Description

Intro: 

At its core, Campbell Soup Co. (CPB) is a 4x+ levered US-focused center-of-store food company, dependent on a secularly declining category for the lion’s share of profitability and cash flows, that is up 41% YTD even as forward earnings expectations are flat to down. We believe the shares are worth $32/share, or -33% from current, which is 10x our FY21 EBITDA estimate of $1.55bn. 

·      Soup: We see little opportunity for the company to improve its lot in soup, since its core product has been declining for a decade through multiple turnaround attempts, retailers have shut the door on price hikes after CPB’s perennial use of this growth lever, comps in the Meals & Beverages segment are about to get a lot harder in FY20, and CPB has pulled forward some sales into FY19 which have inflated growth in the segment in recent periods. Soup and other shelf-stable items in the Meals & Beverages segment are the main source of CPB’s cash flows, since the snacks businesses are capital intensive and structurally lower margin. As soup fades away, the headwind to earnings will be greater than is appreciated by most investors, as this is a high operating-leverage category.

·      Snacks: In the largest of several “growth” acquisitions, CPB purchased snack food manufacturer Snyder’s-Lance (LNCE) for $6.1bn or 19.9x EBITDA pre-synergies, a very full valuation for a business that began declining organically almost immediately after the deal closed. While there was a large synergy and cost savings plan attached to the acquisition, we believe it will be challenging to bring LNCE up to the corporate average gross margin, since a) LNCE operates a largely redundant yet impossible-to-rationalize DSD network, preventing the extraction of distribution synergies, b) LNCE has a decidedly lackluster portfolio of brands in vulnerable share positions, c) LNCE has various low-margin co-packing arrangements in place with third party “partner brands”.

Soup Thesis:

We believe that CPB’s canned soup business is a very high margin business that is responsible for much of the cash flow generation of the group. This business is in decline.

·      According to the CPB FY19 10-K, soup accounts for 29% of sales, and is reported in the Meals and Beverages segment. 

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·      While the company frequently restates segment results to account for portfolio changes, the Meals & Beverages segment has been fairly consistent since FY14. ’14-’19 revenue CAGR is -1.2% and while ’14-’19 EBIT CAGR is -2.6%. Meals & Beverages segment margins have averaged 700bps higher than Snacks over the same period:

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·      CPB also discloses D&A and capex for each segment, so using segment earnings + D&A – capex + restructuring as a proxy for segment free cash flow, we can estimate the following FCF break-down:

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o   Meals & Beverages, led by soup, was 71% of combined FCF before corporate costs in 2018 and 62% in 2019, or 94% and 87% of total FCF including corporate. This is a high level of exposure to earnings that we believe are at risk.

·      Growth in CPB US soup has been negative in 9 of the last 10 years:

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·       Source: RBC Capital Markets

·       Looking at the Meals & Beverages segment, of which over half of revenues are from soup, we see that in the period from FY13 to FY16, organic growth was occasionally positive, with pricing (red bar) nearly always a positive contributor to growth:

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·       However, in the period after FY16, growth has been consistently negative with negligible contribution from price. We believe that after many years of bolstering soup sales with price increases even as unit consumption declined, CPB eventually reached a point where retailers refused to concede further pricing increases.

o   This is logical given the minimal innovation in the category, lack of growth, and price-sensitivity of condensed soup consumers. 

·       This over-reliance on pricing came to a head in Q1 FY18, when Wal-Mart refused to promote CPB during the peak soup selling season, resulting in a volume plunge for CPB as consumers shifted to Progresso (GIS) and private label. Wal-Mart’s traditional role in food retail is to set a pricing floor for the rest of the industry, so with promos off at Wal-Mart and on-shelf pricing too high, CPB soup pricing at other retailers also moved up, in effect amplifying the issue across the other retailers.

·       The decremental margins from the soup volume declines were enormous, leading to an outsized impact on segment earnings (although in fairness, commodity inflation flared up as well):

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·       So has CPB learned their lesson after persistently trying to price at a premium in a budget category where retailers are prioritizing margin dollar growth? The answer appears to be no. 

