Friends and followers of Montaka will be aware that we follow a unique framework to identify great short investment candidates. One of the four criteria that we look for is “asymmetries”, or asymmetric downside risks in a business or stock that are necessarily severe in impact and without counterbalancing upside potential. Recently, we think there may be two such asymmetries developing at Campbell Soup which reinforce the broader short thesis on the stock.
As one might guess, Campbell Soup is the manufacturer of the iconic Campbell’s-branded canned soup. Even though Campbell’s has branched out into other food categories, like vegetable drinks and snacks, the soup business is still the primary driver of the company’s sales, earnings and value. With higher than company-average profit margins, we estimate that soup still might generate 40% of Campbell’s earnings (before the sale of its International and Fresh businesses).
Unfortunately for Campbell’s, soup sales across the industry have been in decline in recent years. Volumes of condensed and ready-to-serve soup in the last 12 months are down 8% and 5%, respectively. For Campbell’s the story is worse still. Their dominant market position has been eroding as smaller niche brands and supermarket’s private label brands alike have been gaining share. This combination of a shrinking market and intensifying competition has caused pressure on Campbell’s sales, which has meant that the stock met our first criterium: “thematic/structural decline”.
Even if the environment for Campbell’s has been worsening it has not been fully reflected in the stock. The market has continued to price in a return to growth and improving profitability for over two years now – albeit off a deteriorating base. Campbell’s business has continued to decline, and the market has not reset its expectations down quick enough. We’ve continued to hold the opposite view of the prospects for the company. This means Campbell’s stock has satisfied the second criterium of a good short: “divergent expectations”.
Armed with these two elements of the framework, Campbell’s always appeared to us to be a good short candidate: a deteriorating business that is also overvalued. But as the story has played out, it appears Campbell’s may tick a third box in our short-side framework, and it may be doing so in two separate ways.
The third element of the Montaka short-side framework is “asymmetries”. These are downside risks in the business that don’t usually pop their heads up above the surface, but when they do the damage they cause can be severe. This category of short may best be described as: everything is OK…until it isn’t.
Asymmetric risks typically stem from three sources:
- Financial leverage. Debt on the balance sheet can act like a noose around the neck of a business and its management team, especially as earnings and cash flows decline.
- Regulatory change. If the rules of the game change then businesses may be impaired.
- Bid premiums. When companies are subject to corporate actions, particularly as the target of acquisitions or activist campaigns, a “bid premium” may be built into the share price. This premium can fall away if the deal (or speculated deal) falls away.
In the case of Campbell’s asymmetric risks have arisen in two distinct forms. Firstly, from debt taken on to fund acquisitions, and secondly, from speculation that the company could be acquired.
As Campbell’s sought to diversify away from the declining soup business it pursued an acquisition strategy which has resulted in the purchase of several companies in the last few years. These have included Garden Fresh Gourmet (2015), Pacific Foods (2017), and Snyder’s Lance (2018) – itself a combination of the legacy Snyder’s Lance snacks business and Diamond Foods, another savoury snacks business. These businesses were purchased for cash, and to finance the payments to the targets’ shareholders, Campbell’s borrowed significant sums. Consequently, Campbell’s has almost $10 billion of net debt on its balance sheet today, up from $2.5 billion in 2012. The financial leverage in the business, as defined by the ratio of debt to earnings before interest, tax, depreciation and amortization, is now more than five turns*.
This level of debt presents a meaningful risk to Campbell’s. To begin with, as earnings decline, and the value of the firm falls, the value of the equity falls even quicker. After all, the claim lenders have on the company is unchanged, so the shareholders take the earnings and the value that is left over.
Even more dangerous is the situation where Campbell’s earnings and cash flows continue to fall, making it harder to pay down interest and debt, or to refinance the borrowings when they come due. This concern is only exacerbated as the cost of funding rises with increasing interest rates.
Warren Buffett once referred to branded consumer food companies like Campbell’s as invincible. Ironically, Campbell’s path may intersect with a restructuring, or even bankruptcy, if the current trends persist. Either would be devastating for Campbell’s shareholders. Yet the debt is not the only asymmetric risk percolating at the company.
Over the last couple months, Campbell’s has become the target of an activist campaign. Dan Loeb, manager of Third Point, a hedge fund, sent a scathing letter to Campbell’s Board of Directors. The letter accused the board of overseeing mismanagement of the company and shareholder value-destruction over a period of two decades. He proposed a slate of a dozen new directors, including a member of the Dorrance family that originally inherited the Campbell’s business from John T. Dorrance, the creator of condensed soup. Loeb also demanded that the Board install new management and/or pursue a sale of the company.
When an activist hedge fund comes knocking, stock prices have a tendency to run up, especially if the investor is calling for a sale of the company. Long term holders tend to be less interested in an immediate sale, and instead focus on long term value creation potential. Perhaps cynically (or maybe just realistically) those holders may also have other interests in the company that don’t align with a sale. But for shorter-term holders the possibility of a deal at a premium to the current share price encourages positive sentiment and buying. Hence the likely stock price appreciation.
This seems to be what has happened at Campbell’s. After trading at lows in June of around $32, Campbell’s stock increased to $42 when speculation of agitation at the company surfaced. Following confirmation of Third Points efforts, the stock has remained north of $41 per share.
To be fair the broader consumer staples sector has rallied during this time. The weighted average of the stock prices of companies in this industry has increased by around 10%, as measured by the S&P500 Consumer Staples Index. But Campbell’s share price is up 24%. Its not unreasonable to posture that Campbell’s stock is pricing in some excitement at the prospect of the entire business being sold. But there’s a rub.
Loeb, in combination with George Strawbridge Jr., a grandson of Dorrance, hold just over 8% of Campbell’s stock. In addition, there are other family members holding around 8% of the stock together who are also interested in selling. But the company’s charter requires two-thirds of shareholders to approve a sale of the company. And on the other side there is a formidable force.
Bennett Dorrance and Mary Alice Malone, grandson and granddaughter of the inventor, themselves siblings, and also cousins of Strawbridge, own 17% and 16% respectively of Campbell’s. Together their stake amounts to the one-third required to block a sale, and they have a long history of wanting to keep the business in the family. Dorrance and Malone are also on the Campbell’s Board, which means that Loeb’s attacks have been aimed squarely at them, and no doubt added insult to injury. The prospect of them agreeing to a deal looks slim. Of course, a deal couldhappen, but we don’t think it is very likely, despite the strong share price performance.
Therein lies the asymmetry. If the prospect of the deal were to one day fall away, then the stock would lose its bid premium and the share price would drop instantaneously. Where it would ultimately settle is not clear, but it’s hard to see support above the mid-$30 level at best.
Since Montaka initiated a short position in Campbell’s in mid-2016, the stock has declined by around 40%, representing a wonderful absolute return. Over this period global equities have appreciated about 35%, so the value-add or alpha from the position is around 75%. And while the first two legs of the short thesis continue to be applicable today as they were two years ago, it seems that the short investment case is now strengthened by a third leg: asymmetries – and two of them at that. So, we see it likely that Campbell’s share price will continue to experience downward pressure into the future and may even see a large step change down if either asymmetric risk is realised.
*As part of a strategic review, Campbell’s CEO announced recently that the company would sell its International and Fresh businesses. These asset sales will help reduce the debt burden to three times earnings. But substantial debt will remain and this reversal from acquirer to divestor will see the business shrink. After all, the only growth in recent years has been acquired growth rather than organic growth. And this has been a ”misperception”, which is the fourth criterium of a good short under our framework.
Montaka is short Campbell Soup Co