EUR 850.00 For Business Accounts Only

Morningstar | CAG Updated Star Rating from 20 Dec 2018

While narrow-moat Conagra's legacy business continues to track in line with our expectations (roughly flat organic sales and high-20s gross margin year to date), these results were largely overshadowed by concerns about the underlying health of Pinnacle (acquisition closed at end of October), which posted 11% operating margin, versus a midteens average over the last few years, on $259 million of sales (11% of revenue this quarter). Both sales and profitability fell short of Conagra's expectations, leading management to revise its 2018 estimates below Pinnacle's internal targets. We attribute this to lackluster innovation that failed to respond to evolving consumer tastes, leading to share and shelf space losses and, consequently, heightened promotional activity. In our view, the inability of these brands to command pricing power and speed at which they lost distribution supports our contention that Pinnacle lacked the brand assets or entrenched retail relationships needed to form an edge on a standalone basis.

Conagra's outlook now calls for Pinnacle to be dilutive by 40 basis points to consolidated fiscal 2019 gross margin, with Pinnacle's adjusted gross margin expected to hover around 27%, below the 29% in its last fiscal year and our above 30% estimate. We plan to trim our $37.50 by a high single-digit percentage as we temper our near-term sales and profitability forecast for Pinnacle, although we aren't anticipating any material changes to our outlook for Conagra's legacy business. Over the long run, we still view low-single-digit sales growth and midteens average operating margin (on a consolidated basis) to be feasible, as management strengthens innovation and execution within Pinnacle's brand set, though we wouldn't be surprised to see further erosion over the next few quarters as these efforts may take time to yield improvement. Shares pulled back by a high-teens percentage on the announcement and look undervalued even relative to our expected revisions.

Pinnacle had made solid progress over the last few years at revitalizing its core brands (including Birds Eye, Wish-Bone, and Duncan Hines) and driving share gains, as evidenced by around 1% compound retail sales growth between 2013 and 2017. However, Conagra's management cited subpar execution among these brands as the primary cause of the retail sales and distribution declines over the last few quarters, claiming that its innovation wasn't supported adequately, and these effects were exacerbated by SKU proliferation and price promotions. This rationale largely aligns with our perspective that companies must maintain consistent investments behind their brands and retail relationships to sustain growth, and that heightened spending or promotional activity alone is not sufficient to yield improvement. Although we acknowledge that it can take some time for underwhelming product innovation cycles to become apparent, we were slightly disappointed by management's lack of visibility into these issues.

Still, we think Conagra's management team has the ability to improve performance within this business, given its solid record at strengthening innovation within languishing categories like its refrigerated and frozen segment (around a third of sales). This business, which faced high single-digit volume declines in fiscal 2016 and 2017, has seen improving performance as of late, with organic volumes up 50 basis points this quarter. Frozen single-serve meals experienced 11% retail sales growth and 8% growth in total points of distribution during the quarter (outpacing 3% category growth) and have seen 4%-5% increases in price per unit over the last six quarters. Conagra has already exited certain promotions for Pinnacle that it didn't view as attractive, and we surmise it may also rationalize lower-margin SKUs in the same way has within its legacy portfolio over the last year. In this context, the company also plans to divest its Wesson oil business (it had planned to sell this brand to narrow-moat Smucker earlier this year, but the deal fell through after a challenge from the FTC) by the end of the first quarter to enhance its portfolio. Further, despite these operational hurdles, Conagra's management expects to exceed its target of $215 million in cost synergies. While we don't plan to incorporate any additional synergies into our valuation, as we’d like to have a more granular understanding of these savings, we think this could free up additional operational flexibility for Conagra to support its brand set.