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ConAgra Foods, Inc. (NYSE:CAG)Q3 2019 Earnings Conference CallMarch 21, 2019, 9:30 a.m. ET
Prepared Remarks Questions and Answers Call Participants
Good morning, ladies and gentlemen, and welcome to the Conagra Brands Third Quarter Fiscal Year 2019 Earnings Conference Call. All participants will be in listen-only mode. (Operator Instructions) After today’s presentation, there will be an opportunity to ask questions. (Operator Instructions) Please note that this event is being recorded.
At this time, I would like to turn the conference over to Brian Kearney, Director of Investor Relations. Please go ahead, sir.
Brian Kearney — Director of Investor Relations
Good morning, everyone. Thanks for joining us. I’ll remind you that we will be making some forward-looking statements during today’s call. While we are making those statements in good faith, we do not have any guarantee about the results that we will achieve. Descriptions of the 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 reconciliations of those adjusted measures to the most directly comparable GAAP measures can be found in either 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. We’ll also be making references to total Conagra Brands as well as Legacy Conagra Brands. References to Legacy Conagra Brands refer to measures that excludes any income or expenses associated with the recently acquired Pinnacle Foods business. Finally, we will be making references to pro forma net sales for Pinnacle. Pro forma net sales refer to results for Pinnacle Foods prior to the acquisition that have been adjusted to align with Conagra’s fiscal calendar.
With that, I’ll turn it over to Sean.
Sean Connolly — President and Chief Executive Officer
Thanks, Brian. Good morning, everyone, and thank you for joining our third quarter fiscal 2019 earnings conference call. There’s a lot to cover this morning; we have strong Legacy Conagra results to discuss, a positive Pinnacle integration update to share, deleveraging to discuss, and a preview of our April 10th Investor Day. But the most important takeaway from everything Dave and I will discuss today is what these results mean, the Conagra Way to profitable growth delivers. The impact of our unwavering commitment to the Conagra Way over the past several years has been consistent progress, most recently resulting in the continued strong momentum in core Legacy Conagra Brands during the third quarter, particularly in our leading frozen and snacks businesses. We are now aggressively applying this approach to Pinnacle and it’s working to keep the technical integration on track as well as driving a reinvigorated innovation lineup.
As we said in Q2, we expect that innovation to lead to improved Pinnacle trends in the second half of fiscal 2020. It also enabled us to gain traction on delevering. In the short five months since closing the Pinnacle transaction, we’ve reduced debt by $685 million. Overall, we are confident we will deliver quality long-term growth at Conagra and we’ll share our robust innovation pipeline and new long-term financial algorithm on April 10th along with details of the increased cost synergy opportunities that we see. Before I get into the quarter, let me talk a bit more about the Conagra Way. We’ll unpack this even further at Investor Day, but this playbook is our bedrock and you’ve seen us execute it for several years now. The Conagra Way to profitable growth is relentlessly principle based and firmly grounded in the consumer. It advocates that growth is essential and that we cannot and will not cut our way to prosperity.
It acknowledges that our ability to build strong brands requires differentiated capabilities, particularly those that fuel innovation; areas like demand science, precision marketing, and omni-commerce. And the Conagra Way recognizes that our success requires a highly disciplined approach to portfolio management, which you’ve seen us execute consistently for the past four years. Importantly, our disciplined approach is repeatable and scalable. It built our healthy and growing frozen and snacks businesses and serves as the basis for how we’re approaching the rest of our portfolio, including Pinnacle. We’re confident about how we do things around here because it works. We don’t take shortcuts. We do things the right way, a way that best positions us for maximum value creation over the long haul. So, let’s talk more about the results the Conagra Way delivered in Q3.
First up is the Legacy Conagra business. We continued to deliver good consumption growth in our Legacy Conagra segments in the quarter with strong trends on both a year-over-year and two-year basis. As you can see on Slide 8, Legacy Conagra’s domestic retail segments had another good quarter. Q3 growth in our Legacy segments was once again based on solid fundamentals tied to the increasing strength of our brands. Our retail sales and base velocities remained in fertile territory and continued to gain momentum on a two-year basis. Turning to our segment results. Refrigerated & Frozen was up 240 basis points in the quarter with Frozen again delivering terrific growth, 490 basis points. Refrigerated was down but as I mentioned last quarter, apart from Reddi-wip, we have yet to renovate these brands and bring new innovation to the marketplace.
