2024-01-15 23:35:45 ET
Summary
- CPB is trying to fix its volume growth challenges with the Sovos Acquisition.
- Sovos's premium brands may be a tough sell in a slowing economy.
- The acquisition of Sovos Brands increases Campbell Soup's debt and poses risks to shareholders.
- Investors can wait patiently for a lower valuation and higher yield.
In May 2023, I rated Campbell Soup ( CPB ) a hold since it was fully valued. Since then, the stock has dropped 16% on a total return basis compared to a 15% gain on the S&P 500. The U.S. Treasury ( US10Y ) offers attractive interest rates on its notes and bonds, posing a threat to many consumer staple stocks with good dividend yields, such as Campbell Soup. The high yields and low beta were the primary reasons to own the consumer staples sector when interest rates were low. But, when interest rates increased, government bonds offered a viable and no-risk option to dividend-yielding sectors such as utilities, consumer staples, and real estate.
Besides bond competition, many consumer staples companies have long struggled to grow their volumes. Campbell Soup has long struggled to grow its volume in its soup category. Although its Snacks portfolio continues to do relatively well on the volume front, its Meals & Beverages portfolio has struggled to grow revenues, thus capping earnings growth. The management is looking to grow volumes by acquiring Sovos Brands ( SOVO ). However, there are risks to the company and the shareholders due to this deal, and it may be best for investors to be patient before buying Campbell Soup. I rate Campbell Soup a hold.
Volume Growth Challenges
In my article, I pointed to the lack of volume growth as a challenge to Campbell Soup and other consumer staples companies. Price increases can only go so far in helping grow revenues before consumers pull back their spending or switch to lower-priced or generic brands. In short, price elasticity increases. Campbell Soup's management was grappling with low-single-digit volume growth. In Q4 FY 2023 , the company reported a 5% decline in net sales due to declining volumes. In Q3 , a volume decline led to a 7% decline in net sales. In Q2 , the story was similar, with a volume decline leading to a 130 basis points decline in net sales. The company raised prices in these quarters to compensate for declining volumes.
Further price increases may be capped, and large customers like Walmart have the buying power to push back on price increases. Ultimately, the company has to increase sales volumes to bolster revenue. Campbell Soup was staring down low single-digit volume increases for the foreseeable future. This lack of volume growth may be the primary reason behind the Savos acquisition.
Stalling Revenue Growth
Although price increases have helped, quarterly revenue growth has stalled in FY 2023, with less than 5% growth in the April and July quarters and a drop in revenue of 2% in the October quarter (Exhibit 1) . Gross and operating margins have also stalled. Gross and operating margins peaked at 32.3% and 17% in October 2022. The lower profit margins have pressured operating cash flows, with margins coming in at 12.2% compared to the average of 15.7% over the past decade. Operating cash flow was $1.14 billion in 2023 compared to $1.18 billion in 2022, a modest drop.
Exhibit 1:
The free cash flow margin has dropped to 7% compared to its average of 11.2% over the past decade. Although the company's free cash flow has dropped, its free cash flow yield has increased primarily due to the drop in the stock price. In May 2023, the stock was trading at around $54, compared to its current price of $43. Based on the FY 2023 free cash flow, the yield was 5.8%, a good yield compared to the U.S. Treasury Bond yield of 3.93%. However, Campbell Soup is paying for Sovos Brands by issuing debt, which increases the debt ratio to 4x. If things do not go as planned, its cash flows can be pressured, reducing its capital return to shareholders by pressuring dividend growth and share buybacks.
Sovos Brands Acquisition Poses Risks
Campbell Soup announced its planned acquisition of Sovos Brands on August 7, 2023, for a total enterprise value of $2.7 billion. The company is paying a premium multiple of 19.8x EBITDA to acquire Sovos Brands, which may be a high premium. The company is paying for this deal by issuing debt, increasing its debt ratio to 4x, and increasing the risk for shareholders. Campbell Soup hopes Sovos Brands, best known for its Rao's Italian Sauces, would bolster its Meals and Beverages segment.
Sovos Brands may also allow Campbell Soup to venture into new markets, such as frozen meals. But Sovos Brands offers premium products. Consumers are struggling to grow their income, and the high inflation over the past two years has taken a toll by crimping spending. Credit card delinquencies just surpassed pre-pandemic levels . Given these stresses on the consumers, it isn't easy to sell a premium brand. Consumers are more likely to trade down when their budgets are tight and wish to stretch every dollar. Besides, even as inflation fades, prices at the grocery store are much higher than in 2019 and have stayed that way, giving consumers sticker shock when they look at their grocery bills.
Sovos Acquisition Increases Debt to Risky Levels
Campbell Soup carries a net debt of $4.5 billion (Exhibit 2) , but the Sovos acquisition would put the debt load close to $7 billion. The net debt to EBITDA ratio would increase from a manageable 2.6x to 4x. This level of debt may be too high given the rate environment and the weakening economy.
Exhibit 2:
The company gets a yogurt brand, Noosa, with the Sovos acquisition. Campbell Soup has already indicated that yogurt is not core to its strategy. If the management decides to sell the yogurt brand, it may be able to reduce its debt. But, Noosa may only reduce the debt by a little, and it may not matter much to reduce its leverage. Sovos does not break the sales and EBITDA from its Noosa brand, but given the total sales at Sovos were $990 million TTM, the sales and EBITDA from its yogurt brands might be low, yielding very little cash to pay down a meaningful portion of the debt. The one advantage of selling Noosa is that the company will eliminate a non-strategic asset.
Campbell Soup trades at a forward GAAP PE of 14x compared to the sector median of 19x. It trades at an EV/EBITDA multiple of 10x compared to the sector median of 11.3x. This is an attractive valuation for Campbell Soup, but the uncertainty brought on by the Sovos Brands acquisition, coupled with the increased debt, keeps me on the sidelines. The company's management faces economic and execution risks, and shareholders face the risks of increased debt. Any execution challenges or fall in demand for Sovos products could lead to lower outlook, earnings, share price, and valuation. That may be the signal to buy Campbell Soup cautiously.
Consumer staples stocks such as Campbell Soup offer low volatility and good dividend yields. Campbell Soup's acquisition of Sovos Brands may bring higher volatility and lower dividend growth, assuming the dividend would remain safe. Dividend CAGR over the past five years was a respectable 7% , above the sector median of 5%. But the three-year CAGR was 1.3%, well below the inflation rate. Investors should demand dividend growth to exceed the inflation rate.
Dividend income is the primary reason to own the stock despite the positive commentary by the management about their Sovos Brands acquisition. Growing premium brand sales will be complex and could challenge the capital return to shareholders. The stock has gone nowhere over the past decade, returning 1.3% on a price return basis (Exhibit 3) . The total return for Campbell Soup was 35% over that period; essentially, 33% of the return was from dividends. If the dividend is the only reason to own the stock, then the valuation has to be compelling, the dividend has to be safe, and the yield has to be close to 5%. Given the current rate environment, investors should expect a yield more significant than the 10-year U.S. Treasury Bond.
Exhibit 3:
Campbell Soup has accumulated a great set of solid brands. However, the Sovos Brands acquisition does pose execution risks. Investors own the stock for the dividend income, and given the risks and the rate environment, they should demand a higher yield. Investors can better assess the company's prospects after the deal closes. The deal is expected to close in mid-2024 . Campbell Soup is rated a hold at this time.
For further details see:
Campbell Soup: Sovos Acquisition Has Risks