2023-04-04 16:44:58 ET
Summary
- Traders have focused heavily on the direction of profit margins within the consumer staples sector.
- Conagra already has focused on cost-cutting and is now getting another tailwind on the margin front due to falling commodity prices.
- All this leads to a favorable set-up for Conagra in this quarter's earnings report and the rest of 2023.
- However, the firm's weak long-term growth and lackluster brand portfolio will limit share price gains over a longer time horizon.
Packaged foods company Conagra Brands (CAG) is set to report its earnings on Wednesday. With the consumer staples sector on the upswing in recent months, it's worth checking in on Conagra ahead of its next earnings release.
I last covered Conagra shares in December 2022 at the time arguing that the stock was a sell based on valuation especially compared to other peers in the packaged foods industry. Since that time, Conagra shares have dropped a couple of percent, while the S&P 500 has rallied 5%. It's not a huge change in either direction, but CAG stock is slightly more attractive on a relative basis compared to the overall market.
Additionally, we've seen several measures pointing to a meaningful deceleration in inflation and in input costs for food companies in particular. As such, I'm now somewhat more upbeat about profit margins for Conagra now than I was in December.
Neither of these are huge changes, to be clear, but I'm slightly more optimistic heading into Conagra's earnings this week. Here's why I'm moving from my prior sell rating to a hold on CAG stock.
All Eyes On Profit Margins
The driving factor in the consumer staples sector lately has been profit margins. Firms with rising profit margins have enjoyed soaring stock prices, while firms that have suffered from margin compression have seen their share prices slump. Just look at a firm like Hershey (HSY) trading up sharply and sitting at all-time highs while food industry peers like Hormel Foods (HRL) and Tyson (TSN) have dropped sharply.
Over the past couple of years, for example, Hershey shares have doubled while Hormel is flat. It seems unlikely that the long-term franchise value of Hershey has appreciated quite that much, nor that Hormel's performance has been quite that bad over the same time period. But, for now, traders seem focused on the direction of profit margins at the expense of any other factor.
We can see a stark example of that with spices and flavorings company McCormick's (MKC) earnings last week. While its earnings were still unimpressive on a year-over-year basis, the company showed a strong rebound in profit margins from its summer 2022 trough. The result? MKC stock has leapt 15% higher merely on the first signs of rising profit margins:
I bring all this up because Conagra is in an interesting position when it comes to profit margins.
That's because Conagra already has been focused on driving margin growth since before the pandemic. CEO Sean Connolly has based Conagra's turnaround effort primarily around cost-cutting and reshaping the portfolio to focus on higher profit margin products.
Conagra is continuing to zero in on its supply chain, targeting another $1 billion in savings through fiscal year 2025.
Between Conagra's internal efforts to cut costs and outside factors, namely commodity prices, Conagra should be in a good position for the next couple of quarters. Consider wheat prices, for example:
Last February, around the time of the invasion of Ukraine, wheat futures spiked from 750 to as high as 1,400. Now, they're below pre-war levels, with wheat struggling to hold the 700 mark. As a result, packaged foods companies which buy wheat will see sharply lower cost of goods sold for 2023 vs. the same period of 2022. Note, however, this effect will be more evident next quarter, as opposed to the quarter being reported now, as the majority of acute war-related commodity price inflation occurred between March and May 2022.
It's hardly just wheat, either. You can find similar charts for canola, corn, oats, and soybeans, among other key inputs for packaged foods companies. And, over time, lower grain prices should translate into some relief in livestock pricing as well. All in all, 2023 should be a year of improvements for companies like Conagra that already pushed through price hikes in 2022 and will now get help on the cost of goods side of the ledger this year.
If I were to argue the devil's advocate position to this, it's that expectations are already relatively high for Conagra. Analysts expect 13% EPS growth and 7% sales growth for FY '23. And, notably, the company has enjoyed 15 upward analyst earnings revisions and not a single downward revision over the past three months. This speaks to Conagra facing a higher bar than, say, McCormick did ahead of that firm's narrative-shaping earnings report.
CAG Stock Verdict
I wouldn't be surprised if Conagra trades up following its earnings report. The company already was targeting the metric, profit margins, that traders are most interested in at the moment.
Throw in the fact that inflation appears to be moderating and that other staples companies are delivering solid results, and things are set up here for a decent quarter and year for Conagra. This could be a year of relative strength for the company.
That said, I wouldn't read too much into the near-term results. After all, Conagra is a company that, on a GAAP basis, earned $1.85 per share in 2013 and $1.84 per share in 2022. The company's revenue growth, while complicated by various M&A activities over the years, has been similarly underwhelming. Conagra's brands are not particularly strong and it faces significant competition from store brands and other alternatives.
And, over the longer term, we should only expect low single-digits revenues growth once this current inflationary period passes. These just aren't the sorts of figures I look for when picking consumer staples companies.
To put it another way, Conagra is likely to push the right buttons in the near term thanks to its dedicated focus on cost cutting and improving its operating margin. This is what the market is asking for in today's environment, and Conagra is set to deliver. Over the longer term, however, I believe Conagra's weak brand positioning and slow organic growth will cause Conagra stock to remain at a relatively depressed valuation compared to other industry peers.
Conagra is likely to serve well enough as a defensive stock that will hold its value alright if the economy slides into a recession in coming months. And the 3.5% dividend yield gives a solid incentive for holding onto shares. Without fundamental improvement in the firm's brand positioning and growth prospects, however, I don't see much long-term share price appreciation. As such, I'm at a hold rating on CAG stock for now.
For further details see:
Conagra: Upbeat On Earnings, But Long-Term Questions Linger