Conagra Brands Inc (CAG) — Q2 2019 Earnings Call Transcript

Good morning, everyone. Thanks for joining us and happy holidays. I’ll remind you that we will be making some forward-looking statements during today’s call. While we are making these statements in good faith, we do not have any guarantee about the results that we will achieve. Descriptions of risk factors are included in the documents we filed with the SEC. Also, we will be discussing some non-GAAP financial measures. References to adjusted items, including organic net sales growth, refer to measures that exclude items management believes impact the comparability for the period referenced. Please see the earnings press release for additional information on our comparability items. The reconciliation of those adjusted measures to the most directly comparable GAAP measures can be found in either of the earnings press release or in the earnings slides, both of which can be found in the Investor Relations section of our website, ConAgrabrands.com. Finally, we will be making references to total ConAgra Brands, as well as legacy ConAgra Brands. References to legacy ConAgra Brands refer to measures that exclude any income or expenses associated with the recently acquired Pinnacle Foods Business. With that, I’ll turn it over to Sean.

Thanks, Brian. Good morning, everyone and happy holidays. Thank you for joining our second quarter fiscal 2019 earnings conference call. On today’s call, we will unpack our driving consumption and growth, particularly in our frozen and snacks businesses and we will provide our initial perspective on and plans for the Pinnacle Business. There is a lot to cover, so let’s jump right in. In terms of the legacy ConAgra Brands Business, we built on our recent momentum during the second quarter as we continued to gain share in key refrigerated and frozen, and grocery and snacks businesses. Given our performance to date and our expectations for the year, we are reaffirming our fiscal 2019 sales and margin guidance for legacy ConAgra Brands. In addition to driving results in our legacy ConAgra Brands Business, we completed the acquisition of Pinnacle Foods. In the short time since we’ve owned the business, our team has been working hard on the integration, which is progressing seamlessly. Later in the call, we’ll share more on what we’ve learned about Pinnacle over the past several weeks, including our initial plans to address some of the challenges facing that portfolio. Importantly, we believe that we have the right playbook to address these issues and that work is already underway. While today’s comments regarding Pinnacle will be preliminary, we will have much more to say about Pinnacle at our Investor Day on April 10, 2019 in Chicago where we plan to provide a comprehensive update on our progress, opportunities, and outlook. We hope you can attend. Turning to the results for the quarter. From a high level, we continued to deliver consumption growth for legacy ConAgra Brands driven by Frozen and Snacks where we have focused our efforts on brand building and innovation. The optics of the quarter were affected by the impact of last year's hurricanes. Also, some shipments slid from late Q2 into early Q3, which is not unusual around the holidays. Overall, the sales are largely in line with our expectations. And importantly, we exceeded our margin expectations. You can see on Slide 7, our domestic retail segments continued to demonstrate the impact of the successful execution of our strategy in the form of consistent accelerating consumption trends. Consumer takeaway is the key driver of growth. Our deliberate actions to invest in brand building and deliver strong innovation slate, particularly in our Frozen and Snacks and Sweet Treats businesses, are driving strong year-over-year consumption growth, as well as consistent improvement on a two-year basis. It's worth noting that we posted positive year-over-year retail sales growth in every month of calendar 2018 except for September the month that we experienced last year's hurricanes. As you can see on Slide 8, we continued to drive growth based on strong fundamentals tied to the strength of our brands, base velocities, sales and TPDs remain in fertile territory and continue to gain momentum on a two-year basis. To provide the proper context for this quarter's sales performance, we would like to take a quick step back and remind you of what took place in fiscal 2018. As you may recall from Q2 of fiscal '18, we saw an uptick in demand due to the hurricanes, which increased last year's Q2 net sales by approximately 220 basis points. So don't look at this year's Q2 growth rate in isolation. As you can see on Slide 9, if we look at the growth on a two-year basis, organic net sales have grown 70 basis points. We will now turn to our segment results starting with Refrigerated and Frozen. Our results here tell a tale of two things based on where we have applied our playbook and where we have not. The segment overall is up 50 basis points with Frozen driving all of the growth. The decline in refrigerated reflects the fact that, with the exception of Reddi-wip, we have yet to bring innovation to the marketplace. As one of the final pieces of the legacy ConAgra portfolio to receive attention, our Refrigerated products still appear on the shelf today largely the same way they did in the 90s, and it shows in the results. However, there's a slate of exciting innovations coming to Refrigerated in 2019, which we will debut at our Investor Day in April. So stay tuned. We've talked a lot in prior quarters about the successful implementation of our playbook in Frozen. As you can see on Slide 11, that success continues. We are reinvigorating and leading this $5.2 billion category. And our Frozen single-serve meals continue to be the fastest growing in terms of total retail sales. The chart on this page demonstrates that our growth in the absolute is not only strong but accelerating. This growth has been the result of our rigorous approach to modernizing and premiumizing our brands through renovation and innovation and that is our view. We're increasing our whole penetration, average selling prices are moving up and promotions are moving down. We're growing both sales and distribution, and customers are benefiting via category growth and improved margins. As you can see on the left, we’ve also benefited from increasing household penetration, which continues to build. In the most recent quarter alone, we attracted 1.7 million more households to our products, which is on top of the 1.8 million added a year ago. While we see growth coming from all age cohorts, including millennials, Gen X and boomers, our growth does over-index to younger generations. Younger consumers are clamoring for contemporary frozen foods, but large manufacturers have been slow to move in that direction. We’ve incorporated the modern food attributes millennials value into our iconic brands to re-imagine our frozen portfolio. As a result, we’re capturing an outsized share of the growth among millennials and Gen X consumers.

