Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.
Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheets of General Mills (GIS) and Kellogg (K), in order to get some clues as to how well these companies are doing.
I will go through the balance sheets of these two companies, reviewing the most important items, and seeing if there are any major differences between the two, making one a better investment than the other. Information that I used on General Mills can be found here, and information on Kellogg can be found at this link. Note that this article is not a comprehensive review as to whether either of these two stocks should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.
This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.
In a way, the title of this article is a bit misleading, in that both of these companies produce more than cereals. Both General Mills and Kellogg produce other items like snack foods and frozen foods. General Mills produces cereals like Cheerios and Wheaties, yogurt under the Yoplait brand, ice cream under the Haagen-Dazs brand, Progresso soups, refrigerated and frozen dough products under the Pillsbury brand, Betty Crocker dessert and cake mixes, Nature Valley granola bars, and frozen and canned vegetables under the Green Giant brand. Approximately 28% of their sales are outside of the United States, leaving plenty of room for international growth.
Kellogg also produces cereals, snacks and frozen foods. Their snack offerings include Cheez-It crackers, Pringles potato chips, and cookies that are made under the Keebler brand. Their cereals include Rice Krispies, Special K, Corn Flakes, and Frosted Mini-Wheats. Frozen food items include Eggo waffles. They have plenty of room for growth in international sales, as only 32% of their sales over the past year came from outside of North America.
Cash and Cash Equivalents
The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.
General Mills is one such company. As of Nov. 25, 2012, General Mills had $735M in cash, versus $509M the year before. This increase is due mostly to a rise in earnings. While $735M is not a lot of money for a company with a market capitalization of $27.8B, you should keep in mind that this company bought back $293M in stock over its trailing twelve-month period and paid out about $835M in dividends, which are well-supported by its free cash flows of $1.9B over the same time period.
Kellogg had $281M in cash as of the end of 2012, down from $460M a year ago, due to the effects of its acquisition of Pringles in 2012. For a company with a $21.4B market cap, $281M doesn't seem like a lot of money, but it did pay out $622M in dividends, which are well-supported by free cash flows of $1.23B over the same time period.
The table below illustrates this information pretty clearly. From looking at this table, you can see that the dividend payout and buyback amount of General Mills are both supported by its free cash flow. The same can be said for the dividend of Kellogg. However, we can also see where Kellogg had a net issuance of shares worth $166M in 2012, as opposed to a share reduction.
Dividend Payouts (TTM)
Free Cash Flow
Table 1: Cash Positions and What GIS and K Do With Their Cash
Receivables constitute money that is owed to a company for products or services that have already been provided. Of course, the risk with having a lot of receivables is that some of your customers might end up not paying. For this reason, you usually like to see net receivables making up a relatively small percentage of the company's sales.
General Mills had a total of $1.67B in net receivables on its balance sheet, which represents 9.7% of its trailing twelve-month sales of $17.2B. Kellogg had $1.45B in net receivables, amounting to about 10% of its 2012 sales of $14.2B.
I don't see anything at all to worry about in this department for either company.
With manufacturing companies like the ones we're reviewing today, I like to keep an eye on inventory levels. I usually like to see inventory levels stable or slightly rising from one year to the next. If I see inventory levels rising, then I want to see revenues rising as well, to indicate higher demand for the company's products. I don't like to see rapidly fluctuating inventory levels that are indicative of boom and bust cycles. In some instances, if inventory ramps up without increases in volumes or revenues, then it may indicate that some of the company's products are going obsolete. We don't need to worry about that here, though, as I don't believe that cereals or other packaged foods are going to go obsolete any time soon!
Fortunately, that is not a problem with General Mills or Kellogg. General Mills had approximately $1.77B in inventory as of the end of November 2012, 8.6% higher than what it had one year prior. This inventory increase was accompanied by a 5.4% increase in revenues.
Kellogg had $1.37B in inventory, 17% higher than the $1.17B that it recorded a year ago. Given that this was accompanied by a 7.6% increase in sales, I don't see much of a problem here.
Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of their operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.
If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.
The current ratio of General Mills is 0.80, while Kellogg sports a current ratio of 0.75. Both of these figures are less than ideal. However, I wouldn't worry too much about either company in this regard, because what are the odds that the entire operations of General Mills or Kellogg come to a grinding halt? It is something to consider, nonetheless, but I would be a lot more concerned if I was dealing with a smaller and younger company with operations that are concentrated in just one or two places, as opposed to all over the world, like these two companies.
