Conagra Brands, Inc. (NYSE:CAG) Q2 2023 Earnings Call Transcript

Conagra Brands, Inc. (NYSE:CAG) Q2 2023 Earnings Call Transcript January 5, 2023

Conagra Brands, Inc. beats earnings expectations. Reported EPS is $0.81, expectations were $0.66.

Operator: Good morning, everyone and welcome to the Conagra Brands Second Quarter and First Half Fiscal 2023 Earnings Conference Call. Please also note today’s event is being recorded. At this time, I’d like to turn the floor over to Melissa Napier, Senior Vice President of Investor Relations. Ma’am, please go ahead.

Melissa Napier: Good morning. Thanks for joining us today for the Conagra Brands second quarter and first half fiscal 2023 earnings call. I am here with Sean Connolly, our CEO and Dave Marberger, our CFO, who will discuss our business performance. We will take your questions when our prepared remarks conclude. On today’s call, we will be making some forward-looking statements. And while we are making these statements in good faith, we do not have any guarantee about the results we will achieve. Descriptions of our risk factors are included in the documents we filed with the SEC. We will also be discussing some non-GAAP financial measures. These non-GAAP and adjusted numbers refer to measures that exclude items management believes impact the comparability for the period referenced.

Please see the earnings release for additional information on our comparability items. The GAAP to non-GAAP reconciliations can be found in the earnings press release and the slides that we will be reviewing on today’s call, both of which can be found in the Investor Relations section of our website. I will now turn the call over to Sean.

Sean Connolly: Thanks, Melissa. Good morning, everyone. I hope you all are off to a happy and healthy start to the new year. Thank you for joining our second quarter fiscal €˜23 earnings call. I’d like to start by covering some key points for the quarter on Slide 5. Despite our most recent wave of inflation-justified pricing, consumer demand for our products in the second quarter was strong as elasticities remained muted and well below historical norms. The ongoing durability of demand is a testament to the strength of our portfolio and demonstrates how the Conagra Way playbook has positioned our brands to continue to resonate with consumers even in an inflationary environment. The successful execution of our playbook is clear in our second quarter results.

We drove a significant increase in our top line. We continue to have solid share performance across the portfolio, especially in our key frozen and snacks domains and we made excellent progress recovering both gross and operating margin. Operationally, we made good headway on our supply chain and productivity initiatives. While we are pleased with what we’ve accomplished to-date, our supply chain is not yet fully normalized. That will improve. And overall, we see a long runway of opportunity ahead. We also continue to prioritize strengthening our balance sheet while making strategic investments in our business and returning capital to shareholders. In short, Conagra had a strong quarter across the board. Given our positive results during the first half of fiscal €˜23, we have increased our expectations for the year, raising our full year guidance across all metrics, including organic net sales growth, adjusted operating margin and adjusted earnings per share.

With that overview, let’s dive into the results on Slide 6. As you can see, we delivered organic net sales of more than $3.3 billion, representing an 8.6% increase over the prior year period. Our adjusted gross margin of 28.2% represents a 310 basis point increase over the second quarter of last year. And our adjusted operating margin of 17% represents a 237 basis point increase over that same period. Adjusted EPS rose 26.6% from last year to $0.81 per share. Slide 7 goes into more detail on our sales results on a 1 and 3-year basis. Given the timing when the pandemic and inflation began to impact our industry, we believe that the 3-year comparison provides important context to highlight the underlying strength of our performance. At the total Conagra level, we grew retail sales more than 10% on a 1-year basis and more than 26% on a 3-year basis.

We are pleased with our solid share performance, including how our strong brands allowed us to largely maintain total company market share while taking several inflation-justified pricing actions, particularly during the past year. Notably, we have continued to drive robust share gains in key frozen and snacks strategic domains on both a 1 and 3-year basis. I want to spend a minute putting our sales growth in context. Slide 8 shows our performance over the past 3 years compared to our near-in peer group, including Campbell’s, General Mills, Kellogg’s, Kraft Heinz and Smucker’s. We have a great deal of respect for our peers, all of which have been navigating the same macro demand and inflation dynamics over the past 3 years. Among this group, Conagra ranked second in dollar sales growth and first in unit sales performance.