Refrigerated is one of the final pieces of the Legacy Conagra portfolio to receive attention, but the work is well under way and you’ll see exciting new products on store shelves in 2019. But turning back to Frozen, we’ve talked a lot in prior quarters about the successful implementation of our playbook in Frozen. As you can see on Slide 10, that success continued in Q3. We reinvigorated and continued to lead the Frozen category and our fundamentals remained strong in the quarter with improvement in consumption trends, TPDs, and base sales velocity. Our approach is having a positive impact on our results and importantly, it’s also driving category growth in frozen single-serve meals. Our rigorous approach to modernizing and premiumizing our brands through renovation and innovation has delivered impact for Conagra and for our customers. While we began our innovation journey in Frozen more than a year ago and went broader and deeper in frozen in fiscal 2019, we have even more on the way.
In fiscal ’20, we expect to have our most robust and powerful slate of innovation in this segment yet. The team has done a lot of great work to develop a strong multi-year pipeline of innovation across our Legacy Conagra frozen brands and across refrigerated brands like Hebrew National, Egg Beaters, and Reddi-wip. Turning to our Legacy Conagra Grocery & Snacks segment, we have more positive news to report. The snacks business grew by 8.2% during the quarter. This tremendous growth validates our recent investment in the business. Looking at our snacks business in more detail on Slide 14. The growth we delivered in Q3 came with contributions from every key snacking vertical; popcorn, meat snacks, sweet treats,and seeds. On a two-year basis, retail dollar sales for our Legacy Conagra snacking portfolio were up an impressive 14%. Dissecting the snacks growth which we’ve done on Slide 15; you’ll see that while TPD’s were down, base velocities increased significantly.
In other words, our growth in snacks during the quarter was driven by bringing terrific products to market that consumers wanted. Those products were in high demand and moved off shelves very quickly and growth through improved consumer pull is sustainable growth. Of course TPDs have been an important metric in assessing brand health historically, but TPDs are not always a helpful barometer of brand vitality. As an example, look at the Slim Jim results. Slim Jim is one of our healthiest brands and is driving strong snacks growth, but Slim Jim’s TPDs declined nearly 18% year-over-year as we optimized our assortment. With that data point alone, you’d think the brand was struggling, but it was not. Velocity was up more than 28% and the net result was a retail sales improvement of more than 7% in the quarter. Our Slim Jim business became stronger by increasing shelf inventory and facings on our best selling, fastest moving items and by pruning low velocity SKUs.
These actions led to higher sales for both Conagra and our customers and TPDs did not tell the story. We saw the exact same dynamic on Swiss Miss in Q3 and I share this because it’s a good reminder that TPD optimization does not always come through TPD growth. I’m very excited about the innovation that we deployed across snacks in the last year and even more excited about the impact of that innovation, but we’re not even close to being done. To the point I highlighted earlier regarding Refrigerated & Frozen, our innovation and renovation machine is humming and we have a terrific multi-year pipeline built out for the brands you see here. I won’t go further into it now, you’ll have to wait until Investor Day. So in summary on Legacy Conagra, we feel very good about our momentum. We’re pleased with the results we delivered in Q3 and are confident that with the Conagra Way, we’ll continue to deliver.
Turning to Pinnacle priorities on Slide 18. It’s been a short five months since we completed our acquisition of Pinnacle, we’ve accomplished a great deal in that time with much more to come. I’ll spend a few minutes covering each of our focus areas, integrating the business; reinvigorating Birds Eye, Duncan Hines, and Wish-Bone via innovation; and deleveraging. First, let’s talk about the integration. I couldn’t be happier with our progress on this front so far. We’ve said all along that the similarities between Legacy Conagra and Pinnacle made a combination of our two companies an obvious opportunity and the fact that we’ve been able to quickly align our organizations and deliver our integration work plan to-date is evidence of how well the two companies mesh. Put a finer point on it, work transitions are on track and processes are being aligned; systems integration are well on their way with key milestones being hit; and importantly, we captured approximately $12 million of cost synergy in Q3 which paces ahead of our expectations.