§ Below is an image from earlier this year of Wal-Mart’s soup aisle: CPB like-for-like product costs 14.1 cents per ounce vs. PL at 4.8 cents per ounce

·      Less anecdotally, the IRI data through October 20 (within 10 days of capturing the entire first fiscal quarter) show soup organic growth declining by 320bps Q-o-Q in 1QTD vs. 4Q19, suggesting that CPB’s 4Q19 soup growth of +3% was little more than a fluke on incredibly easy comps.

·      Speaking of comps, CPB’s 4Q19 Meals & Beverages organic was +1% or -5% on a two-year stacked basis. Holding this two-year stack constant for the next three quarters would imply Meals & Beverages organic growth of +0% in 1Q20, -4% in 2Q20, -5% in 3Q20, and -6% in 4Q20. This is a much more difficult set of comparisons than CPB has faced in the recent past, and the company will no longer be able to skate by without a real underlying inflection in growth. 

·       Lastly, it’s worth mentioning that for two straight quarters, CPB’s reported soup numbers have been flattered vs. tracked retail takeaway, which calls into question the sustainability of recent less bad trends.

o  In 4Q19, CPB reported +3% soup growth but retail takeaway was only +1.4%. Adjusting for the difference between sell-in and sell-through in soup, CPB Meals & Beverages organic growth was overstated by 80bps, which is the entirety of the segment’s organic growth reported in the quarter (so growth would have been +0% over a -6% comp)

o  In 3Q19, CPB reported flat soup growth but retail takeaway was -2.6%. This implies segment organic growth was overstated by 140bps (so growth would have been -1% over a -2% comp):

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o  While it may seem pedantic to pick away at 100bps here or there, CPB’s high operating leverage in the Meals & Beverages business means that the company’s earnings benefit inordinately from small topline outperformance in this segment; moreover, assuming an eventual normalization between takeaway and sell-in, these benefits will become nontrivial headwinds in the future.

Snacks Thesis:

Though snacks exhibit better growth than soup, we believe the acquired LNCE business (which represents over half of the Snacks segment pro forma for the divestiture of $1.1bn of Campbell International revenues) is poorly positioned, unlikely to yield the targeted cost savings, and has lower profitability by virtue of its arrangements with third party brands, for whom LNCE acts as a distributor.

·      CPB’s decision to acquire LNCE seems misguided in a few different ways:

o   The deal got them mostly a collection of me-too brands without much category leadership (in fact, only Snyder’s of Hanover is a leading brand in its subcategory): 

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o   Source: Bernstein 

o   The LNCE brands went ex-growth nearly as soon as CPB acquired them:

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o   What made the LNCE deal more palatable was the ambitious cost savings and synergy plan, which aims to deliver $295mm by FY22, more than doubling LNCE EBIT if CPB allows it to drop through to the bottom line. Like LNCE, CPB is already an experienced operator of DSD networks via its Pepperidge Farm bakery and Pepperidge Farm snacks DSDs, so at first glance the inclusion of LNCE’s own DSD network seemed like a promising source of savings, as redundant routes could be rationalized and route density optimized. However, unlike Frito Lay North America (to which CPB’s snacks business is occasionally benchmarked), all three DSD networks that now sit within CPB are third-party owned, so CPB is unable to merge these disparate systems without buying out route owners, which would be time-consuming and likely prohibitively expensive. Without this obvious source of savings, CPB must resort to other, less juicy opportunities, like warehouse consolidation, right-sizing the manufacturing footprint, and back-office cuts. LNCE already spent very little marketing its brands, so A&P is more likely a source of dis-synergies.

o   In addition, although it didn’t receive much airtime until recently, LNCE is reliant on third party “partner brands” for ~20% of revenues. This is a copacker relationship which LNCE must maintain in order to keep operating leverage high in the DSD system. Since LNCE is just functioning as a distributor for another manufacturer, it stands to reason that these partner brand revenues are significantly lower-margin than the core Snyder’s-Lance brands. CPB has announced its intention to reduce its partner brand exposure, but there is no quick fix given the necessity of keeping the network fully utilized.