It’s important to keep in mind that all of these peers have taken pricing actions to help offset inflation and Conagra is in the middle of the peer set in terms of the price per unit increases in this time period. It’s clear that consumers continue to appreciate the quality, convenience and superior relative value that our strong brands have to offer, which has enabled Conagra to perform extremely well on both an absolute and relative basis. Let’s take a closer look at our top line performance during the second quarter by retail domain, starting with Frozen on Slide 9. We maintained our momentum, delivering strong retail sales growth on both a 1 and 3-year basis improving 9% and 26%, respectively. This growth was driven by a number of our key categories, including breakfast sausages and single-serve meals, which both experienced double-digit retail sales growth compared to last year.

Turning to Snacks on Slide 10, you can see a similar story. We drove a 14% increase in retail sales compared to the second quarter of fiscal €˜22 and a 41% increase over the second quarter of fiscal €˜20. The continued momentum of our snacks business is broad-based across a number of categories. Compared to last year, microwave popcorn was up 21%, seeds was up 18%, and meat snacks and hot cocoa both rose more than 14%. We also accelerated growth in our highly relevant staples portfolio, increasing retail sales 10% this quarter compared to the second quarter of last year and 22% compared to the same period 3 years ago. This growth was led by pickles and whipped toppings which grew more than 11% and 10% respectively on a year-over-year basis.

As I have mentioned, our strong top line performance was primarily driven by inflation-justified price increases, coupled with ongoing muted elasticities. Slide 12 details the relationship between pricing and volume over time. As you would expect, increased pricing does have an impact on volume, both for Conagra and the total industry. However, you can see how elasticities have remained steady even as we have continued to increase the price per unit of our products to help offset ongoing COGS inflation. And as we detailed a few minutes ago, Conagra’s 3-year CAGR on unit sales performance leads its near-in peer group. The relatively modest elasticities, both compared to historic norms and our peers are a testament to the strength of our brand.

Now that we have unpacked the relationship between price and volume and the resulting net sales, I’d like to spend a few minutes on the relationship between net sales and COGS and the resulting impact on our margin performance on Slide 13. Generally speaking, when a business has strong brands, strong processes and strong people, as Conagra does, it is able to navigate inflationary cycles in discrete, predictable phases. As we have detailed for some time, when unprecedented inflation increased our cost of goods, we took strategic pricing actions to help offset the rising costs. However, there was an inherent lag between when we implemented pricing actions and when we realized the benefits of those actions in our top line results. This pricing lag resulted in temporary margin compression.

Furthermore, continued inflation extended this period of margin compression as new inflation-justified pricing actions led to additional lag effects. That is the dynamic we have experienced over the last several quarters as we continue to play catch-up by increasing price incrementally to account for the extraordinary extended rise in inflation. At the end of the first quarter, we reached a significant inflection point in the relationship between net sales and COGS, marking the end of the temporary margin compression phase in the beginning of the margin recovery phase. As you can see in the chart, inflation has begun to moderate in certain areas enabling our inflation-justified pricing actions to catch up to the rising costs. Slide 14 shows the impact this inflection has had on our gross margin results as continuously rising inflation weighed on our COGS throughout fiscal €˜22 and into the first quarter of fiscal €˜23, our margins were compressed.

Now predictably, as pricing has finally caught up to COGS inflation, you can see the recovery of our gross margin to be more in line with pre-pandemic levels. While our gross margin can vary quarter-to-quarter due to a range of internal and external factors, the strategic pricing actions we have successfully executed, combined with moderating inflation and our strong brands, position us well to recover and maintain a healthy gross margin going forward. Of course, inflation remains elevated in many areas and we continue to closely monitor our costs, just as we have in the past. We will continue to take appropriate inflation-justified pricing actions as needed. Another key driver of our margin recovery is our supply chain performance shown on Slide 15.

This is due to a combination of macro factors as well as the strategic initiatives we are executing to improve our operations. We made good progress on our supply chain during the second quarter, which benefited from improvements in the service we provided to our customers, continued headway on our ongoing productivity initiatives, which remain on track to achieve the targets we outlined at our most recent Investor Day, more moderate increases in commodity prices and improved inventory levels due to an increase in the availability of materials. The takeaway here is that we are pleased with the progress we are making, but industry-wide challenges do persist. There is more room for improvement as we advance our productivity initiatives and the macro environment continues to normalize.