Thank you, Sean and good morning, everyone. Slide 33 outlines our performance for the quarter. As Sean mentioned, Q2 came in largely in line with our expectations for legacy ConAgra. I'll walk through the quarter and elements of both the legacy ConAgra and Pinnacle businesses, and share our perspectives on the balance of the year. So let's jump in. Net sales for the second quarter were up 9.7% compared to a year ago, reflecting the inclusion of Pinnacle for 31 days. Organic net sales, excluding the effects of the sale of Trenton, were down 1.6%. Organic net sales were impacted by both the hurricanes in Q2 a year ago and some quarter-end shipments that moved into early Q3. For the quarter, adjusted gross profit increased 7.6% to $704 million and adjusted gross margins declined 58 basis points to 29.5%. The addition of Pinnacle's results drove the adjusted gross profit dollar improvement, and I'll walk you through the adjusted gross margin bridge in a moment. In the quarter, total company A&P expense decreased to $69 million or 2.9% of net sales. Although down from the prior year, our investment was up from 2.3% of net sales in the first quarter due to seasonality. The year-on-year comparison reflects our continued shift from A&P investment to higher ROI retail marketing. Adjusted SG&A for the quarter was down 4.4% compared to the prior year and was 9.1% of net sales. The decrease was primarily driven by lower incentive base compensation in the legacy ConAgra business. This included lower stock-based compensation expense due to the lower share price, which was partially offset by the addition of expenses related to the Pinnacle Business. Adjusted operating profit increased 22.3% for the quarter and adjusted operating margin was 17.5%, up 181 basis points versus year ago. Higher than expected gross margin in legacy ConAgra, together with favorable SG&A and A&P spending, contributed to these results. Adjusted diluted EPS was $0.67 for the quarter, up 21.8% in the prior year, driven by strong operating profit in the legacy ConAgra business.

I guess, first off, just I know Sean that Pinnacle had its own gross margin targets before the deal was announced. And it seems to us that maybe some of this could be incremental to the Pinnacle deal synergy target that you had put out there. So a more optimistic scenario could have led maybe closer to 10% of sales as synergies rather than the stated 7%. And I admit that that was before the deal closed. But it certainly sounded to us that you thought maybe initially that some of that Pinnacle margin opportunity could be delivered upon under ConAgra’s ownership. So it certainly doesn’t seem like that’s the case at this point. Is it a matter of just digging into Pinnacle once the deal closed and finding out some of the things that you mentioned? Or I guess just another way of asking, is the Pinnacle asset just in a completely different place than maybe you thought it was when you agreed to the deal, because I’m still -- I guess I’m seeing some of the -- hearing some of the language that you’re using in describing the asset and the position it's currently in. And we’ve all seen the scanner data. But it just -- that seems far more severe right than I think at least I would have expected?

