- The company maintains a strong and sustainable competitive advantage.
- A recent pullback in the company’s stock price is offering investors a purchase bargain.
- We're forecasting an 11.5% compound annual rate of return over a five-year investment horizon.
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While it is clear that the global cereal market will likely continue to suffer from declining demand, General Mills (NYSE:GIS) has an incredible cereal and non-cereal brand portfolio with definite product sustainability and tremendous cash generating power. Given softness in the company's stock price over the last year and valuation targets set on the stock, we think it's a good time to take a position in the company, provided our estimates prove accurate and you have a 1-2 year investment horizon.
As is the case with most consumer packaged food manufacturers, changing consumer tastes over the last 5 years has led us to make some portfolio changes as it relates to some of our long-term holdings in the food and beverages industries. Traditional breakfast cereals have been experiencing declining demand; today's customers are seeking healthier alternatives and unique convenient food offerings. But because of its tremendous brand power and more diverse product lines than some of its competitors (i.e., Kellogg (K)), we decided to keep General Mills in our portfolio and cut our position in Kellogg.
General Mills is the second-largest producer of breakfast cereals in the U.S. and the fourth-largest food manufacturer in the world. The company's sales are derived from three major distribution channels: north american retail (about 65 percent of revenues), international sales (about 23 percent), and convenience store sales (about 12 percent of revenues).
The company's most recognizable cereal brands include Cheerios, Wheaties, Lucky Charms, Total, and Chex. The company also owns Pillsbury, Betty Crocker, Bisquick, Progresso, Green Giant, Hamburger Helper; Pop Secret, Bugles, Nature Valley, Yoplait, and Häagen-Daz. Wow, talk about an impressive brand portfolio! Who doesn't know virtually every brand just listed, and who doesn't have at least one or two related products in their kitchens right now?(Below is a neat infographic (a little dated but still relevant) prepared by Kate Taylor and published in Business Insider comparing brand portfolios of the 10 largest food manufacturers in the world.
In assessing this company, it is important to know that Europe accounts for the largest share of its international revenues (approximately 40 percent) with Canada accounting for about 25% of revenues and Latin America and Asia-Pacific accounting for the remaining 35%.
As a weekly buyer of cheerios for over 20 years, I can hardly resist investing in General Mills.
- Although competition in the industry is fairly intense and the customer-base is constantly evolving, we think the company has a strong and sustainable enough competitive advantage to continue to invest in the company.
- General Mills has incredible cash generating power and should be capable of weathering most economic storms.
- The company has sufficient financing to realign itself into new business lines if required without punishing shareholders.
- The company continues to repurchase shares, which is providing nice support to earnings and dividends per share. Further, sizeable repurchase activities are expected to continue with decent dividend increases in the future.
- General Mills continues to be a reasonably safe company with a beta of 0.6, which is lower than a lot of the companies in our portfolio.
- We like that the company is placing emphasis on product development in both the Millennial and 55-and-over age groups.
- General Mills is now the third largest producer of natural and organic foods, a market that continues to grow.
- A recent pullback in the company's stock price is offering investors a purchase bargain.
There are a few reasons for caution, however.
- There is a continual trend among consumers to shift breakfast eating away from cereals. This trend is a major risk factor for the firm and is likely to continue into the future. That said, our long-term outlook for the company is less ingrained in the cereal market and more dependent on advancements in their non-cereal product lines, and in particular healthier and more profitable food lines, such as gluten-free snacks and dough products.
- While commodity prices have stabilized, the company is highly sensitive to commodity price shocks and cycles.
Estimating Sales Growth
When assessing the competitive strength and investment merit of a firm, we like to first assess what's going on with sales. Ideally, we are looking to invest in companies whose sales are strong, consistent, and are generally growing faster than nominal GDP growth (that is, real GDP growth and inflation combined). Based on General Mills historical sales data, you can see that General Mills' revenues have grown by about 1.4 percent over the last 10 years. This compares to average nominal GDP growth of 3.1 percent per year over the same period.
General Mills' sales have grown by -2.4 percent per year over the last five years and -3.7 percent per year over the last 3 years. It is worth noting that General Mills' 3 year revenue growth rate is ranked lower than 68.0 percent of the 1,460 companies in the packaged foods industry. That said, we still think the company is on solid ground. We also believe that it retains modest pricing power. We feel comfortable recommending investing in this company for growth and expect impressive things from this company in the future.
The second thing we like to do when assessing sales is to look at consensus market estimates. As reported by Morningstar, the market is projecting 10.1 percent annual growth for this year, 1.6 percent annual growth for next year, and 2.5 percent for the year after that. These growth estimates translate into $17.3 billion in sales for this year and $17.6 billion in sales for next year. The projected increase in sales is expected to be driven by an increase in product demand, stable pricing power, and improved production capacity.
A third thing we like to do when assessing sales is to compute the firm's sustainable growth rate. The sustainable growth rate reflects the rate of growth in sales that a firm can support given its existing earnings power, capital resources, and dividend payout policy. In any given year, a firm's sustainable growth rate is calculated by multiplying its return on equity (ROE) by its retention rate. Rather than rely on data from only one year, however, we calculate sustainable growth by using the firm's 3-year average ROE and 3 year average retention rate. General Mills' ROE averaged 34.3 percent over the last 3 years while its retention rate averaged 37.5 percent, giving the firm a sustainable growth rate of 12.9 percent per year.
Let's recap briefly what the sales data is showing us. From what we can tell, it is not unreasonable to estimate that sales over the next 5 years could grow at a rate of somewhere between -3.7 percent and 12.9 percent.