With companies that have significant amounts of inventory, I like to consider another ratio that is known as the quick ratio. While inventory is generally regarded as a current asset that can be converted into cash within a year, what if it can't be converted for some reason or another? The quick ratio takes this uncertainty into account. When calculating the quick ratio, just subtract the inventory from the current assets, and then divide the rest by the current liabilities. Ideally, you like to see this ratio at 1.0 or above. However, for both companies, this ratio comes out at 0.45. This is less than desirable for both companies, but as with the case of the current ratio, I don't expect any major disruptions in the operations of either of these two companies, since they have operations all over the world.
Property, Plant, and Equipment
Manufacturing, like any other industry, requires a certain amount of capital expenditure. Land has to be bought, factories have to be built, machinery has to be purchased, and so on. However, less may be more when it comes to outlays for property, plant and equipment, as companies that constantly have to upgrade and change their facilities to keep up with competition may be at a bit of a disadvantage.
However, another way of looking at it is that large amounts of money invested in this area may present a large barrier to entry for competitors. Right now, General Mills has $3.8B in property, plant, and equipment on its balance sheet, while Kellogg has $3.78B on its balance sheet in this area, fairly stable versus a year ago for both companies.
With both of these companies, the biggest intangible asset is goodwill. Goodwill is simply the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could, in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case-by-case basis, as good companies are rarely purchased at or below book value.
General Mills has $8.6B of goodwill on its balance sheet, higher than the $8.12B that it posted a year ago, while Kellogg is carrying about $5.05B in goodwill, versus $3.62B a year ago. The increase in goodwill for General Mills is due in part to its acquisition of Brazilian food producer Yoki Alimentos, back in August 2012. The increase in goodwill for Kellogg is due in part to its acquisition of Pringles.
Both of these companies also have intangible assets like trademarks, patents and the like. These other intangible assets total $5.03B for General Mills (versus $4.8B a year ago), and $2.36B for Kellogg (versus $1.45B a year ago). These increases are also due to the acquisitions mentioned above. Intangible assets are important as trademarks, patents, and brand strength can present a big barrier to entry against would-be competitors.
Due to the problems with goodwill that I just spoke about, you generally don't like to see intangibles account for more than 20% of total assets. However, they account for 59% of the assets of General Mills and 49% of Kellogg's assets. However, you must also consider that much of these assets are good, in that trademarks, brand strength and patents aren't going away.
Total Intangible Assets
Intangible Percentage Of Total Assets
Table 2: Percentage of Total Assets That Are Intangible
Return on Assets
The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:
Return on Assets = (Net Income) / (Total Assets).
For General Mills, the return on assets would be $1.81B in core earnings, divided by $23B in total assets. This gives a return on assets for the trailing twelve months of about 7.87%, which isn't bad. For Kellogg, the return on assets is $1.21B in core earnings, divided by $15.2B in total assets, producing a return on assets of 7.96%, basically identical to General Mills. Overall, both companies are doing fine here.
Return On Assets
Table 3: Good Returns On Assets From Both Companies
Short-Term Debt Versus Long-Term Debt
In general, you don't want to invest in a company that has a large amount of short-term debt when compared with the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.
General Mills carries $2.76B in short-term debt, while Kellogg carries $1.83B. Given the earnings and cash flows of both companies, some of this debt might need to be refinanced, but with interest rates as low as they currently are, and the creditworthiness of each company, that shouldn't be a problem in the near term, emphasis on near term.
Long-term debt is debt that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.
Right now, General Mills carries $5.57B of long-term debt, while Kellogg carries $6.08B of long-term debt.
In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of each company's core earnings over the last 3 years. The average earnings of General Mills over this period is $1.64B. The 3-year average for Kellogg is $1.21B. When you divide the long-term debt by the average earnings of each company, here is what we find.
Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings
For General Mills, here is how it looks: $5.57B / $1.64B = 3.40 years
For Kellogg, it looks like this: $6.08B / $1.21B = 5.02 years
General Mills doesn't look too bad in this regard, but I would be concerned about Kellogg. It will take it five years worth of earnings to pay off its long-term debt. While a substantial chunk of that debt doesn't come due until at least 2017, interest rates will probably be higher by that point, making refinancing a less attractive option than it is now, meaning that it will need to find a way to pay for this debt.
When it comes to management of long-term debt, I give the edge to General Mills.
