Campbell Soup - No Longer A Bubble

Reality Hit Campbell

The last article I did calling Campbell Soup (NYSE:CPB) a bubble appears to have been perfectly timed as the stock has fallen over 13% since then. The bearishness expressed in the article was valid. The reason why I was bearish was because the company's results weren't reflected in the stock. Investors were buying dividend paying stocks even if the firm's performance was subpar. However, the market decided last quarter's results were bad enough to send the stock down. While the analysis was valid, getting the timing correct on the stock was lucky.

The reason I say this is a stock like Caterpillar (NYSE:CAT) was one that was going up because of unfounded optimism as it has a nice sized dividend. The company reported terrible results and rallied on the news. In this particular market, stock moves seem to be senseless. Therefore, the market coming to its senses on Campbell Soup was lucky timing.

Macro Analysis

I've been adding macro analysis to my articles on consumer staples stocks because understanding the point in the cycle and degree of Fed manipulation helps investors understand the direction of sector rotation and changes in asset allocation likely to come in the future. While this matters to every stock, it matters more to consumer staples stocks because their generally aren't large surprises in how the businesses are doing.

The point in the cycle is odd because growth has been slowing since 2015. There has been an extended period of slow growth without a recession. The economy may prove to be in a recession now, when the data is adjusted a year from now, but the market perception is we are late in the business cycle. The best stocks to buy late in the cycle are consumer staples because investors want to lower their risk. This sector rotation had been in place until recently. Fears of interest rate hikes and an overall 'risk on' move has been the cause of this recent change. While I would argue against buying consumer staples stocks because the cycle is over, the rationalization consumer staples buyers have is, at least, close to reality. The rally in industrial stocks like Caterpillar is unexplainable.

The chart below supports my thesis that the credit cycle is in the stress period. There is now 251 companies issuing $359 billion in the lowest of junk debt with a negative outlook. The downgrading of debt is an objective determination that a firm's balance sheet is weak and its business prospects are becoming more negative. The lowest junk bonds have a 10 times higher default rate than other high yield bonds. When these risky businesses start to default on their loans, it starts a snowball effect that hurts the entire economy as banks tighten their lending standards, so even previously credit worthy firms have a difficult time getting a loan. This causes a recession as businesses can't invest in new prospects which would create jobs.

The extension of the cycle past when it should have ended by the Fed, had caused consumer staples stocks to have a large period to rally. I made an assertion that this latest "risk on" trade where investors are buying cyclicals was unexplainable or irrational. My support of this claim is shown in the chart below. Recovery rates are indicating we are in a stress period, yet investors are buying high yield bonds. The difference between recovery rates and high yield bond buying is at a record. This is bad behavior caused by Fed policy of near zero interest rates and a $4.5 trillion balance sheet. The difference between high yield prices and recovery rates hit a similar high point in late 2009/early 2010, but that was caused by investors anticipating a turn in the cycle. The chances we are at the beginning of the next cycle given that business investment and productivity are declining is minimal.

The takeaway from this macro analysis is investors may switch back to consumer staples when they realize the Fed isn't raising rates and the economy is very weak. Soon afterwards, a market decline will occur causing these stocks to fall. In the beginning of the next cycle, consumer staples underperform relative to cyclicals like they are doing now. The rotation now is not supported by economic evidence and will be reversed.

Bad Earnings

The earnings report was bad and 2017 guidance was weak as well. The topline is where the weakness has been all year for Campbell as the fourth quarter and full year saw organic sales fall 1%. The EBIT growth guidance for 2017 was weak even as the company anticipated sales growth improving. In 2016 adjusted EBIT increased 11% because of supply chain improvements, cost cutting, and net price realization which was able to offset weak sales. In 2017 adjusted EBIT is only expected to increase 1 to 4 percent as sales are expected to increase 0 to 1%.

The two big problems in the quarter were executional in nature, meaning they could have been avoided. On the bright side, they should be able to be overcome by next year. The first problem was the recall of 3.8 million bottles of Bolthouse Farms' Protein PLUS beverages due to possible spoilage. The manufacturing equipment and process was the culprit of this spoilage. To solve this issue, the company shortened the production run from 72 hours to 24 hours. However, this change reduced capacity which will take time to gain back.

The other issue in the quarter was the company made poor strategic decisions with regards to planting and harvesting carrots which made the weather issues worse than they would have been. It resulted in small carrots which the consumer didn't want to buy. The company shook up the management and made changes to the planting and harvesting, so this problem won't happen again. These two issues caused operating earnings in Campbell Fresh to fall 62% in Q4 and 2% in the full year.

Besides these short term problems, the company continued its trend in losing market share in the wet soup category. The plan to improve this downtrend is better marketing, cleaner labels, and changing some recipes. Campbell is chasing the market which has clearly changed as consumers have become more health conscious. Campbell's brand recognition used to be a positive, but has become a negative as some consumers may associate it with being unhealthy. The brands need more advertising dollars to support them than in the past.

The final issue with the quarter was the weak guidance. The decelerating EBIT growth is a problem because it implies relying more on sales growth. Investors view the cost cutting which led to the 11% EBIT growth last year as something that has a higher probability of occurring than sales growth. In the long term sales growth on the topline is the only way the company can succeed, but 0% to 1% is not enough to satisfy investors.

The company has a 3 year $300 million cost cutting program underway. $130 million of incremental cost cutting was achieved in fiscal 2016 bringing the total to $215 million. Guidance for cost cutting is only $50 million in 2017, making it less of a catalyst for profit growth than last year. To give context, improved supply chain performance led to 250 basis points of margin expansion. Other margin improvements came from cost savings and net price realization. For example, adjusted administration expenses fell 19%. 40 basis points of gross margin improvement came from price realization.

Conclusion

Investors have been less interested in consumer staples stocks in the last few weeks. Judging by the credit cycle, I would expect investors to be selling all stocks, but they are actually moving to more cyclical stocks as they ignore the negative economic situation. This sector rotation needs to reverse. At the least, investors should rotate back into consumer staples stocks, but we're so late in the cycle even that would be a mistake.

Investors have ignored some bad earnings results from firms this quarter, but not Campbell Soup as the stock is down 13% since its recent high. This makes the stock lose its bubble qualification, but doesn't make it a buy since the fundamentals are poor. Bad execution, trends of market share losses, and guidance for a decline in cost cutting are all factors which make this a stock to avoid if you are looking to buy a consumer staples stock