Let me try to tackle that, Andrew, there’s a lot in there. Clearly, we’ve coveted this portfolio for a while because of the long-term value creation potential it offers. Unfortunately, as you know, there is only so much you can see in the public company diligence, particularly when you buy a competitor. But as you’ve heard in our prepared remarks, we can see it all now. And from the beginning, we took a conservative approach, both to the price we offered and our synergy commitments and now we are glad we did. Because while we are starting from a lower base, we anticipate delivering strong EPS growth off of that new base and actually hitting the 2022 EPS target that drove our original EPS accretion guidance for this transaction. Clearly, the gross margin status within the Pinnacle portfolio right now is not where we expected it to be or wanted it to be, but make no mistake about it. The gross margin potential for the business is still there. Gross margin in many ways is a symptom of the health of the brands. And as we laid out earlier today in our prepared remarks, there are really three brands that are driving the vast majority of the weakness here, Birds Eye, Duncan Hines, and Wish-Bone. And those are the businesses that we got to get back on track. It's not going to be overnight. We’ve got some work to do. But there is not a doubt in our mind that there is significant opportunity to get those brands back where they need to be. It’s just going to take some work. We’ve got to apply basically the ConAgra playbook we applied to our own portfolio back in 2015. We’ve got to do it to Pinnacle, particularly on those three businesses.

John, I wanted just to go back over Pinnacle. I mean, I’ve heard that we can -- you said it. But I wanted to just try to ask you a question about your 2022 target that we look at differently. North of 5% inflation is a very strong number, you don’t see that number very often in packaged food companies, typically results in gross margin compression but the target enough price to offset that level of inflation. You've also shown very clearly all these distribution losses. I'm going to boil it down. I think, what I think you're trying to tell us that I need you to course correct me. Is this confidence that you can get to the 2022 numbers really based upon a very significant over delivery on synergies or are there some really big things that need to happen on the Pinnacle business, i.e., sales half that really start to improve, pricing needs to accelerate dramatically? I guess I just want to get this out in the open, because I think people will really worry about if you have to do something heroic to Pinnacle in order to get to that 2022 goal. Thank you.

Let me start there and Dave you can fill in more detail on inflation and things like that, because you want to come back to a threshold point here. The vast majority of Pinnacle's challenges reside within three businesses, and I talked a little earlier around what's driven the challenges there. There is no question in my mind that we will make progress on these three businesses, one of them for example is Birds Eye. Birds Eye is an extraordinary brand. It is number one in the veggie and veggie-based meal space. And good things are still happening within the franchise like the Veggie Meal. But the brand architecture has become too fragmented in this final space within vegetables with flat out passed over for being too low margin. And when the consumer is hyper passionate about our space as they are about spiralized, you just can't opt out. You've got to give the consumer what they want and figure the margin challenge out as you go. If you opt out, the competitor will fill the vacuum and that's exactly what happened. The good news is as the number one brand you've always got the opportunity to get back in. And if you look at the Bird's Eye performance in the market over the last few years, five years or so, it's been nothing short of extraordinary. If you look at Duncan Hines, this is another good news bad news story. Good news is that Duncan Hines has gotten a fair amount of attention over the past two years, and it's been highly responsive. And that makes sense to me, because Duncan Hines is an iconic brand. However, the mental model at Pinnacle was to think of Duncan Hines as a cake mix brand. And accordingly, last year's innovation was named after a portion size it was called perfect size for one, and that cake frame of reference was highly limited. And then when the SKU proliferation occurred to sell optimal execution was really exposed. So the way that we think about this here at ConAgra is we think of Duncan Hines as a sweet treat brand not as a cake mix. We view perfect size for one not as a portion control cake, but as a convenient warm sweet treat. And as the frame of reference being different, the product design would've been different. And frankly, it would've been more appealing. And unfortunately, the competition figured this out and has been stealing share, so we've got work to do. And then the third one that we pointed to was Wish-Bone. Now this is a big category. It's also a great brand. But frankly, it has not benefited from enough disruptive innovation. What has been launched hasn't resonated, for example, the - yellow line and that will change. And not only will we innovate within Wish-Bone, we will look at leveraging other iconic ConAgra brands as leverage to disrupt the salad dressing category. So we've got a very strong handle on all three of these big businesses and we've got plans that are already being mobilized against. And with respect to the inflation, you point out 5% is a high number. But don't forget in veggies we had a bad crop year this year and bad crop years do happen. And those are transitory issues, so you're not going to have a bad crop, here you have a bad one, you have some good ones. So that too shall pass. We do have other elements in inflation that continue to be pesky like transportation that everybody is struggling with. But the overall point I’m making here is I do not seek any need for heroic action. What I see need for is clarity of thinking and an excellent execution of the very same ConAgra playbook that we have applied to different brands over and over again.

