General Mills: 'Functional Foods' Will Drive Shares Higher

| About: General Mills, (GIS)
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The company has noted that the food industry has become more "entrepreneurial" and it must compete against an increasing number of smaller competitive food brands.

One segment of the food market garnering significant attention and experiencing strong consistent growth is the “functional food” market.

A “functional food” is said to provide additional health benefits beyond basic nutrition either through the addition of new ingredients (or more of an already present ingredient).

Industry reports expect the global-functional food market to reach $92.3 billion by 2021 from $64.6 billion in 2016 at a CAGR of 7.4 percent.

The company is pushing further into the functional food market through internal innovation and start-up company investments (and possible later acquisitions) to jumpstart revenue/earnings growth.

General Mills (NYSE:GIS) has struggled recently due to changing consumer food trends despite the company being one of a small group of major American food companies that dominates the American food landscape. As many of our readers know, we never bet against the success of a dominant American food company over the long term. With this in mind, we note that GIS has been mainly experiencing weakness in its U.S. retail division (about 60 percent of its total sales) where revenues and profits for the division have been decreasing in recent quarters due to lower product demand given weak food industry trends and changing consumer food preferences. In fact, most major U.S. food producers, not just GIS, continue to adapt to changing consumer food trends towards natural and organic foods. Although many of GIS' existing brands remain successful sellers, the company remains focused on natural and organic food trends that many smaller nimble inventive companies more readily recognize and offer innovative natural products to meet such trends. GIS has noted that the food industry has become more "entrepreneurial" and it must compete against an increasing number of smaller competitive food brands. One segment of the food market currently garnering significant attention is the "functional food" (or nutraceuticals) market. A reader may ask, "What is a functional food?"

Companies offering functional foods claim such foods have health benefits, such as decreasing cholesterol and preventing cancer. In fact, companies offering such products will list their claims on the packaging of such products in stores. Although most food is functional given that it provides basic nutrition, "functional food" is a group of foods that are said to provide additional health benefits beyond basic nutrition. Foods in the functional food category are frequently given additional "functions" through the addition of new ingredients (or more of an already present ingredient). The functional food group segment includes: 1) conventional non-organic foods such as grains, fruits, vegetables and nuts; 2) fortified foods such as orange juice with added calcium for bone health; 3) medical foods such as tube feeding solutions or nutritional drinks for diabetics; and 4) foods for special dietary needs such as infant formula and gluten/dairy free foods. The U.S. Food and Drug Administration ("U.S. FDA") regulates functional foods and the claims for such foods are based on scientific evidence. Although the U.S. FDA monitors health claims, such claims represent a marketing tool that attract many consumers' purchases. GIS, as noted below, is continuing to move further into the functional food space through internal innovation but primarily through acquisitions and investment in functional food start-ups that they may later purchase outright.

Food companies frequently offer many functional food products that are fortified or enriched - which means vitamins, minerals or other nutrients are added after processing. There are, however, foods that naturally contain beneficial functional ingredients such as: 1) Salmon for omega-3 fatty acids, which lower the risk of heart disease, improve brain development and function, and reduce joint pain; 2) whole grains contain fiber to help lower cholesterol and blood pressure and improve digestive health; 3) beans that contain cancer-fighting plant chemicals, fiber, protein, potassium and folate; 4) berries with antioxidants, which prevent/slow oxidative damage to the human body and boost its immune system; and 5) yogurt which contains probiotics that keep your gut healthy and protect the immune system. Of course, there are many more natural "functional foods," and, food companies are increasingly taking notice of this growing and already significant market opportunity. For example, industry reports expect the global nutraceutical market to reach $285.0 billion by 2021 from $198.7 billion in 2016 at a compound annual growth rate ("CAGR") of 7.5 percent. Such reports also see the: 1) functional beverages market reaching $105.5 billion by 2021 from $71.5 billion in 2016 at a CAGR of 8.1 percent; and 2) functional food market reaching $92.3 billion by 2021 from $64.6 billion in 2016 at a CAGR of 7.4 percent.

With the functional foods market (including nutraceuticals) increasing by the day, it is no surprise that GIS wants to push further into the market to jumpstart revenue/earnings growth for the overall company. As noted above, the company can move further into the functional food market through internal innovation or acquisition of (investment in) outside companies. For example, GIS recently made a significant investment in a company named Farmhouse Culture ("FC" - a maker of high-end sauerkrauts, fermented vegetables and other foods noted for their positive effect on the gut). In particular, the company's "investment arm" made a $6.5 million investment in FC. GIS' investment in FC relates to FC's products having beneficial probiotics, which are a fast-growing market among health-conscious consumers and contain "good" bacteria that assist in maintaining healthy gut flora. Probiotics in the gut assist in digestion and products such as yogurt, Kombucha tea and pickles are all sources of good bacteria if the products are fermented using live cultures. FC specializes in fermented foods. In addition to vegetables and gourmet sauerkrauts and kimchi, FC makes sauerkraut krisps and "Gut Shots" (a bottled probiotic drink). Although GIS established its in-house investment fund about 18 months ago to locate future acquisitions in the functional food category, the company has yet to acquire any of the seven start-up companies it has invested in, but still has the long-term goal of acquiring some of such companies.

