Description

I believe Conagra (CAG) is a long investment at this level.  The stock is down nearly 50% since CAG announced the acquisition of Pinnacle Foods (PF) on 6/27/18.  The majority of the decline has occurred since last October. CAG was a crowded hedge fund long with significant leverage and not surprisingly did not trade well in the risk off environment last Oct-Dec.  In addition, on CAG’s 12/20 FYQ2 earnings report, it had to materially reduce expectations for PF’s outlook due to poor execution under the previous leadership team. The magnitude of the decline was surprising considering CAG announced this acquisition just six months ago.  As a result, the stock dropped from ~$30 to ~$20 in a matter of days. I believe many of PF’s issues are ultimately fixable under Sean Connolly and CAG’s valuation and now lowered expectations provide an asymmetric long opportunity.

Thesis:

1. Sean Connolly has a track record of creating value (Hillshire, spinning Lamb Weston, divesting Ralcorp).

2. The combination of CAG/PF makes more sense than most recent packaged food M&A (CPB/LNCE, GIS/BUFF, SJM/Ainsworth) and should result in higher cost synergies.

3. CAG’s valuation is attractive at 10x FY20 EBITDA vs. 11-13x EBITDA for packaged food.  The company was trading at ~12x EBITDA last May/June (pre-PF announcement).

4. Management has lowered its outlook for PF’s contribution to CAG’s FY19 (May 2019).

Management

Sean Connolly has one of the better track records in packaged food.  He joined CAG in February 2015 after leading Hillshire through its sale to Tyson Foods.  At CAG, he has spun Lamb Weston, divested Ralcorp and has completed a number of smaller bolt-on deals in attractive, higher growth areas such as snacking.  He has also divested non-core, lower growth businesses such as Wesson. The Ralcorp divestiture in early 2016 was an unwind of a deal completed just three years earlier under previous management.  This was a better decision than trying to fix a lower margin and structurally pressured business. Connolly used the proceeds to prudently deleverage the balance sheet. On Pinnacle, to be fair, the rapid decline of the business does raise flags related to Sean/CAG’s due diligence process.  However, it’s not totally surprising PF’s business has moderated given the previous management team was singularly focused on selling the business. In sum, while not an ideal start, I think Connolly has the focus and experience to fix these temporary issues. He was pretty fired up on the last conference call.

M&A

Packaged food has been under top line pressure for the past couple years (see Bernstein graph below).  As a result, many companies have levered up to buy high growth assets (especially outside their core). GIS/BUFF, CPB/LNCE and SJM/Ainsworth are just a few examples.  Pet and snacks are two focus areas for growth (GIS/SJM paid north of 20x EBITDA for higher growth pet businesses). As a result, sector leverage is nearly 4x compared to 2x in 2010 and 2.5x on average between 2010 and 2017.

CAG is in a similar situation with 5x leverage but the rationale behind combining CAG/PF makes more sense than GIS expanding into pet or CPB paying up for LNCE.  I believe there should be upside to management’s $215+ mm cost synergy target based on industry diligence. CAG outlined $215 mm in cost synergies at the time of the deal announcement but recently said there was upside to that estimate based on a bottoms-up analysis.  55% of the cost savings are SG&A and 45% are COGS. There should be upside to COGS synergies based on manufacturing/plant consolidation and procurement. CAG/PF were already run relatively lean at the SG&A level. Based on the recent PF issues, management is focused on reinvigorating PF’s innovation and product pipeline (especially among the three leadership brands: Birds Eye, Wish Bone and Duncan Hines).  This suggests any “heavy lifting” manufacturing savings will probably be pushed out. My understanding is that CAG management did not include these cost synergies in the initial estimate.

Valuation

CAG is trading at 10x FY20 EBITDA.  This is one the lowest valuations in packaged food.  Levered/M&A peers such as GIS, CPB and SJM trade at ~11x EBITDA.  The sector is trading in the 11-13x range. There is clearly execution risk with CAG/PF but arguably less than at GIS, CPB or SJM.  GIS levered up to buy an asset outside its core for 20x EBITDA. The sector as a whole has de-rated over the past couple of years and this is probably warranted given its less defensive nature and higher cost of growth.  The sector challenges can be hedged with other packaged food stocks. Connolly has also shown a willingness to divest non-core assets (Ralcorp, Wesson recently). I think he’s focused on deleveraging and will divest assets opportunistically and tax efficiently given CAG has $720 mm remaining on its capital loss carryforward.  The company is targeting 3.5x leverage by the end of FY21.

PF expectations

Pinnacle’s three key leadership brands, Birds Eye, Wish Bone and Duncan Hines, have slowed considerably since the deal close due to a lack of investment in innovation and inefficient trade/promo spend.  PF’s prior management reduced investment in order to support margins as it shopped the company. The consequence was a poor innovation pipeline, reduced negotiating power with retailers and lost market share.  As a result, CY2018 net sales and margins came in well below earlier expectations (PF’s management and consensus).

I believe these issues are fixable with focused reinvestment.  It won’t happen overnight given the lead time needed for product innovation and retailer discussions but Sean has done this in the past.  It will probably take until the second half of 2019 or early 2020 to begin seeing results. However, this is partially factored into CAG’s estimate of PF’s contribution for FY19.  CAG management is assuming PF net sales decline mid-single digits and EBIT margins are in the 14.6-14.9% range. This compares to a ~1% PF retail sales CAGR between CY13-CY17 and 18-18.5% target margin in CY18.  The lower margin should provide a cushion for reinvestment and continued top line pressure. Potentially offsetting some of these headwinds in the near term is an opportunity for PF to leverage CAG’s freight/transportation infrastructure and rates (approx. half of PF’s gross margin miss was due to freight).

In summary, I think CAG’s 10x EBITDA valuation and the lowered outlook for PF provide for a compelling long investment.  The integration is not without risk but I believe similar risks also exist at peers that trade for 11-13x EBITDA. I also believe Sean Connolly is better equipped to navigate a rapidly changing industry.  CAG will be hosting an analyst day in April to provide an update on the integration and a long term financial algorithm for the combined company.

Risks

Financial leverage at 5x.

Frozen food cycle slowing.

Further PF deterioration.

Management distraction causing legacy CAG to slow.

Continued packaged food industry pressure (slowing top line and margin pressure).

Catalyst

Analyst day in April, divestitures, earnings.