Yes. So just to build on that, if you look at the calendar year 2018 chart that Sean showed. The gross margins are 220 basis points below the Pinnacle forecast. Half of that mix was from inflation on freight transportation and also as Sean just mentioned coming out of the fresh pack season with higher vegetable inflation. Another part of that though was given the volumes of clients that Sean discussed in the big three Pinnacle attempted to add price promotions in the second half to make up for the volume. These were not efficient programs and result in additional gross margin erosion. So to Sean’s point, the inflation is transitory. We’re on it. And we’re also in the process of eliminating these inefficient trade deals. So we’re confident that we’re going to work through this. But the forecast that we put out through the end of fiscal ’19 reflects the continued inflation on vegetables and us working through the inefficient trade.

One thing I wanted to understand a little bit better is I understand the virtuous cycle that you've talked about. But I don’t quite understand why Pinnacle’s performance worsened so suddenly. And I imagine it’s largely because of the disappointed customers you talked about with shelf reset, so there’s that. And then I guess adjacent to that, I understand you can’t do all of your due diligence that you want to do on a competitor. But it still feels I think to some people I’ve talked to this morning and I'll admit to me too like the due diligence could have been better, right? And I wanted to ask you about that, because why weren’t the conversations being held with customers to see that this was going to come? So this feels like a really big surprise to most of us, something that maybe could have been a little bit avoided but maybe not. I just wanted to get your thought on that.

I appreciate that Ken. I will tell you that our passion for this business did not lead us to overlook anything at all as already mentioned, there’s only so much you can’t see in public due diligence. There were, Pinnacle it's not a brand, it’s a diverse company of brands. And so there were obviously businesses that were up and businesses that were down, we were back that in the middle diligence, Wish-Bone as an example was a business, one of the businesses that was beginning to show challenges. But as you can see in your own charts, a lot of what we’re talking about here has really accelerated very dramatically in the second half of this calendar year. So that’s pretty late in the equation. It’s disappointing I’m not going to tell you that we are not disappointed with the State of the Union. But by the same token, I would tell you we are very confident that we know exactly what to do here, not an overnight trip. This is going to be fundamentals and hard work as we’ve done before. But these are very good brands. I just pointed out we’ve got a concentration here on three businesses. The big one is Birds Eye. Birds Eye was the latest one to emerge, to your question, in terms of its really showing its weakness

So two questions, the first would be for you I guess Sean or Dave. On the revenue, slight miss in the second quarter for the base ConAgra business. It sounds like it was a calendar shift. Can you walk us through that a little bit more, maybe like what caught you off guard? What business gets better sequential? And then I’ve got a follow up. Thanks.

Yes, glad to be brought this up. Let me talk net sales, because I know you all see the ramp in net sales in the second half and therefore it'd be on your mind. I wanted you to just be very clear of where we stand on this. Overall, we are very pleased with our top line strength. I think you can see from our presentations, and I’m talking legacy CAG here. I think you could see from our presentations, we have been very successful innovating and modernizing our brands. And because of the Pinnacle acquisition, we have done something out of the ordinary for us, which is provide quarterly guidance for the past two quarters, which is something we prefer not to do given typical shipment volatility around quarter close. We saw a bit of that this quarter as some of our shipments fell after Thanksgiving and into December. So you’re really talking about a small shift here really between Thanksgiving and Christmas. And as I mentioned earlier that is not a typical, and it can add some unpredictability to how our revenue was recognized in the quarter. But most importantly, our consumption patterns have continued to build, which is the real story we want to stress, and that will translate to a very strong second half. And the way to think about that ramp is that our first half innovation is now hitting its stride fully out there in the marketing programs they're on and our second half slate, which includes the snacking initiatives I just showed, is very strong and it's also very good mix. And on top of that, the pricing that we have taken is now in the marketplace and being realized, particularly in the second half; so all of that conspires to result in continued momentum on our top line, which we feel very good about for the balance of the year, and the reiteration of our standalone legacy ConAgra guidance.