We're going to select a rate of 3.2 percent. This represents a blended rate forecast reflecting consensus 3 year rate projections scaled by a 10 year average incremental change for the last 2 years of the 5 year forecast horizon. With $16 billion in sales generated last year, this means that we believe that sales will reach about $18 billion in 5 years. This estimate reflects our understanding of the firm's historical results, market demand, pricing trends, levels of competition, and changing regulatory requirements.
Estimating Earnings per Share
Now that we have generated our sales estimate, we're going to estimate growth in earnings per share. The method applied below takes the sales growth projection - in this case, 3.2 percent per year - and subtracts the expenses and taxes. What we're left with are the earnings. Then we divide by the projected number of diluted shares outstanding to determine the earnings per share (see table below).
A projected growth rate of 3.2 percent will result in about $18 billion in sales five years out. Now we need to take a look at the firm's pre-tax profit margin (what's left over after expenses but before taxes are subtracted). In the figure below, we can see that General Mills produces some pretty stable margins - 13.6 percent in 2018, 14.5 percent in 2017, 14.5 percent in 2016, and 10.0 percent in 2015. The average for the last five years has been 13.5 percent and the average for the last 10 years has been 14.0 percent. We believe that General Mills' margins will remain stable at 13.5 percent. At this rate, projected pre-tax profits on $18.5 billion in sales would be about $2.5 billion. This means expenses would amount to $16.0 billion.
The next step in our estimation process is to establish what tax rate will be paid on the company's profits. The most recent year's rate was 2.7 percent. Normally we wouldn't play with that number too significantly because in general, it shouldn't change very much from year-to-year. The only time we would make major changes to this number would be in instances where maybe the current rate differed significantly from that of the past or if we had some knowledge about what rate was likely going to persist in the future, perhaps because the company is going to get some preferential tax treatment on operations abroad or because of a broad change in state or federal tax policy.
For General Mills over the last 10 years, the company's tax rate has been as low as 2.7 percent and as high as 37.1 percent. Tax rates for most U.S. companies are around 20.8 percent. We're going to select a rate of 20.0 percent. This would result in a tax expense of $0.5 billion from pre-tax profits of $2.5 billion in five years. This would leave us with $2.0 billion in projected earnings five years from now.
Our next main consideration is a matter of determining the number of diluted shares that will be outstanding in 5 years. General Mills has decreased the number of shares outstanding over the last decade. There were 694 million shares outstanding in 2008, then the number of shares went to 666 million in 2013, and then fell to 612 million in 2016. Currently there is 586 million shares outstanding. This data suggests that the company has been redeeming about 11 million shares per year. We're going to rely on the company's historical share repurchase activities to guide our estimation process. As such, we project share repurchases of 11 million per year over the next 5 years.
With shares estimated at 531 million in 5 years, EPS is expected to rise at an annual compound rate of 0.6 percent over the period. This is lower than our projected 5 year revenue growth rate. Based on this EPS growth forecast, we are expecting EPS of $3.76 five years out. Results of our forecasting procedure are summarized in the table below.
Forecasting a Target P/E Multiple
General Mills' stock has traded with a relatively stable P/E multiple over the last decade, averaging 18.0x over the last 10 years, 20.6x over the last 5 years, and 18.3x over the last 3 years. Currently the firm is trading at 12.1x trailing 12-month earnings per share and 14.3x expected future earnings.
For determining an estimated target P/E multiple, the first thing we like to do is eliminate any outliers from the historical data series. This includes abnormal P/Es that are not reflective of the normal operations of the firm, and this could be the result of abnormal growth or significant one-time non-recurring charges/gains. The next thing we like to do is to run an optimization procedure that tells us what P/E multiple yielded the best forecasting accuracy over the evaluation period. If in our judgement this multiple continues to accurately portray the earnings and cash generating power of the company as well as the growth and risk characteristics of the firm, then we will use this multiple as our target multiple. If not, we will adjust the multiple upwards or downwards accordingly.
The figure below presents the historical P/E profile for General Mills. We will utilize a target P/E multiple of 17.6x which we believe reasonably characterizes the risk-return attributes of the company's stock. This multiple represents an expansion of 49.4 percent relative to the current multiple. It also represents a contraction of 9.2 percent relative to the 5 year average P/E multiple.
Setting a Target Price and Valuation Range
Now we need to take a look at the price history of the company's stock. From the figure below, we can see that the spread between the high and low stock prices has increased over the last 10 years. We have a current price of $44.17, with a high in the past 10 years of $65.36 and a low of about $23.61. We want to keep this variability in mind when establishing our upper and lower valuation range. Specifically, given the firm's historical stock price behavior, we should expect the stock to fluctuate by at least $10.06 over the course of a year.
Given our selected target P/E multiple of 17.6x, to determine a price target 5 years out, we then multiply this by our EPS estimate. EPS are estimated to reach $3.76 in five years giving us a target price of $66.16. This price is higher than the current price. To properly judge to what extent the stock may be under- or over-valued, we need to determine a fair-value range within which we expect the stock to trade. To do this we rely on the trend-adjusted average annual trading range for the stock, which from the analysis above we know is $10.06. This means that, given our target price estimate, we expect the stock to trade naturally, and fairly, between $61.14 and $71.19. The result of this is that when the stock is trading below $61.14 it is in the Buy Zone and when the stock trades above $71.19 it is in the Sell Zone. Currently the stock is in the Buy Zone.
So what return can we expect for holding General Mills' stock? Well, we now know we can expect stock price appreciation of 49.8 percent. We can also expect to earn dividend income of about $9.80 over the evaluation period. Added to our price estimate, this means we could earn a compound annual rate of return of 11.5 percent, provided our estimates prove accurate.
In all, we are happy with this company and believe that it offers sufficient return potential to qualify for investment. We recommend buying the stock at current valuation levels.
This article was written by
Analyst’s 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.
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