Despite Simmering Cost Pressures, Campbell's Brand Investments Should Add Flavor to the Long Term
Despite Simmering Cost Pressures, Campbell's Brand Investments Should Add Flavor to the Long Term
Business Strategy and Outlook| by Erin LashUpdated Sep 28, 2021
Even as it faces rampant cost inflation and stepped-up competition, we surmise Campbell had been implementing a prudent strategic playbook before the pandemic (anchored in investing to drive profitable growth in its meals and snacking arms) that should aid its ability to navigate the current challenging backdrop.
From our vantage point, the biggest test facing Campbell now is whether it can hold on to the increased households it has entered over the past year. Attesting to some initial traction, management touted that three quarters of its portfolio held or gained share in the most recent period. Despite this, we recognize consumer trends are constantly evolving, and Campbell will need to prove agile in its product innovation and marketing over a longer horizon to sustain its edge. In this context, we think Campbell intends to stay the course outlined in its strategic roadmap (which was initially articulated in June 2019)--directing additional investment behind research, development, and marketing and moving away from large scale launches to speed up its time to market. This aligns with our forecast for these pillars in aggregate to top 7% of sales ($650 million) on average through fiscal 2031 (up from the 6% average--$475 million--it expended annually between fiscal 2017 and 2021). We view this as essential to ensuring that its fare stays top-of-mind for consumers and the organization remains entrenched with its retail partners.
Even though Campell is also battling cost inflation (related to freight, steel, labor, and protein), we think it is pursuing a prudent course to stymie the impact. For one, the firm intends to raise prices across its mix to offset these headwinds (with loose guidance of around mid-single-digits on average), while also continuing to pursue cost efficiencies (to the tune of $850 million by the end of fiscal 2022). And we anticipate opportunities for further savings are likely in the cards, particularly within its supply chain and inventory management, which, based on management commentary, is still quite complex (with an astounding 1,300 facilities in its network currently housing inventory).
Economic Moat| by Erin LashUpdated Sep 28, 2021
In our view, Campbell has a wide economic moat resulting from brand intangible assets and a cost advantage. As such, we expect the firm’s returns on invested capital to remain above its cost of capital (even under a more bearish outlook) over the next 20 years. By operating as a leading packaged food manufacturer (controlling nearly 50% share of the U.S. soup aisle, according to Euromonitor), Campbell is a valued partner for retailers, in our view, supporting its intangible asset moat source. Further, the resources Campbell maintains to bring new products to market (spending just north of 1% of sales, or nearly $100 million, on research and development annually on average the last five years) and tout its fare in front of consumers (allocating nearly 5% of sales, or about $385 million, on average toward marketing each year) to drive customer traffic into outlets, enhances the stickiness of its retailer relationships. In our view, this positioning and its resources have enabled Campbell to maintain valuable shelf space for its offerings, even in areas like soup, where its share has been challenged by peers, lower-priced private-label fare, and smaller foes. While we don’t expect this competitive pressure to subside, we believe it is the strength of these relationships that ultimately should ensure Campbell's edge persists longer term. We also believe Campbell possesses a cost edge resulting from the economies of scale in production and distribution across its network, which has afforded it the ability to invest significant resources behind research, development, and advertising. We believe these factors have enabled Campbell to boast returns on invested capital (including goodwill) of nearly 14% on average over the past decade, which is about double our 7% cost of capital estimate. We expect the firm will continue generating excess returns over our explicit forecast.
We think the firm's dominant position in U.S. soup, combined with investments to reshape its portfolio (most recently with the addition of Snyder's-Lance's portfolio of on-trend snacks and the sales of its fresh business and international operations), should enable Campbell to maintain its negotiating power with retailers. In our view, retailers prefer to stock brands that will drive traffic into their outlets and are reluctant to expend shelf space to unproven suppliers that likely lack the resources to satisfy supply chain needs. As such, we believe the firm’s portfolio mix shift toward more on-trend categories (like snacks) has been prudent, given that these offerings align with consumer preferences for healthy and convenient fare. We think Snyder’s-Lance is ahead of the trend with a portfolio that skews more to better-for-you snacking than the sector overall. When taken together, we believe Campbell’s intangible asset edge, borne of multicategory strength built on its pre-eminent soup offering and its brand dominance and favorable cost structure, attributable to its vast distribution network, should increase Snyder’s-Lance’s clout as the businesses are integrated.
