ConAgra Foods, Inc. (NYSE:CAG) stands out as a winner in the food industry over the last few years. Its mix of value brands in the consumer division, expanding private label business and, a commercial foods division (which has been expanding profits strongly over the last few years) has stood it in good stead to deal with a challenging environment.
In summary, I think the company is well-positioned to do well, but a lot of its prospects depend on believing the management can execute successfully.
How ConAgra makes its money
I’ve broken out the recent fourth-quarter numbers, because private-label manufacturer Ralcorp hasn’t been part of ConAgra Foods, Inc. (NYSE:CAG) for a full year yet.
In order to properly reflect its performance ConAgra will change the way it reports by splitting the commercial foods division into a private-label segment (to reflect the addition of Ralcorp to its existing private-label business) and, a food service segment which will contain its Lamb Weston potato operations.
The three things its management needs to execute
The first question is it can continue to generate volume growth in its consumer foods division. ConAgra Foods, Inc. (NYSE:CAG) increased prices last year; in common with so many other companies in this slow economy, it then saw volume decreases. Consequently, it’s taken a while for ConAgra to get back to organic volume growth. Indeed, it only did so in the recent fourth-quarter results with a 3% gain. Overall, consumer foods sales were up 7%, with acquisitions contributing 5%.
Credit: ConAgra Foods, Inc. (NYSE:CAG)
The second question relates to the Ralcorp acquisition. The good news was that It raised its synergy projections to $300 million by 2017, as opposed to the initial target of $225 million. Moreover Ralcorp’s profits were in line with expectations, but its sales performance was softer than ConAgra Foods, Inc. (NYSE:CAG) expects to see in the future. The subsequent restructuring activity was described as short term and fixable in the conference call.This is fine, but it still needs to be done.
Looking at the wider question of private label manufacturing I would issue caution. As investors in TreeHouse Foods Inc. (NYSE:THS) will tell you, manufacturing private-label foods can be a volatile business. Industry trends may be favorable right now, but Treehouse has had to deal with difficult conditions in recent years. Its customers’ sales channels have changed along with the trend towards trading down.
Private-label companies are subject to the sales patterns of their customers, and while TreeHouse Foods Inc. (NYSE:THS) is currently doing well with things like single-serve coffee and refrigerated dressings, it has also suffered before with categories like soup and pickles. It’s a business that requires a constant adjustment to the end market conditions of customers. Don’t be surprised if Ralcorp faces similar issues in future. Treehouse is on a forward PE of over 20 and is hardly cheap for such an uncertain business.
The third issue is that its commercial foods segment saw its potato operations (Lamb Weston) lose a major long-term customer. This will reduce EPS by $0.10 next year.The contract loss will also hit margins, but ConAgra expressed confidence that it would make up for it. Again, the management needs to deliver.
In addition, ConAgra talked of “short term challenges in Asia,” which caused profits to decline for its potato operations for the quarter. Frankly, I don’t believe in coincidences, and anyone looking at McCormick & Company, Incorporated (NYSE:MKC)’s latest results would note that it reported weakness from its quick service restaurant customers in both China and the Americas. Yum! Brands, Inc. (NYSE:YUM) is a major customer of McCormick and much of its problems are company specific but the truth is that it’s Chinese same store sales growth has been falling since the first quarter of 2012.
In addition McCormick & Company, Incorporated (NYSE:MKC)’s industrial growth has been negative for the last two quarters. Is this a short term issue or is it a deeper one relating to slowing quick-service restaurant sales growth? These types of restaurants are major customers of ConAgra’s potato operations.
The bottom line
In conclusion, I think these three concerns require you to express a fair amount of confidence in the management to execute over the next year. This might be okay if the stock traded on a more attractive valuation. A forward PE of around 13 may look attractive, but recall that the company has to pay off significant amounts of debt.
Looking at these companies’ current enterprise values (EV) in relation to their earnings before interest, depreciation and amortization (EBITDA) reveals that none of them are cheap. The measure helps to account for debt levels in evaluating a stock.
CAG EV / EBITDA TTM data by YCharts
ConAgra Foods, Inc. (NYSE:CAG) is the most expensive of the three companies above, and it’s not cheap enough to compensate for the execution risk. It’s a stock for the monitor list. The market may be in love with food stocks, but there is no excuse for not sticking to your valuation principles.
The article The 3 Big Risks in This Stock originally appeared on Fool.com and is written by Lee Samaha.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends McCormick. Lee is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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