Shares of General Mills (GIS) have been riding on an uptrend since June 2012, when they reached the 52-week low at $36.75. At $40.82 per share, the stock has returned 11.1% from the 52-week bottom, and offers an attractive dividend yield at 3.2%. Should investors ride on the momentum? In this article, I will elaborate on my valuation analysis, which may assist you in formulating the investment decisions.
From a relative valuation standpoint, GIS appears to be reasonably valued based on its solid financial performance relative to the peers (see comparable analysis chart below). Sell-side analysts on average predict the firm's revenue, EBITDA, and EPS to rise by 2-year CAGRs of 3.9%, 5.8%, and 6.0%, respectively, over the next 2 fiscal years. Those consensus growth estimates are below the averages of 4.8%, 6.9%, and 11.4%, respectively, for a peer group consisting of GIS' primary competitors. However, GIS' EBITDA margin is forecasted to expand by 0.7% over the same period, slightly higher than the peer average of 0.6%.
On the profit side, all of GIS' profitability margins are above the par. Although the company's ROE is below the peer average, its ROIC metric is fairly in line with that of the group. GIS's debt level is comparable to the peer averages, as reflected by its in-line debt to capitalization and debt to EBITDA ratios. In terms of liquidity, the company's trailing free cash flow margin of 10.2% is considerably above the peer average of just 5.9%. Due to the higher profitability and the slightly below-average leverage, GIS was able to maintain a healthy interest coverage ratio. However, both the firm's current and quick ratios are below the par, reflecting a mediocre balance sheet performance.
To summarize the financial comparisons, GIS' relatively weaker growth potential would appear to be the primary drag on the stock's valuation. However, given the company's stronger margin performance and above-average free cash flow margin, I believe the stock's fair value would be only slightly below the peer-average level or even on par. The current stock valuations at 9.9x forward EV/EBITDA and 14.8x forward P/E represent an average discount of 6.9% to the peer-average trading multiples (see chart above), suggesting the GIS' current valuation is fair.
Moreover, GIS' forward P/E multiple of 14.8x is currently trading at 5.8% premium over the same multiple of the S&P 500 Index (see chart below). I believe the slight multiple premium is justifiable provided that 1) GIS' long-term estimated earnings growth rate at 7.5% is fairly close to the average estimate of 8.0% for the S&P 500 companies; 2) the stock's dividend yield is markedly above the average yield for the S&P 500 Index; and 3) GIS has a superior free cash margin, especially compared to the peers in the packaged food sector.
From a historical valuation perspective, GIS' current valuation appears to be supported by the company's fundamentals. The stock's current trailing P/E multiple of 15.1x is now trading at 4.3% discount to its 5-year historical average (see chart below). Over the past 5 years, GIS was able to maintain a stable margin and capital return performance, and it appears that the current valuation is weighed by the company's slightly slower expected growth rates for revenue, EBITDA, and EPS. It should be noted that GIS' interest coverage ratio has trended up significantly over the period with an almost unchanged leverage level (see charts below).
To further support my view, I also performed a DCF analysis which incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2017 (see DCF chart below). Other free cash flow items including depreciation, tax expense, capital expenditure, and net working capital investment are projected based on their historical figures relative to the revenue as those ratios have been trending steadily over time. The terminal revenue growth rate is set to be 2.0%, which is almost in line with the long-term inflation estimate. The terminal EBITDA margin is assumed to be the average estimated EBITDA margin from fiscal 2013 to fiscal 2017.
A relatively high company-specific risk premium of 5.0% is used in the cost of equity calculation to account for the projection risk of the market's revenue and EBITDA estimates. Instead of using the currently depressed 10-year US Treasury Bond yield, a normalized 10-year risk-free rate is applied. I also added a 1.0% size premium for conservatism. As such, based on a WACC of 8.0%, a terminal growth rate of 2.0%, and an implied terminal EBITDA multiple of 9.1x (currently at 9.9x as mentioned earlier), the model yields a stock value of $43.56, which is 6.7% above the current share price at $40.82. Given the relatively conservative assumptions used in the model, the DCF analysis suggests an attractive valuation level.
GIS has a solid history of raising dividend. The company lifted the dividend by 14.3%, 8.9%, and 8.2%, consecutively, in the most recent 3 dividend hikes. Over the past few years, GIS' annual dividend payment only represented less than a half of the firm's annual free cash flow (except for fiscal 2011) (see chart below), indicating that there is an ample room to sustain the current pace of the dividend growth. As such, GIS' sustainable dividend yield and expected dividend growth would likely serve as a floor for the stock price, especially under the current low-interest market environment as demand for high-yield assets continues to be significant. Assuming a target dividend yield range from 3.0% to 4.0%, and supposing that the annual dividend per share would be raised by 8.0% from the current level at $1.32 to $1.43 in the July 2013 payment period, this conservative scenario would suggest a stock value range from $35.75 to $47.67, or an attractive price return range between -12.4% and 16.8% without considering the 3.2% dividend yield.
Deutsche Bank's research analyst, Eric Katzman, elaborated on his bullish view in a recent research note (sourced from Thomson One, Equity Research):
We continue to see upside to the stock with General Mills trading at a discount to its peers based on most valuation metrics. Our updated model suggests the company can expect to generate around $1.9 billion of free cash flow in calendar 2013. This implies a FCF yield around 7% based on today's stock price vs. the food group average closer to 6%. From our perspective General Mills has done a decent job of managing working capital during a period of raw material cost volatility. Management has chosen to take over 3% of the 7% FCF yield to fund the annual dividend. The last 2 years, non-U.S. acquisitions (global yogurt, Yoki in Brazil) have been funded by the remaining FCF although we note the company is becoming more aggressive in repurchase activity (which had been suspended for a period of time). It is possible CEO Powell will continue to take the "extra" 3-4% FCF yield and use it to make more global acquisitions but ultimately we view the company's capital allocation decisions the last few years as reasonable. Combined with a solid balance sheet, 3%+ dividend yield (above the group's 2-3% average), and undervalued International joint ventures, we see minimal downside to the stock at current levels.
Bottom line, GIS' reasonable valuation and limited price downside warrants a Buy rating. To limit the investment risk, investors may sell out-of-money put options to either collect upfront premium or take a potential opportunity to acquire the shares at a lower price.
Disclaimer: The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data is sourced from Capital IQ unless otherwise specified.