We continue to expect to over deliver the $215 million of cost synergies we previously announced and we’ll share more detail on refined cost synergy opportunities next month. Thank you to the entire Conagra team across Legacy Conagra and Pinnacle for all their terrific work to-date on the integration. We’ve also been spending time in Q3 undertaking a concentrated effort to begin deploying the Conagra Way to the Pinnacle portfolio and first up is our proven value over volume philosophy. We are starting the process of cutting slower turning and lower margin SKUs while redesigning Pinnacle’s customer investments for better ROI. Retail sales and TPDs continued their downward trends in Q3, but base velocities improved as shown in the chart on the right. Non-investment grade SKUs were the ones being pruned in the quarter and that means that the Pinnacle products remaining on shelf are higher quality and generating consumer takeaway.
As we did with our Legacy Conagra business several years ago, we are creating a stronger foundation on which to build. While we won’t be happy until total retail sales begin to turn in the Pinnacle portfolio, we are confident that the value over volume process under way gives us that stronger foundation. As we introduce future innovation slates into the market, the net result will be more profitable sustainable growth. To be clear, our Pinnacle-related work is incredibly focused. Right now, it’s all about strengthening Pinnacles Big 3; Birds Eye, Duncan Hines, and Wish-Bone. Pinnacle historically referred to these brands as leadership brands and with good reason. However, in the second half of last year, each of these businesses struggled with executional issues. These challenges hurt sales and profit representing the vast majority of Pinnacle’s drop off on each.
While recent performance in these great brands has been below historical norms, as we discussed last quarter, we’re confident that we can reinvigorate them through great innovation and Q3 brought the beginning of our implementation of focused action plans for each brand. First, let’s talk about Birds Eye. Birds Eye is an iconic billion dollar brand previously the largest in the Pinnacle portfolio and now the largest in the Conagra portfolio. Recently, however, the Birds Eye brand was slow to respond to key consumer trends, opting out of innovating in important growth pockets. That is changing. The differentiating capabilities that come with the Conagra Way include a well-developed innovation muscle and the know-how to identify and capitalize on consumer trends. Applying these capabilities to Birds Eye means that we’re not only opting in to the innovation opportunities in this key category, but opting in in a big way.
Here again we’ve already built a multi-year pipeline of innovation and renovation that will deliver a sequenced deluge of new Birds Eye products. We’ll share a lot more in April. Now let’s turn to Duncan Hines. While Duncan Hines’ recent results have been disappointing, it faces a different situation than Birds Eye. Recall the Duncan Hines brand actually did a fair amount of innovation over the past two years. The brand moved into broader snacking with a very innovative idea for Mug Cakes. With this innovation, the Pinnacle team was clearly heading in the right direction. However, the execution of that innovation was not up to our standards. Inefficient SKUs proliferated while competitors entered the space with a more provocative execution, generated better velocities, and gained share. And that new innovation from the competition caused Duncan Hines to suffer. The good news is that we see the solutions here as straightforward even if they’ll take a bit of time to cycle into the marketplace.
Slide 23 shows how deploying the Conagra Way to Duncan Hines is leading to a restage of the product with simplified branding, a larger size impression, an optimized SKU range, and an upgraded product with the simple addition of the hero ingredient consumers want, frosting. And finally, let’s talk about Wish-Bone where the situation is again unique. In the summer of 2018 Wish-Bone labels were updated, but unfortunately the execution came up short. Despite a more modern design, the labels did not effectively communicate the flavor variety and variety communication is absolutely essential in salad dressing. Take a look at the picture on the left. The modernized label communication was flawed and sales velocities declined quickly and considerably following the label change. Fortunately, this issue has an obvious fix. The right side of Slide 24 shows our updated label. It prominently features the dressing variety.
Again, a simple solution, but one that will take a bit of time to cycle into the marketplace. After it does, we believe that consumer takeaway for this iconic brand will improve. Overall, the health of the big three Pinnacle brands is critically important and you can be assured that our teams have spent the last five months incredibly focused on each of them. There is definitely more work to do and it will take some time for customers to add our new innovation into their shelf resets. Again as we said in Q2, we expect innovation to lead to improved Pinnacle trends in the second half of fiscal 2020. But the point I want you to take away today is that we have dug into what exactly ails each brand and we are squarely on top of the solutions. But topline growth isn’t our only focus, we’re also focused on improving margins across the Pinnacle portfolio and generating more cash from each dollar sold.