I want to come back like many people to really make sure I understand what's happening in Pinnacle. We saw the first half of the year delivered right through and you reported that. And I know you mentioned that the profit contribution from Pinnacle's below your expectations this quarter. But it looks like it's flowed through around 22% EBIT margin, which isn't that bad. It's just a shade of what we were expecting. So I look at those data points and I contemplate what you're saying about profitability on the forward. And it sounds like the vast majority of the drop is what's happening now and what's going to be happening over the next few quarters, not necessarily what's happened already to reported results. Is that fair? And related to that, for me to bridge to your EBIT guidance and there’s a lot of guess work here to recalendarize the base. I have to cut profit by almost 30% year-on-year for the back half of the year, which seems very, very jarring. Can you help walk me to what's going to drive that such a substantial downtick on the forward, especially when I contemplate what you're saying about point out inefficiency point out inefficient promotions and some other things that sound like they may actually help you?

First, I’m going to take the big picture, Jason, just to come back to the Pinnacle business. And I think I've talked about this in quite a bit of detail today. But the way this virtuous cycle, as I described it manifests itself, is when your innovation is subpar, it does not show out of the gates. It shows up eventually. And it's clearly -- the side effects of it are showing up in the back half of this calendar year frankly very recently. And it is manifesting itself in increased significant distribution cuts on the three businesses as I talked about. As you can imagine, once you’re cut and you’ve got half way to get back in but it's not going to be with the exact same items that have just been discontinued. You basically got to rebuild the innovation pipe and get it back in when the products are ready and when the window is open. And hence the amount of time it’s going to take to get this thing back. But if you look at whether or not that is executional or structural, it's clearly executional in nature. These brands are still number one in their categories, Birds Eye's example by a country mile. So we've got work to do but we’ll get it back in. In terms of the near-term flows, Dave?

So, Jason I understand the confusion right, because it's a stop here, because we closed October and there is a lot here. So let me try to break it down for you little bit if you look at our quarter that is basically the month of November for Pinnacle. And you’re right it shows a higher operating margin relative to what we forecast. November is probably the highest single margin month for Pinnacle because their margins are higher in the second half of their year than the first half. So we’re basically capturing one month where gross margins are in the 29. But if we look at that month relative to the prior year month, which you don’t see, it's down about 200 basis points. So the first point is and it's reflected on that calendar year 2018 chart. The gross margin versus prior year trending down by 220 basis points is directionally. The second piece is that and we did say it and in our comments is that we have made some decisions to pull low ROI programs, which had an impact on sales of about $30 million. So that is also in our forecast because you're pulling volume out and you have short-term impact of doing that. But we have long-term benefits when your trade rate improves. When you get into the second half of ConAgra, that’s really the first half of what Pinnacle would be in their calendar year. That’s always been a lower absolute gross margin, right. So a little bit of this is we’re cutting off our May fiscal year and you’re seeing a forecast of gross margin that only picks up the first half of Pinnacle. Having said that, that forecast reflects coming out of the recent tax season for vegetables inflation on vegetables. So, now that’s layering into the forecast as well plus the additional transportation inflation that will continue. So I know it’s complicated but there is a lot of dynamics and because we cut off in May, it doesn’t allow you to show the full calendar 2019 Pinnacle, because it’s our fiscal year. So hopefully that gives you -- sheds a little light on the gross margin dynamics.

So quick question on the fiscal '22 guidance just to be clear, so I'd say the guidance held so high single digit accretive relative to the base before that would have included some buy backs. Obviously, you have talked a lot about Pinnacle today what potentially has changed now relative to due diligence process and pre-close. But then you're saying the guidance is held, synergies are higher and we expect to get the margin profile back to where it was because of the playbook that's obviously been implemented across a number of different businesses historically and worked well. So that's the case. The excitement is there and the confidence is there. And we understand the problems and we know how to address it, and we have high confidence in how we're going to fix it and get it back to where it was despite there's a lower starting point. At the end game on the base -- and relative to your original expectations, would probably still be similar plus you have the synergies. So I guess the question is why wouldn't those expectations then be a little bit higher or are you just playing it safe because obviously we're in ‘19 and we're talking ‘22 so a time in between that maybe you need a little bit more investment, maybe you don’t. But just walk me through why it would be the same and not higher given the synergies are higher and you think you can get back to the original Pinnacle margin profile?