GIS has been monitoring the functional foods market in recent years (and seeing exponential growth over that time) and aside from its recent investment in FC the company has also invested two times in Good Culture, a company that makes thick, organic, single-serve cottage cheese with live cultures. The company also recently invested in a company named D's Naturals, a maker of plant-based, non-GMO protein bars. Expect GIS to continue to make multiple investments in start-up functional food companies with potential for rapid growth in healthy food categories. Although the company is taking proactive steps to reignite consistent revenue/earnings growth, its shares trade at a more value-oriented price as it transforms to adapt to U.S. organic and health food trends. The opportunity to buy GIS shares at a lower price arises from the company's recent weak quarterly earnings reports. In GIS' most recent quarter, it announced below expectations adjusted earnings per share of 85 cents, a 4 percent increase from the year-ago quarter. The company's revenue decreased 7.1 percent to $4.1 billion (also below expectations) due to its Green Giant brand divestiture and lower organic sales. (Excluding currency and acquisitions/divestitures effects, organic revenues decreased 4 percent.) Adjusted gross margins increased 130 basis points to 36.8 percent as input cost inflation was more offset by savings from cost reduction efforts.

While GIS will continue to invest in (and acquire) companies making healthier and more natural foods, it has also been determining what to do with its weaker legacy products that no longer appeal to consumers. For example, GIS' divesting of its Green Giant frozen vegetable brands business. To overcome its weak revenue/profit performance, the company is also increasing its cereal investments, increasing its healthy snacking products offerings such as its yogurt and snacks businesses and driving double-digit growth in its natural and organic food portfolio. The company understands that consumers want more natural foods, with simpler ingredients. The company also knows that consumers are avoiding gluten, simple carbohydrates, artificial ingredients and seeking out more fiber, protein and whole grain. GIS also understands that marketing for smaller natural and organic food brands focuses on the product itself and what is in the product and the origin of the product. We believe that GIS, a known innovator in developing and marketing food brands, will succeed over the long term through internal innovation and acquisition of food brands that meet consumer's changing tastes. With this in mind, we also believe that investors should wait to purchase GIS shares at or below $60 during a strong overall market selloff. Over the long-term, a GIS investor will be rewarded by the company's transformation with increasing dividends, share buybacks and share price appreciation.

Our view

Anyone who doubts GIS' ability to adapt, survive and thrive over the long term in the U.S. and global food market has not been paying close attention to the company's ongoing activities to remedy its current product portfolio issues. As we consistently ask our readers, "When was the last time they heard of an upstart food company in the U.S. growing to a size to be able to challenge an established major U.S. company (that is part of what is known as "big food") in any significant manner?" Such challenges never happen because upstart innovative companies either succeed (and get taken over by a major U.S. food company) or they fade away into a niche market of little economic consequence. With this in mind and as noted above, the functional food (and nutriceuticals) market is becoming an increasingly significant market opportunity to start-up companies and established major food companies such as GIS. Make no mistake: as discussed above, GIS through internal innovation and its investment arm investments is making a strong and consistent move into the functional food market and is likely to be a significant and successful player in such market, thereby driving revenue/earnings growth.

GIS continues to faces weak food industry trends as it also experiences intense competition. The company continues to adapt legacy food products by decreasing salt, sugar and the number of ingredients in such products. Further, GIS continues to reduce costs through restructuring activities. GIS' strong brands will likely protect it partially from lower-cost product competition. The company's earnings growth, however, will continue to be pressured by weak U.S. demand, slowing international growth and increased marketing and merchandising investment to drive revenue/earnings growth. Despite continued adverse market conditions, GIS will thrive long term due to its strong brands; product and marketing innovations; its push into the growing functional foods market; profitability and cash flow; and long-term record of earnings and dividend growth. GIS shares currently have a dividend yield of about 3.15 percent. Earnings estimates for fiscal year 2017 are $3.06 and for fiscal year 2018 are $3.30. We should note that earnings estimates have fallen for each year in recent months. The company has a price-to-earnings ratio of about 19.85 based on fiscal 2017 earnings estimates and a price-to-earnings ratio based on 2018 fiscal year earnings of about 18.40.

We recommend that an investor wait to buy the company's shares in the price range of $52.80 to $56.10 (a price-to-earnings ratio range of about 16.00 to 17.00 based on 2018 fiscal year earnings).

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Disclosure: I am/we are long GIS.

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.