 fair value estimate for wide-moat Campbell Soup (outside of a low-single-digit bump to account for additional cash generated since our last update) following first-quarter results that included a 3% downdraft in organic sales (1 point of which resulted from a change in revenue recognition and included a 6% falloff in U.S. soup sales), a 490-basis-point erosion in adjusted gross margins to 31.6%, and a 410-basis-point degradation in adjusted operating margins to 15.2%. The stock popped at a mid- to high-single-digit clip after the earnings release, leaving the shares at about a 10% discount to our valuation. However, for investors interested in the packaged food space, we’d suggest wide-moat General Mills, which trades more than 20% below our fair value estimate and boasts a dividend yield north of 4%.

A step-up in input cost inflation (particularly for steel cans, vegetables, wheat, dairy, and resin) as well as persistent pressure ensuing from higher transportation costs, which have been plaguing firms across the country, took a toll on profitability to the tune of 290 basis points and was only partially offset by efforts to drive efficiencies throughout the organization, which favorably affected gross margins by 120 basis points. However, we believe Campbell is not sitting still but 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. We don’t anticipate that the entirety of these savings will fall to the bottom line, though, as we expect these efforts will free up funds to bolster spending behind Campbell's brand mix to differentiate its fare in this intensely competitive space and ultimately support its competitive edge.

Although Campbell pulled back the reins on marketing investment in the quarter (down 15% on the base business), management attributed this to supply chain challenges, as the firm opened a new distribution facility with a third-party logistics provider and didn’t juice up its marketing spending until this operation was online later in the quarter. As such, we don’t believe this evidences a reluctance to invest behind its brands and support its entrenched relationships with retailers. We maintain 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.

Following its Aug. 30 announcement, the firm is still pursuing a sale of 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 its stated intent to direct any proceeds to the paydown of debt, with leverage sitting at nearly 6 times at the end of fiscal 2018.

Further, we don't think Campbell’s integration of Snyder’s-Lance will face a demise similar to its Bolthouse Farms. We maintain that 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.

The ongoing proxy battle with activist investor Daniel Loeb is set to come to a close at the annual shareholder meeting Nov. 29. Because Campbell is a controlled company, with the Dorrance family (direct descendants of the man who invented the process by which wet soup is turned into condensed soup) owning about 40% of the outstanding shares and maintaining board representation, we don’t expect Loeb's pursuit will ultimately prove successful; the dissent has already reduced its aims from replacing the entire board to just gaining five seats. Further, the firm is still on the hunt for a permanent replacement for CEO Denise Morrison, who stepped down abruptly in May. Since then, Keith McLoughlin, a board member who previously was CEO at Electrolux, has served as CEO in an interim capacity. Management still expects to announce a permanent replacement by year-end. While fresh insights could be exactly what Campbell Soup needs as its works to steady its course, we see COO Luca Mignini as the most likely candidate to fill the top spot. Over his five years at the organization, Mignini has gained significant experience running the international and global biscuits and snacking operations (the latter of which has been a relative bright spot in Campbell's portfolio). Further, we believe that recent executive appointments across its business (including a new head of marketing and leader for the meals and beverages business) could infuse operations with added perspective that might have been lacking in the past. In this light, we don’t intend to alter our Standard stewardship rating.