Conagra Brands: Balancing Near-Term Upside Against Out-Year Growth Challenges (NYSE:CAG)

Despite a relatively strong set of FQ1 numbers, I am concerned about the Conagra (NYSE:CAG) outlook on several fronts. Firstly, there will be some tough comparisons ahead as consumers eventually regain mobility, and the food at home tailwind fades. Secondly, I see the company’s low level of advertising reinvestment is negative for the future earnings outlook, especially with competitors stepping up investments in longer-term brand equity. At the current multiple, I don’t think CAG shares offer much in the way of long-term value.

Strong FQ1 Results Benefit from Packaged Food Tailwinds

CAG posted a better-than-expected set of FQ1 results, with EPS of $0.70 on the back of better-than-expected organic sales (+15.0%), significant gross margin expansion of c. 244 bps, and opex leverage.

Source: Conagra FQ1 Presentation Slides

The key to the quarter was continued demand for packaged foods through the pandemic, with retailer inventory restocking also providing a c. 600 bps benefit. The latter was reflected in Grocery & Snacks and Refrigerated & Frozen organic sales growth, which accelerated to +20.7% and 19.0%, respectively. Pricing trends also benefited from lower promotional activity in the quarter. On the other hand, foodservice trends remained under pressure, with organic sales down 20.3% due to lower away-from-home consumption.

Source: Conagra FQ1 Presentation Slides

While these are certainly very strong numbers, I do question the sustainability going forward. As both US retail segments were helped by a sizeable trade load that likely implies some front-loaded demand, I expect to see this reverse in the upcoming quarter. Additionally, top-line growth was also boosted by c. 70 bps from non-recurring trade accruals, implying a lower underlying growth trajectory.

Dissecting the Bottom-Line Strength

The bottom-line performance was also very commendable – gross margins reached 30.7%, above expectations on better volume leverage, and the trade spend accrual benefit. Meanwhile, advertising and promotion spending was offset by lower operating expenses, resulting in EBIT margins above expectations at 20.2%. By segment, the operating margin strength was spread across Grocery & Snacks, International, and Foodservice, while Refrigerated & Frozen lagged.

Source: Conagra FQ1 Presentation Slides

As a result, adjusted EPS rose 64% to $0.70/share, on the back of the increase in adjusted gross profit and SG&A tailwinds, which offset an expanded share base as of quarter-end. On another positive note, the quarterly dividend was also hiked, bringing the annualized dividend to $1.10/share. But even though the bottom-line strength in FQ1 was again impressive, it is difficult to gauge the true extent of the beat, as trade inventory accruals did also provide a one-off boost to margins.

Updated FQ2 Guidance Implies Deceleration Ahead

On account of the ongoing uncertainties due to the pandemic, CAG refrained from providing a full-year outlook but did offer FQ2 guidance. For the upcoming quarter, sales growth is guided to decelerate to 6-8%, mainly due to the unwinding of the c. 400 bps benefit from reloading inventory at retailers. But as some of the FQ1 trade accrual benefit will also spill over into FQ2, I would caution against extrapolating these growth numbers. On the flip side, the timing of Thanksgiving is also less favorable this year, which means some holiday shipments will also shift to FQ3.

Meanwhile, operating profit margins are guided to decline sequentially to 18.0%-18.5% (from 20.2%), due to the unwinding of a c.40 bp accounting benefit from trade accruals. While FQ2 will also include higher expenses for merchandising and slotting fees, along with investment in innovation and marketing, adjusted EPS of $0.70-0.74 is still encouragingly within consensus estimates.

Source: Conagra FQ1 Presentation Slides

FY22 Targets Reaffirmed

The fact that the company also reaffirmed its fiscal 2022 targets was also encouraging, largely reflecting increased confidence in the outlook. While strong repeat rates and increased consumer trials during the pandemic will make the path a lot easier, I am not as bullish on the longer-term outlook once the COVID-19 tailwinds fade. To recap, the targets are as follows – 1) organic growth at 1%-2% CAGR, 2) adjusted EBIT Margins within the 18%-19% range, 3) adjusted EPS within the $2.66-$2.76 range, and 4) FCF Conversion at over 95%.

Source: Conagra FQ1 Presentation Slides

Long-Term Consumption Stickiness is the Key Debate

My concern with CAG is that, unlike its peers, it seems more focused on maximizing flow-through, instead of reinvesting for the future. This might be beneficial for margins near term, but it raises questions as to whether the company will be able to compete effectively in at-home consumption over the longer term.

Management’s view, on the other hand, is that CAG remains well-positioned to benefit from a structural shift to at-home eating, as value is prioritized during challenging economic times. The company pointed out several key benefits beyond the pandemic. Firstly, work-from-home arrangements are likely to increase as more of the workforce goes remote. According to management, the number of at-home eating occasions requiring over 15 minutes of prep time has risen across all age groups.

Source: Conagra FQ1 Presentation Slides

Finally, the company also believes dinner is the prime beneficiary from a shift in eating patterns coming out of the pandemic, with a +11% rise in at-home occasions. Considering the dinner category makes up c. 43% of company occasions, management is calling for a structurally higher earnings trajectory.

Source: Conagra FQ1 Presentation Slides

That all makes sense, but I would contend that these outcomes are far from certain. Furthermore, these observations are based primarily on the company’s research, and as such, I am not fully convinced that the research is entirely free of bias. At present, with FQ2 growth already decelerating, I would rather adopt a ‘wait-and-see’ approach, pending improved visibility around at-home consumption stickiness.

Staying Focused on the Long-Term Trajectory

In sum, Conagra’s quarter was a very good one on the surface, but on deeper examination, signs of deceleration are already emerging. While the company has done well in capitalizing on favorable COVID-19 tailwinds, I remain uncertain on the out-year growth outlook as the recent consumption spike fades and reinvestment ramps up. Balancing the near-term earnings upside against a slower expected out-year growth trajectory, I see limited upside to CAG shares from here.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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