Campbell Soup Co. (NYSE: CPB). While the company has a new CEO and opportunities to refocus the business, cut costs and reduce leverage, we believe that it needs to develop more innovative products to become a multiyear outperformer. We would consider upgrading the shares based on valuation. Our analysis suggests that the shares are trading close to fair value. We would take a harder look at our rating and consider an upgrade if the company’s financial strength continues to improve and if greater innovation leads us to boost our five-year growth rate forecast to 8% from 5%. CPB shares have held up very well during the coronavirus crisis – likely reflecting the perception of soup as a classic comfort food. In a hopeful observation, CEO Mark Clouse also suggested that millennial shoppers may have a greater-than-expected affinity for tomato soup. The company is making investments in advertising to retain the customers who came to Campbell for comfort or convenience during the pandemic. This could be an opportunity. A less hopeful observation is that some investors may be turning away from the defensive stocks that outperformed during the worst of the pandemic and towards more cyclical stocks that could rise in an economic recovery. That said, there are potential scenarios under which we could become more bullish on CPB.
On the fiscal 1Q call on December 9, CEO Mark Clouse said that CPB has seen purchases from millions of new households, including many younger households. Some 70% of the households gained since the beginning of the pandemic continue to purchase Campbell products, and the company has stepped up marketing to retain these buyers.
Adjusted 1Q EPS rose 31% to $1.02 per share. Our estimate was $0.89. The consensus was $0.91. The increase was driven by higher adjusted EBIT and lower interest expense. GAAP EPS also totaled $1.02, with several small offsetting items.
The company provided guidance only for fiscal 2Q21. CPB expects adjusted EPS of $0.81-$0.83 per share. The range represents 12%-15% growth and assumes continued strong demand as people continue to eat meals at home. The guidance range is just below the prerelease consensus of $0.84. Our estimate was $0.80. CPB expects net sales to rise 5%-7% from $2.16 billion in 2Q20. The midpoint of that range is $2.29 billion. Consensus was $2.3 billion. Our estimate was $2.2 billion. Management provided adjusted EBIT guidance calling for a 5%-7% increase, or $385 million at the midpoint of the range. Our estimate was $3.74.
First-quarter sales rose 7% to $2.34 billion, with organic sales up 8%. Our estimate was $2.31 billion. The Meals & Beverages business was up 12% on an organic basis, helped by growth in U.S. retail soup sales and strong sales of Prego pasta sauce and V8 beverages. Operating earnings were up 18%. The food service business was weak, but it only represents about 5% of company sales. The Snacks business was up 4%, with growth from Pepperidge Farm cookies, Pop Secret popcorn, and Cape Cod chips. Operating earnings were up 11%. Sales of Goldfish crackers were flat as lower away-from-home consumption offset increased demand for family-size products.
Adjusted EBIT rose 18% to $463 million. Our estimate was $412 million. The gross margin rose 100 basis points to 34.8%. That was 40 basis points better than we expected, helped by product mix, productivity improvements, the cost-savings program, and operating leverage. Marketing and selling expense was up 1% to $208 million. This was just below our estimate of $210 million as the company ramped up advertising and promotions. Interest expense declined on lower debt levels and was lower than we expected.
Cash flow from operations was $180 million for the quarter, compared to $182 million in the prior-year period.
EARNINGS & GROWTH ANALYSIS
We have adjusted our model to reflect the work the company has done to reposition the business. CPB is now organized around two primary businesses: Meals & Beverages and Snacks.
First-quarter earnings were stronger than we expected. We are raising our 2Q sales growth estimate to 5% from 2% and trimming our 3Q and 4Q estimates.
We don’t like to tinker with our long-term-growth rate. On one hand the company will have to lap the COVID-related pantry loading in 2H20, but it may be able to retain some of those customers.
CPB’s long-term targets call for organic sales growth of 1%-2%, adjusted EBIT growth of 4%-6% driven by cost reductions, productivity improvements, and investments to launch new products and adjusted EPS growth of 7%-9%. These targets reflect the divestiture of the International and Fresh businesses. We expect the post-divestiture business to have an EBIT margin that is approximately100 basis points higher than the current margin as well as lower debt. This would likely reduce interest expense and allow for share repurchases. We would still like to see more innovation and stronger organic sales.