As a result of our strong performance this quarter and the first half of fiscal year 2023, we are raising our full year guidance for all metrics detailed here on Slide 16. We now expect organic net sales to grow between 7% and 8% compared to fiscal €˜22; adjusted operating margin to be between 15.3% and 15.6%; and full year adjusted EPS growth of 10% to 14% or $2.60 to $2.70 per share. Dave will provide more detail on the underlying assumptions behind these expectations. Before I turn the mic over, I want to summarize what I have covered today. Our strong performance during the first half of fiscal €˜23 was primarily driven by a combination of inflation-justified pricing actions and muted elasticities, reflecting the strength of our brands.

Consumers continue to recognize the value our brands provide despite the higher prices, allowing us to gain share in key domains such as frozen and snacks. Our top line growth was coupled with encouraging progress in a number of different areas of our supply chain that enabled us to operate more efficiently. Together, these factors as well as improvement in the inflationary environment helped us recover our margins to near pre-pandemic levels. As a result of our strong performance, we are raising our full year fiscal €˜23 guidance for organic net sales, adjusted operating margin and adjusted EPS. Finally, we are looking forward to seeing everyone who can make it to CAGNY this year. We plan to host our annual kickoff dinner on February 20 and are scheduled to present the following morning.

We will follow-up with more details on the event as we get closer. With that, I will pass the call over to Dave to cover the financials from the quarter in more detail.

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Dave Marberger: Thanks, Sean and good morning everyone. I will begin by discussing a few highlights from the quarter as shown on Slide 19. We are very pleased with our second quarter results, which reflect the ongoing strength of our business and successful execution of the Conagra Way playbook. For the quarter, we delivered organic net sales growth of 8.6%, primarily driven by inflation-justified pricing and muted elasticities. Adjusted gross margin increased to 28.2% and adjusted gross profit dollar growth was up 21.7%, benefiting from higher organic net sales and productivity initiatives. The increase in adjusted gross profit, combined with another strong performance from our Ardent Mills joint venture, contributed to adjusted EBITDA growth of 21.5%.

Slide 20 provides a breakdown of our net sales. As you can see, the 8.6% increase in organic net sales was driven by a 17% improvement in price/mix, which was a result of inflation-justified pricing actions that were reflected in the marketplace throughout the quarter. This was partially offset by an 8.4% decrease in volume, primarily due to the elasticity impact from those pricing actions. However, the impact was favorable to both expectations and historical levels. Slide 21 shows the top line performance for each segment in Q2. We are pleased with the robust net sales growth across our entire portfolio. Net sales growth in our domestic retail portfolio remained strong, with our Grocery & Snacks segment and Refrigerated & Frozen segment achieving net sales growth of 6.8% and 10.5%, respectively.

The difference between the organic and reported net sales performance in our International segment reflects the unfavorable impact of foreign exchange. I’ll now discuss our Q2 adjusted margin bridge found on Slide 22. We drove a 12.2% benefit from improved price/mix during the quarter, driven by the previously discussed inflation-justified pricing actions. We also realized a 1.3% benefit from continued progress on our supply chain productivity initiatives. These pricing and productivity benefits were partially offset by continued inflationary pressure with 11% gross market inflation negatively impacting our operating margins by 7.5% and a negative margin impact of 2.9% from market-based sourcing. As a reminder, as commodity prices rose quickly last year, we benefited from locking in contracted costs that were lower than the market.

Even though we see commodity inflation moderating, we will not immediately realize a benefit to the P&L as our costs may remain higher than the spot market due to the timing of our contracts and when they roll off. Slide 23 breaks down our adjusted operating profit and margin by segment. As Sean detailed, our decisive inflation-justified pricing actions, coupled with improved service levels and productivity, allowed us to successfully navigate ongoing inflationary pressures and industry-wide supply chain challenges and deliver adjusted operating margin expansion in each segment during the quarter. We were also pleased that higher sales and productivity, once again, offset headwinds from inflation and elevated supply chain operating costs across all four segments in Q2.

