Food producers have been struggling recently from an inflationary input environment. At the same time, intense competition between General Mills (NYSE:GIS), Kellogg (NYSE:K) and Kraft Foods (KFT) is limiting pricing power. While the Street currently rates the respective shares "buy," "hold" and "strong buy," I believe that all three are fairly valued. In addition I find that the risk/reward is not favorable for any of the firms given the challenging environment. While General Mills is the cheapest, its lack of exposure to emerging markets and relatively low dividend yield limits upside and increases risk. On the other hand, while Kraft will benefit from a breakup, its relatively low margins and leverage come at the most inopportune time.
From a multiples perspective, General Mills appears only slightly undervalued. It trades at 14.7x earnings versus Kellogg's 15.2x and Kraft's 18.7x. Net debt stands at 31.4% of market value versus 31% and 44.8% for Kellogg and Kraft, respectively. Kellogg has the highest dividend yield, while General Mills has the lowest at 3.2%. I anticipate impressive ROIC growth for both Kellogg (graphic here) and Kraft (graphic here).
At the first quarter earnings call, General Mills' CEO, Ken Powell, noted the problems facing the industry as a whole and how the firm fits in:
"As we assess the performance of our U.S. businesses and our International operations, we're encouraged by resilient sales results for our brands in what remains a very difficult operating environment. We're dealing with high inflation and volatility in our input costs. Consumer trends are a tale of two worlds. An increasing number of consumers in emerging markets are buying branded packaged goods as their income expands, but high unemployment, a soft housing market and concerns about the economy are pressuring consumer confidence and spending in developed markets. Despite these challenges, we remain very optimistic about the opportunities for those of us in the food business. Consumers around the world continue to seek products that provide nutrition, taste, convenience and value."
Most notably, General Mills once again proved that it can hold up even in a challenging backdrop. In addition to slightly beating consensus, top-line growth in bakery and food service exceeded that of the industry and is anticipated to do so again in the following quarters. Moreover, sales abroad soared 30%, renewing confidence in the successful integration of Yoplait, an iconic yogurt brand. Even in Europe, where prolonged economic stagnation is anticipated, revenue grew by an outstanding 36%.
Going forward, General Mills' main concern will be to fight inflationary pressures. Its strategy will revolve around marketing and product innovation. For the last six months, General Mills has lagged behind the competition in terms of promotion - accordingly, market share has declined in recent months. I am optimistic that promotions will boost volumes, while product innovation will allow for premium pricing. General Mills currently has gross margins of 40%, which is ahead of Kraft's 36.4%, but behind Kellogg's 42.7%.
I anticipate commodity costs to normalize more than what the market appreciates. With that said, General Mills should still work more on cutting costs and shifting the mix toward higher margin products. Failing to do so will exacerbate already significant investor concern and reduce the firm's ability to optimize the effects of increases to scale during a recovery.
In regard to the "tale of two worlds," General Mills is also in the worse position of the two. The firm has poor exposure to international markets, which is an issue both in the short and long-term. In the short-term, failure to hedge against domestic stagnation by not entering high growth emerging economies adds tremendous risk with limited upside. In the long-term, failure to penetrate emerging markets now will make it more difficult to increase market share in the future as the competition secures support. Even though consumer trends are highly variable, brand loyalty and culture still play an important role.
Consensus estimates for EPS are that it will increase by 5.2% to $2.61 and then by 8.4% and 8.5% in the following two years. Of the three revisions, two have gone up. Assuming a multiple of 15x and a conservative 2012 EPS estimate of $2.75, the rough intrinsic value of the stock is $41.25. This implies a 6.9% margin of safety - not nearly enough, in my view, to qualify it as a value investment. The same is true for Kellogg and Kraft Foods, which I calculate having a respective 6% and 6.1% margin of safety. And while I believe that Kraft Foods will outperform the competition, I recommend holding out until concerns over input pressures lighten.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.