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Morningstar | Conagra’s Shares Pop, but Still Attractive, After Outlining Innovation Lineup and Margin Trajectory

Narrow-moat Conagra’s April 10 investor day bolstered our confidence that its ongoing efforts to restore top-line momentum while improving profitability have strengthened its prospects over the coming years. We contend management's strategy of refreshing its core brands, bringing more premium fare to market, and expanding its stronger brands into adjacent categories should support its efforts to realign its brand set with evolving consumer tastes. Moreover, Conagra's continued investments behind its brands (increasingly leveraging data analytics to inform product innovation and marketing) show that it is not merely paying lip service to its goal of reshaping its portfolio. These efforts have already been met with a favorable response--management estimates that the percentage of its fare sold on promotion decreased around 6% between 2015 and 2018--but we think further upside lies ahead.

Still, we believe heightened competition in the center of the store (from branded players, niche upstarts, and private-label fare) and a relative lack of differentiation in certain categories (like frozen vegetables) will constrain sales growth to a low-single-digit rate longer term. As such, management's outlook for a 1% to 2% three-year CAGR for organic net sales (ending fiscal 2022) aligns with our existing forecast. Management also provided additional color on its longer-term margin expectations and now is targeting adjusted operating margin around 18% to 19% by fiscal 2022, versus 15% in fiscal 2018. While we view these goals as quite ambitious, we posit that positive contributions from price/mix, further cost efficiencies (with management now targeting $285 million in synergies, from $215 million previously), and more efficient brand investments should materially strengthen profitability. We expect to lift our $34.50 fair value estimate slightly (3%-4%) as we incorporate this information and modestly lift our margin expectations, and continue to view shares as attractive.

In our view, Conagra's impressive slate of new products is largely attributable to its maxim that "you can't cut your way to prosperity"--in other words, focusing exclusively on profitability (and cutting too deep into necessary brand investments) can impede growth longer term. This mirrors our long-standing contention that CPG firms' spending on new product development and marketing is necessary to defend the competitive stance and restore top-line growth amid a challenging competitive landscape. In this context, we aren't anticipating a change to our expectation for Conagra's combined spending on marketing and research and development to amount to more than 4% of sales (or $500 million on average) over our forecast, which is proportionate to its spending in fiscal 2018 (4% of sales, or $326 million) and comparable to the mid- to high-single-digit percentages spent by its packaged food peers.

We anticipate this spending will be increasingly effective as Conagra has been employing a data-driven approach to more precisely gauge consumer demand and target its marketing. However, as management underscored, advertising alone can't create durable brands. Rather, brands must continuously modernize their offerings to align with consumer preferences, and advertising can support brand building by highlighting the product attributes that resonate with a target consumer. As a result, Conagra has leveraged data science (versus traditional research methods like focus groups or surveys) to gain a better understanding of consumer purchase behavior; this approach yielded additional upside in the form of $15 million in advertising and promotion cost savings over the past four years.

The firm has used this data to detect emerging consumer trends and help identify its ideal point of entry (primarily targeting the stage between initial adoption by specialty venues and mainstream proliferation to balance strong velocities with being an early mover) and add more modern, desirable attributes to struggling brands. For example, Healthy Choice had faced several challenges between 2013 and 2015, with a 9% decline in retail sales, 4% decline in penetration, and 7% higher rate of discounting relative to the category average over this time frame. In response, the firm redesigned this offering to emphasize attributes (such as a sustainable bowl, prominently displayed nutrition content, and higher-quality ingredients) with greater consumer appeal. As a result, retail sales for Healthy Choice frozen single-serve meals have growth roughly $80 million over the last year, versus an approximately $70 million decline for the five largest (non-Conagra) brands in the category.

Further, technology has enabled a more targeted approach to advertising, which has further strengthened Conagra's cost structure. Management estimates that digital will account for around 63% of media spending in fiscal 2019, versus 28% in fiscal 2015, and that personalized advertising can reach the same number of people as a mass approach, but with around 50% fewer "wasted" impressions. But rather than let these savings flow entirely to the bottom line, Conagra has reinvested these savings from advertising and promotion into product innovation, supporting its entrenched retail relationships (which underpin our narrow moat rating), and investing in its omnichannel capabilities, which we view as prudent. While e-commerce contributes a relatively small proportion sales at present (2% for Conagra and 3% for the overall food and beverage category in calendar 2018), this figure is expected to expand quickly over the next several years (management estimates 8% share of the food and beverage category by 2022), and we appreciate management's efforts to be responsive to nascent channels and new purchasing patterns.

In comparison, we still view consolidation in the supply chain to be a comparatively smaller opportunity for Conagra. We have historically viewed the firm's relatively complex supply chain as a constraint on its margin potential but were encouraged by improvements in productivity and working capital that should help free up funds for brand investments. Moreover, we were pleased to learn about the firm's strategy of considering materials (nearly two thirds of cost of goods sold) savings in the innovation process, leading to products that are not just higher-margin but also resonate with consumer tastes. For example, the shift to sustainable packaging (lower cost for paper than plastic) has been gross margin accretive. As a result, the firm expects to extract $50 million in materials savings (or nearly 1% of the prior year's cost of goods sold) in fiscal 2019.

Finally, we surmise this improved cadence of innovation and margin expansion will support capital allocation and expect Conagra will continue to return excess cash to shareholders via dividends and share repurchases (totaling $3.6 billion over the last four years). While the firm has temporarily suspended share repurchases to focus on deleveraging its balance sheet (targeting a net debt to last 12 months EBITDA ratio of 3.5 to 3.6 times by fiscal 2021, versus our estimate for more than 4 times in fiscal 2019), we expect repurchases amounting to a low-single-digit percentage of shares outstanding will resume in the out-years of our forecast. Moreover, we expect a dividend payout ratio around 45% over the next few years, implying a dividend yield of nearly 3% at current levels.