As a result of this continued strong performance, total adjusted operating profit increased 25.9% to $563 million during the quarter despite an increase in adjusted corporate expense during the period primarily due to increased incentive compensation. Slide 24 shows our adjusted EPS bridge for the quarter. Q2 adjusted EPS increased $0.17 or 26.6% compared to the prior year. This significant increase was primarily driven by higher sales and gross profit as well as a small benefit from a continued strong performance from Ardent Mills. Slightly offsetting these positives were higher A&P and adjusted SG&A compared to the prior year period as well as lower pension and postretirement income, higher interest expense and the impact of adjusted taxes.

Slide 25 reflects the continued progress we made on our commitment to strengthening our balance sheet. Our net leverage ratio remained at 3.9x at the end of Q2, down from 4.3x at the end of Q2 in the prior year period. As we have previously communicated, Q2 is historically a heavier use of cash quarter from a working capital perspective. So we expect progress on our net leverage reduction to be greater in the back half of the year. With that in mind, we continue to expect to end the fiscal year with a net leverage ratio of roughly 3.7x. Year-to-date CapEx of $188 million decreased by $69 million compared to the prior year period, while free cash flow increased by $104 million year-over-year. We remain committed to returning capital to shareholders as evidenced by our payment of $159 million in dividends in Q2 fiscal €˜23 and $309 million year-to-date.

The first half dividend increase of $27 million compared to the first half of fiscal €˜22 reflects the quarterly dividend rate of $0.33 per share. We also repurchased $100 million worth of shares in the second quarter and $150 million worth of shares year-to-date to offset most of the longer-term performance-based shares we estimate issuing. As we enter the second half of the fiscal year, we will continue to evaluate the highest and best use of capital to strengthen our balance sheet and optimize shareholder value. As Sean mentioned, we are raising our fiscal €˜23 guidance for net sales growth, adjusted operating margin and adjusted diluted earnings per share given our strong performance in the first half of fiscal €˜23 and expectations for a solid performance for the balance of the year.

Turning to Slide 27, I’d like to take a minute to walk through the considerations and assumptions behind our guidance. We expect gross inflation to continue, but moderate through the remainder of the fiscal year, resulting in an inflation rate of approximately 10% for fiscal €˜23. Additional inflation-justified pricing actions that have previously been communicated and accepted will go into market in Q3. However, the magnitude of these pricing actions will be smaller and more targeted than previous pricing actions. As always, we will continue to monitor inflation levels and price as needed to manage future volatility. We anticipate CapEx spend of approximately $425 million in fiscal €˜23 as we make investments to support our growth and productivity priorities with a focus on capacity expansion and automation.

Approximately $200 million of the $425 million was spent in the first half of fiscal €˜23. Lastly, we expect interest expense to approximate $405 million and pension and postretirement income to approximate $25 million for the year, driven by the higher interest rate environment. Our full year tax rate estimate remains approximately 24%. To sum things up, we are extremely pleased with our strong performance in the first half of fiscal €˜23, especially the recovery of Q2 adjusted gross margins to near pre-COVID levels. This, along with our expected continued positive business momentum led to raising our full fiscal year €˜23 guidance. Our strong performance amid such a dynamic environment would not be possible without the hard work of our entire team and reflects the ongoing strength of our brands and successful execution of the Conagra Way playbook.

Looking forward, we remain committed to executing on our strategic business priorities and generating value for our shareholders. That concludes our prepared remarks for today’s call. Thank you for listening. I’ll now pass it back to the operator to open the line for questions.

Q&A Session

Operator: Our first question today comes from Andrew Lazar from Barclays. Please go ahead with your question.

Andrew Lazar: Great. Thanks very much. Happy New Year, everybody. Sean, obviously, you had expected and talked about sequential gross margin improvement as you move through the year. The 310 basis point jump certainly in gross margins is certainly far greater than investors were expecting. And I have to imagine greater than what maybe you were expecting internally. So I guess what was it that came in that much better in the quarter than you had anticipated? And I ask a sort of a view towards getting a better sense on really how sustainable these levels of gross margin are as we move through the year? Because as you have said previously you expected sequential improvement as the year progresses, so is this still the case from this new high level as we go through the back half of the year or are there any reasons to expect a step back? Thanks so much.

