Why Coca-Cola, Kraft Will Surge As General Mills Falls

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Includes: GIS, KO, MDLZ
by: Takeover Analyst

When it comes to stability, General Mills (NYSE:GIS) is a top stock for those fearing depreciation. For the last three decades, General Mills has by and large gone nowhere but up. This has been steady and is complemented by a dividend yield of 3.1%. With the stock being more than 80% less volatile than the broader market, however, the opportunity for high risk-adjusted returns is very narrow. In this article, I will run you through my DCF model on General Mills and then triangulate the result against a review of the fundamentals of Kraft Foods (KFT) and Coca-Cola (NYSE:KO). I find that Kraft and Coca-Cola will appreciate as General Mills declines.

First, let's begin with an assumption about the top-line. General Mills finished FY2011 with $14.9B in revenue, which represented a 1.7% gain off of the preceding year. In FY2010, the company barely grew. I model 7.2% per annum growth over the next half decade or so.

Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 60% of revenue versus 21% for SG&A and 3.9% for capex. Taxes are estimated at 30% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)

We then need to subtract out net increases in working capital. I estimate this figure hovering around 2% of revenue over the explicitly projected time period.

Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 8% yields a fair value figure of $34.34 for 11.9% downside. The market seems to be factoring in a WACC of 7.5%, which is pretty low and, indeed, limits upside.

All of this falls within the context of some promising trends but a challenging environment:

"First, while there are some bright spots in the U.S. foodservice industry, the overall environment remains challenging as we continue to deal with a cautious consumer. Second, we've been outperforming the industry in recent years, and we're building stronger share positions for our brands. And third, we're driving this good performance by focusing on the channels that show the most promising growth and by innovating on many of our branded product lines".

From a multiples perspective, General Mills appears attractive. It trades at a respective 16.7x and 14.1x past and forward earnings versus 19.6x and 16.5x for Coca-Cola and 19.3x and 13.8x for Kraft. Even still, free cash flow momentum is minimal.

Consensus estimates forecast Coca-Cola's EPS growing by 6.8% to $4.10 in 2012 and then by 9.5% and 10% in the following two years. Assuming a multiple of 20x and a conservative 2013 EPS of $4.40, the stock would hit for $88 for 18.8% upside. The firm has strong emerging market potential, offers a 2.6% dividend yield, and is around half as volatile as the broader market. Accordingly, analysts rate the stock around a "buy" (source: NASDAQ).

Consensus estimates forecast Kraft's EPS growing by 10% to $2.52 in 2012 and then by 10.7% and 11.1% in the following two years. Assuming a multiple of 17x and a conservative 2013 EPS of $2.73, the stock would rise by 20.6%. Kraft is rated a "buy" on the Street" is slightly less than 40% as volatile as the broader market, and offers a dividend yield of 3%. I believe in the company's management and view the firm as an ideal way to hedge against an uncertain economy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.