FINANCIAL STRENGTH & DIVIDEND
The main driver was the company’s intention to use most of the roughly $3 billion of proceeds from selling the Fresh and International businesses for debt reduction. We were pleased to see that the 2Q20 balance sheet did show progress. The 3Q20 balance sheet showed additional progress. The company achieved its leverage target at the end of 4Q20, a year earlier than expected.
Debt was 6-times EBITDA at the end of FY19, down from 6.8-times at the end of FY18, but up substantially from 2-times in FY17 and above the 20-year average ratio of 2.7.
The company’s debt is rated BBB- by S&P, the lowest investment-grade rating. CPB’s debt is rated Baa2 by Moody’s. Management has said that it is committed to maintaining investment-grade ratings, as reflected in its significant efforts to reposition the business.
The FY19 payout was $1.40. FY20 dividends also totaled $1.40 per share. Along with its 1Q21 earnings release, the company raised the quarterly dividend by $0.02 to $0.37 per share. This increase was greater than we expected. .
CPB had approximately $1.3 billion remaining under the plan at the end of FY20.
MANAGEMENT & RISKS
Our biggest long-term concern is relevance. While there are few products that are better known than Campbell’s Soup, pre-COVID consumer tastes were increasingly turning from packaged foods to meals and condiments that are fresh, local, natural and organic. A new generation of consumers is also more wary of food ingredients that have been genetically modified and concerned about food allergies. Whole Foods had made it easier to be vegetarian or vegan, or to at least be concerned about the quality of ingredients and the welfare and sustainability of animal populations. In the process, many shoppers have found alternatives to traditional packaged foods.
Food trucks were once a place to get strong coffee and pre-made sandwiches on a construction site. Now, because of evolving preferences that favor fresh, unique, globally inspired and locally made foods, they are the centerpiece of foodie festivals and corporate events and indicative of changing tastes. New Yorkers track the locations of trucks that specialize in delicacies such as ox tails, dumplings, empanadas, kebabs, pupusas, jerk chicken, Belgian waffles, Korean BBQ and lobster rolls. In a recent New York Times article, an entrepreneur said that his favorite way to spend a Sunday was to drive to Red Hook in Brooklyn to sample the food trucks. He favors the huaraches (corn flatbread that is sometimes described as a cross between a tortilla and a pizza and topped with refried beans and ingredients such as cheese, avocado, caramelized onions and ground meat), and fresh watermelon juice. We recently asked a grocery-store executive to define ‘foodie.’ He said that a foodie is someone who posts pictures of meals on social media.
COVID-19 may have changed the game. It certainly changed the timing. The pandemic has reduced eating away from home and left many consumers leery of attending large gatherings. Macy’s even suggested that consumers now prefer things to experiences. Younger shoppers are buying comfort foods. It is hard to know how long it will last or if there has been a permanent change in preferences. We think consumers will go back to demanding healthy foods and packaged foods companies will have to adapt to retain the customers they won in the pandemic. One of CPB’s main objectives is to improve its better-for-you options.
Kroger, the giant grocery chain, has a rapidly expanding fresh and natural brand. It also purchased Murray’s, the Greenwich Village cheese and specialty shop, because it provides uniqueness, product authority and differentiation. Walmart showcases local foods, and the offering of fresh, grab-and-go meals in Whole Foods stores ranks with the highest-grossing restaurants in New York City. An increasing array of delivery options is also a risk to traditional packaged food companies because people can just order fresh soup or cookies rather than storing them in their pantry for weeks.
CPB and other consumer products companies compete intensely with each other and must also contend with private-label brands at a host of retailers, including value-focused stores like Aldi. While older shoppers may have a great affinity for Chunky soup, Goldfish crackers, or Pepperidge Farm cookies, younger shoppers may be more price-conscious or more comfortable with store brands. This is potentially a bigger issue if market share migrates to a declining number of retailers like Amazon, Walmart, Kroger, Target and Costco. Trader Joe’s sells value-priced products under its own name, and many shoppers regard them even more highly than products from the ‘name brands.’ Kroger also has large and growing private brands.