Beyond the edge afforded by its intangible assets, we believe Campbell has a cost advantage stemming from economies of scale. Further, we contend that maintaining an entrenched supply chain creates a virtuous cycle, starting with scale, that affords manufacturers a mutually beneficial relationship with retailers, through which the vendor is an important retail partner, developing sales strategies to maximize volume and retailers’ margins while prioritizing its own brands. With its broad domestic manufacturing and distribution network, we posit that Campbell operates with lower unit and distribution costs, as well as greater supply chain efficiency and an enhanced ability to leverage brand spending, than smaller peers. We think that as a result of these cost advantages, Campbell maintains the ability to replicate competitive products and ultimately offer this fare to retailers at a lower cost. This stands to limit the potential shelf space (and scale) new entrants can amass. We believe it is this self-reinforcing combination of sources of Campbell's competitive edge that has created high barriers to profitable entry, shielding vendors that are entrenched in retailers' supply chains.
Fair Value and Profit Drivers| by Erin LashUpdated Sep 28, 2021
After digesting fiscal 2021 results, we're edging up our fair value estimate for Campbell Soup to $48.50 from $48 to reflect the time value of money. Even in the face of more pronounced near-term commodity, transportation, packaging, and labor cost pressures, we anticipate the combination of higher prices at the shelf and the pursuit of additional cost efficiencies will serve to stem the hit to profits longer term. As such, we haven't wavered on our long-term forecast for about 2% annual sales growth longer term and mid-single-digit adjusted average earnings per-share growth over the next decade. Our revised valuation implies fiscal 2022 price/earnings of 17 times and enterprise value/EBITDA of 11 times.
Campbell's efforts to steady its footing have been facilitated by the sales of its fresh and international operations, which we contend is enabling it to focus its resources and personnel on its core businesses. Further, we still surmise the firm is poised to leverage its combination with Snyder's-Lance, given snacking is a business Campbell knows well (particularly with its Pepperidge Farms and Goldfish brands). We think this is a more poignant opportunity in light of consumers’ penchant for convenient, healthy fare. And we posit Campbell’s recipe for spicing up its product innovation and marketing support (particularly in its core soup niche, which had been starved of investment under former CEO Denise Morrison) should enable it to chalk up 1%-2% and 2%-3% annual segment top-line gains, respectively, in its meals and beverages and snack operations longer term.
From a profit perspective, we view the firm's aims to extract $850 million in costs by the end of fiscal 2022 as prudent, but think rampant, broad-based cost inflation will act as a near-term offset. Over the long term, we surmise Campbell will direct a portion of these savings to its brand spending in support of its competitive edge. We forecast marketing to tick up to nearly 6% on average over the next 10 years (above the 4.8% on average the last three years) and research and development to approximate 1.5% of sales (about $140 million a year, or about 40 basis points above the three-year average). This results in average operating margins of nearly 18% over the next 10 years (70 basis points above the prior 10-year average).
Risk and Uncertainty| by Erin LashUpdated Sep 28, 2021
As the leading global producer of soup, a highly profitable segment in packaged food, Campbell faces intense competitive pressure from its peers, private-label fare, and other niche natural and organic offerings. Prior to the onset of the pandemic, ready-to-serve soup in particular had fallen victim to increased competition from other simple meal categories, and global category growth languished, holding about flat on average during the past several years. The rapidly evolving nature of consumer trends has proved challenging for Campbell, and the firm has been losing out to more nimble startups that have proved more agile in adapting their mix.
