Let's Talk About General Mills

| About: General Mills, (GIS)
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Millennials are transforming the packaged food industry.

General Mills’ cereal sales fell 2% in the U.S. during the third quarter.

The stock looks fairly priced as compared to its peers, but the consumer staples sector itself is trading at a massive premium.

Last year, millennials outnumbered baby boomers, and this age group now represents more than one-quarter of the total population. According to Standard and Poor's (S&P), the decline in population growth has resulted in 0.6% drop in economic growth between 2004 and 2014. The rating agency expects the shift in demographic distribution would cut the economic growth by 0.8% annually over the next eight years. Standard and Poor's said:

"As the millennials move closer toward higher spending and earning ages, a boost in their share of consumption will help power the economy forward, easing some - but not all - of the challenges to growth."

Millennials' spending behavior and lifestyle, both, are continuously changing the packaged food industry. With the growing health consciousness and changing eating habits, some of the major food and beverage companies are witnessing disappointing sales. The change itself is healthy, but most of the packaged food players are struggling to adapt the changing requirements of the consumer. In this scenario, General Mills (NYSE:GIS), one of largest cereal makers, is trying hard to turn the things around. As millennials continue to avoid breakfast cereals, General Mills' net sales have dropped 8% during the third quarter of the fiscal year 2016. However, the maker of Cheerios and Yoplait is trying to address these challenges by incorporating more flexibility in its product portfolio, which would help stabilize the sales.

Under unfavorable industry dynamics, General Mills posted better than expected earnings results. Thanks to margin gains due to cost savings, General Mills reported diluted earnings per share of $0.59 for the third quarter of the fiscal year 2016, which translates into 5.35% year-over-year increase. Though adjusted earnings witnessed 7% drop over the same period, the overall earnings performance was much better than what analysts were expecting 11% decline.

The company is making several possible moves to reduce the pressure on the top-line, but these initiatives will take the time to bear fruits. General Mills recently announced to start labeling its products that contain GMOs, which could increase the impulse buying to some extent. In the meanwhile, expanding the natural and healthy food options, while slashing the poor performing categories, would gradually boost the revenue stream. In this regard, with the launch of whole milk organic Annie's yogurt, General Mills expanded its offerings in one of the fastest growing categories. As the yogurt market in North America is expected to reach $11.7 billion by 2019, General Mills is expanding its ''One Up Your Cup'' marketing campaign to boost the volumes of new yogurt offerings.

According to market research firm Mintel, approximately 40% of millennials think that cereal needs too much work to clean up. This sentiment is negatively impacting the company, which is evident from the fact that General Mills' cereal sales fell 2% in the U.S. during the third quarter. Although breakfast cereals are losing the charm, the demand for snack and cereal bars is rising steadily. Over the past one decade, the number of household eating bars have increased more than 50%. This increasing consumption rate among millennials is beneficial for General Mills, which is partially offsetting the negative impact of lackluster volumes. Nature Valley, which is a key focus business for General Mills right now, witnessed massive 35% growth during the first nine months of the fiscal year 2016.

General Mills is launching new products that fit the consumer requirements. The company recently introduced ready-to-eat cereals and snack bars as the popularity of on-the-go grab breakfast increases, and it would boost the performance of its Nature Valley business. As the overall market for cereal and snack bars is expected to reach $8 billion in 2019, which translates into a CAGR of 5%, General Mills can accelerate solid growth momentum to overcome its weaknesses.

General Mills earns 61.5% of total revenue from the U.S. retail business, thus adapting the changing consumer preferences should bode well for the company. Besides building a product portfolio free from artificial colors, the improved the recipes and expansion of natural food would bring new customers. Although the profitability could remain muted for a while, as expected by the management, the expansion of Annie's, Nature Valley, and removal of additives will enable the company to gain steady and long-term growth momentum.

General Mills generates 27% of total sales revenue from outside the domestic market. The strong currency headwind hammered the international sales during fiscal 2016, but the long-term growth prospects in international markets are quite promising as global packaged food industry is forecasted to reach $3.03 trillion by 2020, which translates into a 5-years CAGR of 4.5%. The new products and healthy demand for cereals resulted in double-digit growth in Mexico and high-single digit growth in Brazil. However, in my opinion, General Mills' performance in Asia-Pacific was not satisfactory despite strong momentum in India. As the overall packaged food market in Asia-Pacific region is expected to grow at a higher CAGR of 5.4% primarily due to the increasing awareness and adoption of packaged foods, General Mills must increase in efforts in this region, particularly in India and China, to benefit from potential demand for cereals and yogurt.

While General Mills should expand its international footprints, the exit from Venezuela is a smart move as the removal of poor performing assets would help the profit margins, though to a minor extent. Moreover, tax loss on Venezuela transaction will unlock $20 million in additional cash flow in fiscal 2016, which General can invest in profitable assets.

Overall, the company's cash flow position is very healthy, which is a major reason to hold the stock in a dividend portfolio. At the end of third quarter, General Mills had $1.4 billion free cash flow, which is a massive improvement of 29% year-over-year. On the other hand, the company's debt to equity ratio of 1.79 times is significantly less than most of its peers, including B&G Foods (NYSE:BGS), Kellogg Company (NYSE:K), Campbell Soup (NYSE:CPB), and ConAgra Foods (NYSE:CAG). Thus, the less financial burden and steady earnings will support the future dividend hikes.

General Mills' efforts are promising, but the risk is always there. However, in my opinion, the valuation is a major concern as the share price has moved in the upward trajectory. With more than 18% surge in the past twelve months, General Mills is now trading at forward price to earnings multiple of 20.2 times, which is its highest valuation since February 2002. Although the stock looks fairly priced as compared to its peers, the consumer staples sector itself is trading at a massive 25% premium as compared to S&P 500 Index. One upside about General Mills is that the stock currently offers solid 3% dividend yield, fourth highest among its peers. The strong cash flow position and comfortable 70% payout ratio suggest the investor can enjoy healthy dividend growth in the future despite the steady increase in earnings.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.