As laid out above, we believe the business fundamentals are more challenged than recent share price performance would suggest. To briefly address the reasons for the market’s enthusiasm:

·      Mark Clouse, respected food industry executive, taking over as CEO

o   Clouse is incorrectly lauded, in our view, for packaging up the challenged Pinnacle Foods (PF) portfolio for sale to Conagra (CAG). No doubt he has displayed talented salesmanship in communications with investors and deal negotiations with competitors, a skill which may obscure for a time the secular weakness in CPB’s operations. As for engineering sustained improvements in the earnings trajectory of the business, however, we would point to the disappointing performance of PF within CAG post the sale.

·      Better than feared earnings results on easy comparisons in 3Q and 4Q

o   In our view this has less relevance for the business moving into the future since there were truly extraordinary headwinds in the comparison periods

·      Successful divestitures of C-Fresh assets and Campbell International to aid deleveraging efforts

o   While expectations are for these divestitures to result in over half a turn of deleveraging (from 4.6x to 4.0x) and only a few pennies of EPS dilution, the trade-off is that CPB is now more dependent than ever on soup and US center-of-store, a state of affairs prior CPB CEOs have spent billions of dollars trying to avoid (via a mixed track record of acquisitions including Bolthouse Farms, LNCE, Pepperidge Farms, Plum, Kelsen, Pacific Foods etc). At 4.0x vs. 5.0x net leverage, CPB still lacks any reasonable measure of financial flexibility, and the onerous combination of capex, restructuring charges, stranded costs from the divestitures and the $425mm annual dividend will likely limit future debt paydown to a trickle. If EBITDA is declining as we assume, then leverage ratios could actually be climbing.  

·      Medium term plan implying improved rate of product innovation, soup category revamp, return to attractive rate of earnings growth

o   It doesn’t take much sleuthing to see that CPB’s new targets are unrealistic compared to historical rates of organic growth:

§  Since 2009, CPB average annual organic has been +0% vs. +1-2% medium term plan, and we would argue industry backdrop has deteriorated markedly over that time horizon

§  Since 2009, CPB average annual EBIT growth has been +1% vs. +4-6% medium term plan

§  Since 2009, CPB average annual adjusted EPS growth has been 3% vs. +7-9% medium term plan

o   The category specific strategies laid out in the July Investor Day seem uninspired and stop short of a true change in direction.

·      Falling interest rate expectations throughout the year improving relative dividend yield and bolstering the valuation

o   This has influenced multiples across the staples sector for stocks viewed as bond proxies

o   For what it’s worth, we would argue that the poorly-covered dividend, increased financial risk, and recent earnings volatility of CPB merit a wider dividend yield than the stock has historically received.

Valuation

We value CPB at 10x FY21E EBITDA, a reasonable forward multiple for a business with deteriorating quality of earnings, in secular decline, and lacking the balance sheet flexibility to acquire its way to growth.

Using estimated pro forma capital structure (adjusted for divestitures announced but not yet closed), we estimate CPB trades at 12.4x NTM consensus EBITDA of $1.65bn at today’s $46.40 price, a full 2.1x higher than the historical average. When we consider the dramatic slowdown in the organic trends in recent years, the ascendency of retailers to the detriment of brands, the earnings mix towards the declining soup business, and an increasing use of significant recurring adjustments to GAAP numbers, the valuation premium seems all the more perplexing. 

We believe organic growth and margin trajectory over the next two fiscal years will underperform expectations. In Meals & Beverages, we assume -2% organic, consistent with the average decline over the past 3 fiscal years. In Snacks, we assume +1-2% organic, reflecting the headwind from partner brands and the generally weak positioning of CPB brands vs. competition. These assumptions, along with steady input cost inflation, lost earnings from divested businesses, cost savings from productivity and an 80% drop-through on LNCE savings, net out to a $1.55bn EBITDA estimate for FY21E vs. Bloomberg consensus $1.65bn (-6%), or EPS of $2.45 vs. Bloomberg consensus $2.70 (-9%). On FY20 expected capital structure and 10x multiple, this works out to a $32 target price including $2 of dividends, -33% from current and a 45% IRR.

Catalyst

Earnings misses

Dividend cut