From an EPS standpoint, Rob, we can get back there in large part because we've now gotten under the hood and we see more synergies and we've modeled a certain cadence very preliminary of business recovery year. As you might imagine, between now on our Investor Day, that's the work that we're going to be scrubbing, that's the work that we're going to be building out for the next few years. So as we think about this for the long haul, there is no question in our minds that there's significant opportunity here. In fact the scale and the combination of these two companies make as much strategic sense as ever. But we've got some hard work to do short term and so that's what we got to deal with. It's a good reminder to me of the importance of focus. Our company has been laser-like focused on getting our brands right for the last few years. Here's a portfolio that is clearly suffering right now and needs focus, and we're bringing that focus. And how high is up over in the fullness of time, we'll talk more about that later. But we know we've got to do here and we are on the case.

Just to add on to that. The synergies we say in the upside, these are the cost synergies right. So the 215 were cost synergies. We did not build any revenue synergies into our model. Now obviously the business is down relative to what we had modeled, so we have to do all the things we discussed to bring that business back. But when you talk about upside going out long-term, we believe that there could be a side on revenue synergies. That's not in the updated cost synergy number that we will have.

Thanks for squeezing me. My question is related to structural versus transitory issue that the industry and ConAgra is facing in the context of the fact that markets value and the entire industry and ConAgra has structurally flawed. So I'd like to ask two questions, one related to the Pinnacle business and one related to the base business in that context right. So you're probably aware of our view, which is that execution is really the big winner for the large CPGs rather than really brand equity erosion. So with Pinnacle, I mean there's a long history here of really good innovation and really good brand building, a very long history and it's been best-in-class, right. And so it seems like the markets are a little bit confused, because your commentary was pretty harsh on the near-term performance. So maybe you can give us an example of the innovation not hitting the mark and how that's execution versus structural. So that's on the legacy -- on the Pinnacle business? And then on your base business, which you lost in all the Pinnacle focus. Aren’t you actually seeing the execution getting better, right? You've executed better. Pricing is ahead of investments on retailer initiatives. Aren't we actually now seeing the fact that if you execute on a portfolio strategy, the brand is actually in good shape. So help me on that if you can. Thanks.

Akshay, I don't think there should be any confusion here. We fully agree with your statement that when you have iconic legacy brands, they're not entitled to performance; they are capable of performance. And they're capable of performance depending upon whether or not the enterprise can innovate them in ways that drive good profitability and do a fantastic job delighting the consumer. When you look at what we've done with our ConAgra Brands over the last four years, we have taken brands that were once iconic that many folks have written off, like a banquet or a healthy choice. We've dramatically modernized them. We’ve dramatically modernized. We’ve improved the margins. We’ve raised the price points to levels no one felt was possible. And the brands are growing at audacious clips now, some of them north of 20%. And so that’s a good example of exactly what you’re saying. Pinnacle, as I’ve mentioned in the prepared remarks, has had equal kinds of success in the past. But just because you’re successful in any given window, doesn’t mean that that brand is entitled for that success to carry on forever. Each year brand folks brand companies like ours bring new innovations in the marketplace or have the opportunity to, or they can pass and they can let their brands atrophy. They can also innovate superior innovations or they could innovate subpar innovations. And so clearly the proof is always in the pudding. I would say, my commentary was not harsh but the results in the marketplace were harsh. And that is what we’ve got to correct with the exactly the same as you’re talking about, which is a return to superior execution on the three key leadership brands that we talked about today. It means not missing big consumer opportunities like spiralized with Birds Eye. It equally means making sure the execution is really buttoned up to communicate the benefit that is being delivered to the consumer. So for example, Duncan Hines, Mug Treats being positioned as sweet treat not as portion size cake. These may sound like nuance but they are very important to repeat purchase and the size of the market you create to household penetration, and that’s exactly what we’ve got to go do.

Great, thank you. So as a reminder, this call has been recorded and will be archived on the web as detailed in our press release. Investor Relations is available for any follow-up discussions. Thank you for your interest in ConAgra Brands.

This concludes our question-and-answer session. I would like to turn the conference back over to Brian Kearney for any closing remarks.