Over the last several years we’ve built capabilities that address each of the margin levers noted on Slide 25 and deployed them across the Legacy Conagra portfolio. And now we’re focused on getting Pinnacle’s gross margins back on track with solid realized productivity above our cost synergy initiatives, margin accretive innovation, improved pricing capabilities, a better brand mix, a better channel mix, and trade optimization. In other words, we’re intensely focused on infusing the Conagra Way into Pinnacle. Part of this is simply ensuring that our newest team members, those from Pinnacle, understand the fundamentals of our approach. I’ve always said that the cultures at Conagra and Pinnacle have many overlaps, particularly with respect to our common embrace of a lean and agile culture and that’s still my belief.
But we also approach some things differently and we’re excited to share our Conagra processes and tools, particularly those that drive innovation based growth such as demand science, precision marketing, and omni-channel selling. I’m proud of how our combined organization is working together in the short time since the completion of the deal. Shifting to our balance sheet, I’m very pleased with our disciplined focus on deleveraging in the last five months. We’re committed to a solid investment grade credit rating and as I said earlier, in a little less than five months since closing the transaction, we’ve already reduced debt by $685 million. We expect leverage ratios to improve over time as we increase our EBITDA growth from both the realization of cost synergies and the application of the Conagra Way to the Pinnacle portfolio. We will also continue to prioritize debt reduction in our approach to capital allocation.
I want to be clear that while we always view our portfolio with a lens toward optimizing growth and returns, we do not expect to need to make any additional divestitures in order to hit our leverage target. Looking ahead, you can be certain that we will not take our foot off the gas in the Legacy Conagra business and we’ve already mobilized to aggressively apply our playbook to the Pinnacle portfolio and we’ll continue to work to return those brands to growth. Finally, we remain squarely focused on executing our margin enhancing capabilities across the entire Company. As you probably glean from my remarks so far, we’ve got a great Investor Day coming up in a few weeks. As I mentioned earlier, we will be going into depth on the Conagra Way, how it has benefited Legacy Conagra and how it’s being applied to Pinnacle to build long-term sustainable growth. And while we’ve previewed a couple of the innovations we’ve been working on, there’s a full slate of new products on deck that we will show you.
We’ll also be sharing additional details on our Pinnacle action plan now that we’ve identified and begun to address the issues at hand. This will include a sneak peek of some new Pinnacle innovations that we’ll be bringing to market. And finally, we will be providing updates to our financial algorithm, including new data on cost synergies. We hope that you will be able to join us in Chicago on April 10th. We’re confident that the future here at Conagra is one of long-term profitable growth. Our Q3 progress contributes to that confidence as does the long-term opportunity we’ll share on April 10th.
With that, I’ll turn it over to Dave.
David Marberger — Executive Vice President and Chief Financial Officer
Thank you, Sean, and good morning, everyone. I’ll walk through the quarter and elements of both the Legacy Conagra and Pinnacle businesses. With approximately two months left in fiscal 2019 and the sale of the Wesson oil business now complete, I will also share our perspectives on the balance of the year. Slide 31 outlines our performance for the quarter. Net sales for the third quarter were up 35.7% compared to a year ago, primarily reflecting the acquisition of Pinnacle Foods. Organic net sales, excluding the effect of the sale of Trenton, were up 1.9%. Organic net sales growth was largely in line with our expectations driven by the strong performance of our Legacy Conagra domestic retail segments, which when taken together exceeded 2.5% organic growth in the quarter. For the quarter, adjusted gross profit increased 30.5% to $781 million and adjusted gross margin declined 115 basis points to 28.9%.
