Has The Market Already Noticed ConAgra's Improvements?

By Stephen D. Simpson, CFA | September 21, 2012 AAA

Investors make money on turnaround stories by coming in ahead of the curve, taking on the risk of being wrong in exchange for the possibility of outsized gains. Once the notion that a company has made real progress and improved its operations is generally accepted, usually the stock has already run up. In the case of ConAgra (NYSE:CAG), the stock is up strongly on better first quarter earnings, but more gains could be on the way if the Street accepts that these improvements are here to stay.

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A Better Fiscal First Quarter
ConAgra delivered a good quarter for the start of its fiscal year. Revenue rose almost 7% (slightly better than expected) on an 8% improvement in the consumer business. Organic growth in the consumer business was more like 1%, as a 5% increase in average prices was offset by a 4% decline in volume. That said, this makes five straight quarters of non-negative organic revenue growth.

Profits were quite a bit better than expected. Gross margin improved almost three points, as the company saw less inflation than management expected. Adjusted operating income rose about 24%, with 14% growth in the consumer business. While there were some assorted odds and ends in the company's operating expenses (as there usually is for large companies nowadays), investors should probably keep an eye on that 14% growth in corporate overhead.

SEE: How To Decode A Company's Earnings Reports

Are There More Deals to Be Done?
During the quarter, ConAgra announced the $265 million acquisition of Unilever's (NYSE:UL) North American frozen meals business, a business that includes licenses for Bertolli and P.F. Chang. I'll be curious to see what ConAgra can do with this business. Nielsen data suggests that these brands were losing share over the last year or so, but maybe ConAgra can turn that around.

Although ConAgra's balance sheet is not pristine, more deals could be on the way. The frozen meal space is pretty significant to ConAgra, but it's still a very fragmented market with just a handful of well-known companies like Nestle (OTC:NSRGY), Heinz (NYSE:HNZ) and Tyson (NYSE:TSN) holding significant share. Tuck-in deals here could be a relatively easy way of boosting growth and leveraging better margins through better capacity and overhead utilization.

At the same time, others out there apparently think ConAgra may get even more ambitious. It seems like many people on the sell-side want to play matchmaker for Hillshire Brands (NYSE:HSH), and ConAgra is one of the names floating out there as a buyer. Although it would make sense on some levels, and I wouldn't rule it out, I think it makes more sense to assume that ConAgra will keep looking for smaller tuck-in deals.

There's Still More Work to Do
Five straight quarters of flat or better organic growth in the consumer business is good, but ConAgra's self-improvement project shouldn't be over yet. ConAgra's operating margins have long been poor relative to comps like Kellogg (NYSE:K), General Mills (NYSE:GIS), Heinz and Campbell Soup (NYSE:CPB) and even the bullish analysts think it will be a while yet before that gap closes. On the other hand, ConAgra doesn't have to be as good as Kellogg for the stock to work. Modest improvement can position these shares to do reasonably well over the next two or three years, but if the company can close the gap with Kellogg or General Mills in terms of free cash flow conversion over the next decade, the shares could really outperform.

SEE: Free Cash Flow Yield: The Best Fundamental Indicator

The Bottom Line
I'm still taking a "show me" approach with ConAgra in terms of those sales and margin improvements. An estimated compound free cash flow growth rate of 5% is good enough for a fair value target near $30 which, combined with the dividend yield, makes this a decent hold. As mentioned above, if ConAgra can find a way to lift its free cash flow margin into the high single-digits, this could be a real outperformer in the sector over the next decade or so.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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