Sean Connolly: Sure, Andrew. Yes, everything we’re seeing is very consistent directionally with what we’ve expected precisely as things come in by month, by quarter, there is a little bit of variability there. But I’d say, overall, I know these inflation super cycles are a complicated thing for our investors to unpack, which is why we always try to be instructive as to the predictable and mechanical way these cycles tend to unfold, if you have three things in place: strong brands; strong processes; and great people. So in a nutshell, the mechanics of this situation is, inflation hits, you announce price. The customer’s 90-day clock starts ticking. Then the customer’s 90-day clock expires. Elasticities exist, but they are, in fact, benign relative to history and consistent overall and margins recover.

And sometimes, if it’s multiple waves of inflation, you rinse and repeat that whole process. And everything we are seeing, sales-wise and margin-wise, is consistent overall with these textbook mechanics and therefore, entirely good news and not some negative surprise. So to come full circle, we don’t see the margins that we’re looking at right now as a peak. We see them as the successful execution of our playbook. Dave, do you want to comment on that?

Dave Marberger: Yes. No, I think that’s a great explanation of the mechanics of this, Andrew. I think as you look at H2, we would expect that the gross margin change in the second half to be pretty consistent with what we saw in Q2 around that 300 basis points. And what I’ll point you to is €“ excuse me, you really need to look at the relationship of price/mix that we deliver each quarter versus the market inflation each quarter going back to the fourth quarter of €˜21. Conagra got hit with inflation earlier and to a much higher level than most food companies. And so we came out of the gate and it impacted our margin significantly, very quickly. So if you just look at fiscal €˜22, we had inflation every quarter that was 16% to 17%.

And we never got to that level of pricing even in the fourth quarter. In fact, our pricing Q1 of last year was only 1.6%. So our pricing ramped up, but had not caught up to that significant inflation. Q1 of this year, our pricing was at 14%. Inflation was 15%, so we were getting close. This quarter, pricing, 17%; market inflation is 11%. So it’s the first quarter where we’ve actually seen the flip. And now that, that flips there, Sean had a chart in his deck. That’s when you see the margin recover. So we saw it in Q2, and that delta is, we expect it to continue as we go forward each quarter. Now I will call out Q2 for Conagra is our highest sales quarter. So the absolute gross margin of 28.2% is usually our highest. But in terms of looking forward, look at the delta that we delivered in Q2 as being a proxy before going forward.

Andrew Lazar: Really helpful. Thanks so much.

Operator: Our next question comes from Cody Ross from UBS. Please go ahead with your question.

Cody Ross: Good morning, thank you for taking our question. Two questions here. First one, you put up a slide showing how your unit sales on a 3-year CAGR basis are performing much better than your peers. What do you attribute that to?

Sean Connolly: Well, as you know, Cody, we €“ going into COVID €“ at the beginning of COVID, we performed extremely well in the peer set. And I made the point then that, that was not entirely a function of just people being forced to eat in their home. It was in part due to the fact that we’ve taken one of the largest portfolios of food in North America and completely overhauled it in terms of modernization and makeover during prior to COVID hitting. So that when COVID hit, we had many, many new households that we’re finding all these new innovations for the first time. And as I pointed out repeatedly over the last couple of years, our repeat performance and depth of repeat with those new households that we’ve gathered has been remarkably strong.

So you put all that together, along with the fact that a lot of these younger consumers that spend so much time eating away from home pre-pandemic are still eating in the home now because prices are so high away from home. That has conspired to lead to benign elasticities overall for our industry. And as we pointed out before, our elasticities not only remained low versus historical norms, but they are consistent and they are among the lowest, if not the lowest, in the entire peer group. So it’s always a function of your brand strength. And the other thing I would add is, recall, we spent a lot of time in the last few years exiting businesses that are more commoditized, where that were more susceptible to trade down and people €“ consumers shifting to private label.

So cooking oil, peanut butter, liquid eggs, I could go on. We’ve done that. So we’ve done a lot of reshaping of the portfolio to be more resilient for a cycle like this, and we’re seeing it in the data.