While we continued to make good progress in driving Legacy Conagra realized productivity and price mix, Pinnacle’s gross margin of 26.2% in the quarter reduced total Company gross margin. In addition, the shift from A&P expense to above the line brand building investments with retailers reduced gross margin by approximately 100 basis points. I’ll walk through the adjusted gross margin bridge shortly. In line with that shift, total Company A&P expense decreased 13.9% to $67 million or 2.5% of net sales in the quarter. Adjusted SG&A for the quarter was up 23.4% compared to the prior year and was 10.1% of net sales. The increase was driven by the addition of Pinnacle expenses, partially offset by synergies and lower incentive compensation expense due to a lower stock price compared to the prior year period. Adjusted operating profit increased 47.5% for the quarter and adjusted operating margin was 16.3%, up 130 basis points compared to the year ago period exceeding expectations.
Adjusted EBITDA increased 35.9% to $554 million from $408 million a year ago. Adjusted diluted EPS was $0.51 for the quarter, down 16.4% from the prior year. I will review the drivers of Q3 EPS performance in a moment. Slide 32 outlines the drivers of our net sales change versus the same period a year ago. Organic net sales growth ex Trenton of 1.9% reflects a 120 basis point increase in Legacy Conagra volume. Total price mix contributed 70 basis points as favorable price mix of 210 basis points was partially offset by increased brand building investments with retailers of 140 basis points. Total Conagra net sales grew 35.7% driven by a 34.3% net benefit from the acquisitions of Pinnacle and Sandwich Bros., the divestiture of the Canadian Del Monte business, and our exit of the foodservice business produced in the Trenton facility. FX negatively impacted net sales by 50 basis points versus the prior year.
Slide 33 outlines our net sales performance by reporting segment. The Grocery & Snacks segment grew reported and organic net sales by 2.9% driven by continued excellent performance in the Legacy Conagra snacks business. Net sales of snacks increased 8.2% in the quarter led by strong end market performance by Orville Redenbacher, ACT II, Snack Pack, Slim Jim, and Duke’s. The Refrigerated & Frozen segment continued its momentum in the third quarter with reported net sales growth of 3.3% and organic net sales growth of 2.4%. The acquisition of Sandwich Bros., which closed in the third quarter last year, added 90 basis points to the net sales growth. Volume grew 3.5% behind strong growth across the frozen portfolio, including Marie Callender’s, Healthy Choice, Banquet, P.F. Chang’s, and Frontera.
The International segment’s organic net sales were down 90 basis points in the quarter as favorable price mix was more than offset by volume declines concentrated in certain global export markets that benefited favorably in the prior year quarter from hurricane related shipments. Foodservice organic net sales declined 60 basis points in the quarter as the segment continued to execute its value over volume strategy. These benefits can be seen in the strong Foodservice profitability metrics I will review shortly. Page 34 shows Q3 and implied Q4 net sales for Pinnacle versus a pro forma prior year number adjusted for Conagra’s fiscal calendar and accounting policies. For Q3, Pinnacle net sales reflects a mid-single digit percentage point decline versus the comparable year ago period on a pro forma basis. As expected, overall consumption declined during the quarter driven by Birds Eye, Wish-Bone, and Duncan Hines.
We also exited low ROI promotions. Additionally, the segment’s year-over-year performance was negatively impacted by this year’s later Easter holiday season. To help you better understand Pinnacles net sales on our fiscal calendar, we have included estimated Q4 Pinnacle net sales versus a pro forma prior year. We have also included additional pro forma sales detail in the appendix of today’s presentation. Moving to Slide 35, you can see that Legacy Conagra adjusted operating profit increased 10.3% and Legacy Conagra adjusted operating margin came in at 16.5% for the third quarter, significantly above year ago performance. Note the 326 basis point improvement in Foodservice adjusted operating margin for Q3 versus the prior year as the segment executes its value over volume strategy. The Pinnacle segment’s adjusted operating profit totaled $130 million.
This performance was above expectations due to lower SG&A and approximately $12 million of synergies realized during the quarter, which were delivered ahead of schedule. The Pinnacle segment’s adjusted operating margin was 18.2% or 15.6% when including the $19 million of adjusted Pinnacle general corporate expenses that had been accounted for in the Company’s total corporate expenses and not in the Pinnacle reporting segment. Total Conagra adjusted operating profit was up 47.5% versus a year ago and adjusted operating margin was 16.3% for the third quarter, up 130 basis points. Slide 36 outlines the adjusted gross margin change for the quarter. As you can see, realized productivity and favora