In this vein, we think the firm could resume the pursuit of select acquisitions or partnerships (similar to its purchases of Snyder's-Lance and Pacific Foods) as a means to gain a greater understanding of changing consumer tastes and preferences (once it steadies its ship now that leverage has been lowered). However, deals could prove less beneficial if the firm is forced to pay an excessive premium or stumbles in the integration, particularly if it opts to venture beyond its core soup niche.
Volatile input costs can also weigh on profits, and if Campbell chooses to raise prices to offset these pressures, volume could be constrained, especially during economic periods when consumers are highly selective in their purchase decisions.
Further, although we don't see risks stemming from environmental, social, and governance as particularly pointed, we aren't blind to the fact that Campbell could be forced to recall its fare if quality standards fall short. In addition, the firm could come under increased regulatory oversight if authorities decide to step up the pressure on packaged food companies to curb obesity, particularly on its home turf.
Capital Allocation| by Erin LashUpdated Sep 28, 2021
Our capital allocation rating for Campbell Soup stands at Standard, reflecting its sound balance sheet, investments that have proven fair, and appropriate shareholder distributions.
After its $6 billion transformational tie-up with Snyder's-Lance (inked in late calendar 2017), Campbell's debt load jumped to 5.8 times on an adjusted EBITDA basis. Despite this, Campbell has continued to prioritize debt paydown (which has included directing funds from the sale of its international and fresh operations), such that debt/EBITDA stood at 2.6 times at the end of fiscal 2021. With no material debt maturities until fiscal 2023 (when $1 billion in debt matures), combined with its low revenue cyclicality and operating leverage, we don't surmise Campbell's debt balance will impede its ability to reinvest in its business while also funneling excess cash to shareholders.
In light of the stagnant prospects for growth in the center-store cateogries where Campbell plays (namely soup), the firm embarked on a course a number of years ago to diversify away from the challenged soup category, primarily by pursuing inorganic opportunities (with the deal for Snyder's-Lance marking its sixth over the prior five years). But we don’t believe this signaled that Campbell was veering away from being a prudent capital allocator. Returns on invested capital have exceeded our cost of capital estimate in each of the past 10 years, and we forecast that the firm will continue to generate returns on invested capital in excess of our cost of capital estimate over our 10-year explicit forecast.
However, since CEO Mark Clouse took the helm nearly three years ago, the firm has abandoned its outsize emphasis on extracting profits from its core soup lineup (starving the business of investment) and its reliance on acquisitions outside its core focus to bolster its trajectory (key tenets of former CEO Denise Morrison’s model during her seven years leading the charge). Rather, management’s updated playbook is anchored in driving profitable growth across its core meals, beverages, and snacking niches, which strikes us as prudent.
While we surmise management's focus will remain anchored in steadying its underlying operations over the next several years, we wouldn’t be surprised if the firm ultimately regained an appetite for acquisitions at some point down the road (now that leverage levels have approached the firm’s 3 times target). However, we expect any potential tie-up will generally center on smaller, bolt-on deals that are unlikely to move the needle on its financial performance. From our vantage point, the benefits from adding niche businesses to its mix extend beyond enhancing its category exposure or capabilities. Rather, we believe smaller niche operators have demonstrated an ability to be more agile in adapting their mix to changing preferences. As such, we perceive tie-ups with these operators as potentially affording Campbell the opportunity to extract insights into how to respond to evolving consumer trends in a timelier fashion. We think the inability to do so has plagued firms throughout the grocery store and view efforts to grease the wheels of its innovation cycle positively.
But we don't think such efforts would stand to limit Campbell's ability to return cash to shareholders. In this manner, we forecast that Campbell will grow its dividend at a mid-single-digit clip annually through fiscal 2031 (maintains a payout of around 50%) while also repurchasing around 2%-3% of shares outstanding (which we perceive as prudent when executed at a discount to our assessment of intrinsic value).