In the equity portion of the balance sheet, you will find the treasury stock. This figure represents the shares that the company in question has repurchased over the years, but has yet to cancel, giving the company the opportunity to re-issue them later on if the need arises. Even though treasury stock appears as a negative on the balance sheet, you generally want to see a lot of treasury stock, as strong, fundamentally-sound companies will often use their huge cash flows to buy back their stock. For this reason, I will usually exclude treasury stock from my calculations of return on equity and the debt-to-equity ratio in the case of historically-strong companies, as the negative effect of the treasury stock on the equity will make the company in question appear to be mediocre, or even severely distressed, when doing the debt-to-equity calculation, when in reality, it might be a very strong company.
General Mills has $3.36B worth of treasury stock on its balance sheet, while Kellogg has $2.94B.
The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how General Mills and Kellogg stack up here.
Debt To Equity Ratio = Total Liabilities / Shareholder Equity
For General Mills, it looks like this: $14.6B / $6.98B = 2.09
And for Kellogg: $12.7B / $2.48B = 5.12
While neither company impresses in this area, Kellogg is really bad in this regard. They have a lot of work to do in order to build its equity and get its debt under control.
A variation of this ratio that I like to use takes into account the presence of treasury stock on the balance sheets of very strong companies. When there is a large amount of treasury stock on the balance sheet, the regular debt-to-equity ratio can make a very strong company appear as a severely distressed company. Here, I add the treasury stock back in to the equity, as treasury stock can be re-issued at a later date if the need arises (although you hope that never happens). I call this ratio the adjusted debt-to-equity ratio. It's calculated like this.
Adjusted Debt To Equity Ratio = Total Liabilities / (Shareholder Equity + Treasury Stock)
For General Mills, it looks like this: $14.6B / $10.3B = 1.42
For Kellogg, it looks like this: $12.7B / $5.42B = 2.34
This calculation makes both companies look significantly better, but far from ideal. Both of these companies have work to do in order to get their debt down and build their equity.
For the sake of comparison, I also calculated these ratios as of the end of calendar 2011. General Mills had a debt-to-equity ratio of 1.93, while Kellogg carried a ratio of 5.61. So, the debt-to-equity ratio for General Mills has crept up some, while there has been some improvement in Kellogg, which still has a long way to go.
While not impressive, General Mills wins the battle when it comes to debt relative to equity.
2012 Debt/Equity Ratio
2011 Debt/Equity Ratio
Table 4: Debt To Equity Ratios Of General Mills and Kellogg
Return On Equity
Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula. Note that this is the adjusted form, which negates the negative impact of treasury stock on the equity.
Return On Equity = Net Income / (Shareholder Equity + Treasury Stock)
Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks. Once again, this is why I strip the negative effect of treasury stock from my calculations.
So, the return on equity for General Mills is as follows:
$1.81B / $10.3B = 17.6%
For Kellogg, it comes out as: $1.21B / $5.42B = 22.3%.
If you do the calculation like most and count the treasury stock as a negative to equity, then General Mills and Kellogg would have even higher returns on equity of 25.9% and 48.8%, respectively.
While Kellogg appears to have better returns on equity, this is largely due to its small equity position that results from its debt load.
Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:
Retained Earnings = Net Income - Dividend Payments - Stock Buybacks
On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.
General Mills has $10.6B of retained earnings on its most recent balance sheet, while Kellogg has $5.62B of retained earnings on its balance sheet. Going back to the end of 2009, General Mills had retained earnings of $7.91B. So, over the last three years, General Mills grew its retained earnings at a cumulative rate of 34%, which is impressive. Kellogg on the other hand, increased its retained earnings from $5.48B at the end of 2009 to $5.62B now, only good for a cumulative gain of 2.6%.
So, as far as growth in retained earnings is concerned, General Mills wins out here.
After reviewing the balance sheets of both General Mills and Kellogg, we see that both of these companies have several things in common. Some of these include small cash positions relative to their market capitalizations, generous dividend payouts, recognizable brand strength and loyalty, and decent returns on assets and equity.
However, I have to say that General Mills has a better balance sheet than Kellogg, due to the fact that Kellogg currently has a very high debt-to-equity ratio, as well as a large amount of long-term debt that will take as much as 5 years' worth of earnings to pay off. That's not to say that General Mills' balance sheet is optimal, because it needs to get debt down as well, but it is not as bad off as Kellogg is now.
Thanks for reading and I look forward to your comments!