Description

Conagra is a clasic, boring break-up that will outperform in this current environment where so many long opportunities are fully priced.  A careful read of the Form 10K filed on July 15^th reveals that CAG is an underappreciated situation. Here is the bottom line: while the shares trade like a utility, CAG will benefit from opportunities to enhance returns through operational changes; it is almost entirely US-centric geographic profile and has healthy dividend yield. Pressured by activists, the shares also offer a wide range of potential strategic catalysts, which should provide pathways for value creation independent of the current macro environment.  These catalysts are potent.

What is the Street missing?

Many on the Street are focusing on the wrong things when it comes to CAG and the food industry, for that matter.  In regards to pricing and volume trends, the consensus view is that it is a tough industry; price and volume will continue to deteriorate.  In the consumer segment – pricing has stalled, sales fell short of expectations due to poor price/mix momentum; Broad-base weakness at the brand level; Private brands continue to show weak volumes; US consumer foods sales weakness will continue.

The Street fail to consider the following: Only temporary transitionary factors are taking its toll, for example, CAG took impairment charges on some brands last Q because the focus has not been on growing the business since the break-up consideration last year; Volume declines beginning to abate last month down 5% vs. 7%; Consumer margins remained healthy at 17.1% despite stalled pricing.  CAG is selling the Private Brands will improve growth profile.

Fully grasping CAG's profitability opportunities are also misunderstood, in my view.  The current thinking is that: profitability was a disappointment last Q and should continue. Commercial margins were 50pbs YOY compared to 160 expected; profits will languish as competitive pressures build in CAG’s markets; management unsure of the future as they provide limited visibility into the business; EPS expectations are lower than company guidance, signaling potential management credibility issue; and the company has poor tax strategies also will continue to hurt cash flows. 

But this is what the Street fail to realize: Guidance for the last Q was withheld pending the planned restructuring; Margins have significant room for improvement, Form 10 recently shows only a 17.5% EBITDA margins for Lamb Weston;  Company will start to aggressively target SG&A reductions; supply chain savings.  Savings targeted at $300MM (largest EBIT opportunity among comps), Conagra Brands is at 28.5% GM while peers at ~36% GM. Taxes were higher in Q4 higher than expected, but should come down from 37% to 33% this year.

While the restructuring has been announced, consensus is not fully reflecting the impact of such reorganization of CAG’s cash flows, and balance sheet.  This is what the bears point to: 1) As competition in the industry remains intense and consumer eating habits are changing, the company needs aggressive strategic efforts in its brand portfolio to respond to changing consumer habits; 2) Management are poor capital allocators; 3) The restructuring is not going far enough and is likely to be delayed; and 4) Too much debt will put pressure on cash flow and restructuring options.  However a break-up delay is very unlikely at this point. Current CEO will lead CAG Brands as a new  (more aggressive) CFO is installed; consumer foods CEO will lead Lamb Weston (with activist oversight); CAG will maintain an invest-grade profile and will continue paying a dividend; CAG has cut debt in half in 3 years, and will be accelerated post restructuring; Also if you read the Form 10 carefully, CAG can continued to seek additional strategic alternatives.

Valuation:

Target price (of all the pieces, post break-up) = $64, based on a 13.5x EV/EBITDA multiple on the Consumer business and 14.5x multiple on Commercial.  There is also an assumption that management can achieve at least $145MM in margin improvements … In this current market cycle, Staples are trading an average P/E of 24x at 1.7% yield.  Staples have a historical relationship between their relative P/E and the 10-year yield (which is down to 1.45% from 1.7% pre Brexit vote). This drove overall P/E for Staples vs. the S&P P/E as of late.

• Potential value based on the use of tax assets is not factored

• Potential brand RMT transactions could generate additional $5/share is not factored

• Past deal multiples: Evidence is growing over the years that the industry continues to be a hunting ground for PE firms and/or consolidation plays. MDLZ offered to buy HSY for 16x EV/EBITDA; Mars/Wrigley at ~18x, KFT/Cadbury at 13x;  and private equity such as 3G Capital/Berkshire Hathaway as a leader - Kraft/Heinz deal at ~16x (2015).

Downside (target for reassessment) = $40, valuing ConAgra as a going concern; 17x P/E on Street numbers with poor executions, no restructuring this year or proven ineffective. Another risk could also be if CEO uses the tax loss carry forwards to make bad acquisitions (unlikely with activists on board).

Company Description

ConAgra Foods is one of North America’s leading packaged food companies with recognized brands such as Marie Callender’s®, Healthy Choice®, Slim Jim®, Hebrew National®, Orville Redenbacher’s®, Peter Pan®, Reddi-wip®, PAM®, Snack Pack®, Banquet®, Chef Boyardee®, Egg Beaters®, Hunt’s® and many other ConAgra Foods brands found in grocery, convenience, mass merchandise and club stores. ConAgra Foods also has a strong business-to-business presence, supplying frozen potato and sweet potato products as well as other vegetable, spice and grain products to a variety of well-known restaurants, foodservice operators and commercial customers. 26 consumer brands are No. 1 or No. 2 in their category. The Consumer Foods segment makes and sells leading branded to retail and foodservice channels, principally in North America. The Commercial Foods segment supplies frozen potato and sweet potato products as well as other vegetable, spice, and bakery products to a variety of well-known restaurants, foodservice operators and commercial customers.

Catalyst

1. In a few weeks: Investor Days will be set for Lamb Weston and Conagra Brands to finalizing cap structure, operating agreements and some guidance – expect incremental costs savings post spin and other incentives.

2. Fall 2016: a break-up: tax-free spin creating two pure play companies (Conagra Brands – consumer foods, Lamb Weston – global frozen product company)

3. Selling more assets: completed the sale of private label unit to TreeHouse Foods for $2.7 billion (Feb ’16); received ~ $480MM proceeds from sales of its Spicetec Flavors & Seasonings and JM Swank businesses (Sept.’16 close); more sales to follow..

4. Reverse Morris Trust option is possible for certain brands and will get clarity over the next few months.  CAG should sell its struggling brands like Orville Redenbacher's, Chef Boyardee and Hebrew National. This will not only allow the company operate with a focused portfolio but will also enable it to improve its operating margins which still trails its peers because of weakness in private brands and consumer foods.

5. Tax loss carry forwards of $1.6 billion+ would be retained in a RMT transactions or could used for accretive brands acquisitions;

6. Management changes: last week on July 14^th, Conagra announced a new CFO David Marberger, an aggressive cost cutter starting in September before break-up.  (At Prestige Brands, as it turns out, David did a lot of spin-outs, restructurings and reformed the business.)  Expect costs cuts and rightsizing the organizational structure;

7. Management incentives will now be aligned: Activists filed 13D on June 18^th and won 2 board seats, looking to unlock maximum value.  New board member Tim McLevish, appointed by the activist will chair Lamb Weston; activist retained Diane Dietz – brand expert and deal maker to provide advice for Conagra Brands.  Following these moves, management has said “…we will consider other options beyond the consumer/commercial split if they create value.”

8. Continued benign commodity input cost relief expected will help increase margins (most important input costs to CAG: poultry, wheat, aluminum, paper, PET).