Another issue is that canned soup isn’t perceived as a particularly healthy or unique food choice. Many Millennials would probably say that they subsisted on ramen rather than Campbell’s chicken noodle. Similarly, ‘break-and-bake’ cookies may be a fun alternative to hard packaged cookies. And V8, which we remember as an iconic American health drink, now has competition from smoothie shops in every mall and carts on many city streets.
Denise Morrison, who had served as CEO since 2011, retired unexpectedly on May 18, 2018. Ms. Morrison had worked to shift Campbell’s focus toward fresh and refrigerated foods. Campbell board member Keith McLoughlin replaced her as interim CEO. Mr. McLoughlin once again stepped up in March 2019. He was elected chairman following the retirement of Les Vinney. At the same time, the company announced that J.P Bilbrey, the former CEO of Hershey, would replace retiring board member Sara Mathew.
On December 20, 1918, CPB announced that Mark Close would become the company’s new president and CEO effective January 22, 2019. Mr. Close was formerly the CEO of Pinnacle Foods and spent more than 20 years at Kraft Foods and Mondelez. Determining the actual number is difficult because family members who are not on the board do not have to disclose their holdings if they hold less than 5% of the outstanding stock. While Third Point has made inroads on the board, the family remains a very important constituency whose goals and capital allocation preferences may differ from those of minority investors.
On December 20, 1918, CPB announced that Mark Close would become the company’s new president and CEO effective January 22, 2019. Mr. Close was formerly the CEO of Pinnacle Foods and spent more than 20 years at Kraft Foods and Mondelez. Descendants of Campbell founder John Dorrance control more than 45% of the company’s shares. Determining the actual number is difficult because family members who are not on the board do not have to disclose their holdings if they hold less than 5% of the outstanding stock. While Third Point has made inroads on the board, the family remains a very important constituency whose goals and capital allocation preferences may differ from those of minority investors.
The company took on significant debt to purchase Snyder’s-Lance. The elevated debt could limit Campbell’s ability to repurchase shares, increase the dividend, or even compete with other less leveraged companies.
The company’s five largest customers account for 43% of sales. Walmart is the largest, representing 20% of sales. No other customer accounts for more than 10%. Kroger represents approximately 9%.
Campbell Soup, based in Camden, New Jersey, manufactures and markets consumer food products. The company’s other brands include Pepperidge Farm, Snyder’s, Prego, Swanson, and V8. CPB had FY20 sales of $8.7 billion from continuing operations. The now-completed FY20 was a 53-week year.
CPB shares have been flat over the last year, and are down about 4% on a year-to-date basis.
The shares are trading at about 13-times our adjusted EBIT estimate for the next 12 months. We use 12-times as a benchmark for our retail coverage. We think CPB could be worth more based on its ownership of proprietary brands.
So what would we need to see to get the shares on the one-year BUY list?. We would need to raise our five-year growth rate from 5% to 8%. We would also need to see continuing improvement in financial strength. We normally use a cost of equity of 9% for consumer companies. When we increased our financial strength assessment in late 2019, we reduced our cost of equity to 8% for the next five years. We would need to see financial strength improve further so that we could reduce the cost of equity to 7% in the steady growth phase. For that to happen, we would need to see continuing improvement in financial strength and continued low Treasury rates. We would also need to assume an 80% dividend payout when the company is growing at a steady 3%. That would require the company to have a solid balance sheet so that it could provide good debt coverage and still make substantial payouts. Is 3% a reasonable assumption for steady state growth? We would need to see more innovation in the next few years to feel comfortable with that. We don’t want to assume perpetual cost cutting because the company will need to keep investing in new and existing brands. The company has scaled back its international presence and we don’t see rapid growth in soup and packaged foods and snacks. That takes us back to innovation.
Our conclusion is that the shares are trading at a fair level and that there are potential scenarios under which we could become more bullish.
On December 10 at midday, HOLD-rated CPB traded at $47.07, down $0.21.