Better Consumer Staples Stock: Altria Or General Mills?

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About: General Mills, Inc. (GIS), MO
by: Ray Merola
Summary

Looking to add a Consumer Staples stock to your portfolio?

Let's consider Altria and General Mills, two venerable companies. Each faces core products in secular decline.

The respective management teams are actively reacting to the challenges.

Nonetheless, one pick appears superior.

During the late 2018 stock swoon, two Consumer Staples sector stocks caught my eye.

Tobacco king Altria Group Inc. (MO) fell hard, tumbling to $42.50 from $65, a 35% hit. It was the latest in a series of drawdowns that began in the summer of 2017. Currently, the stock sits ~$49. Eroding cigarette volumes, regulatory woes, and ongoing litigation continue to pressure the stock.

Altria Group - 3 Yr Weekly Price, Volume, MACD and MFI

Courtesy of BigCharts

Meanwhile, “The General,” or General Mills Inc. (GIS), slipped to a December low of $36.50; shares have since rebounded to ~$44. This was the latest bump in a multi-year downside grind. Persistent fears revolving around changing consumer attitudes towards processed foods continue to dog the shares.

General Mills - 3-Yr Weekly Price, Volume, MACD, and MFI

Courtesy of BigCharts

The purpose of this article is to present a walk-through evaluation / comparison for these stocks.

Does either security appear to be a better buy than the other?

Here's a template for what comes next:

  • Provide a short investment thesis for each stock
  • Examine financial performance / trends
  • Overview of the current corporate narrative
  • Review basic valuation metrics and assess a fair value estimate

Altria Investment Thesis

Altria is the largest domestic tobacco company. Its commanding franchise permits the company to enjoy a level of pricing power.

Generally, the balance sheet is sound. MO spins off a great deal of cash; operating cash flows are greater than adjusted profits. Capital expenditures are modest. Declining cigarette volumes have been offset somewhat by growing margins.

Recently, the company initiated plans to take significant stakes in Cronos Group (OTC:CRON) (cannabis) and JUUL (e-cigarettes, aka “vaping”), thereby diversifying its product base.

The 6.5% dividend yield is strong and safe. The stock seems cheap. Primary risks include continued government regulations, taxation, litigation, and outright product curtailments.

Altria Financial Performance / Trends

The Balance Sheet Is Generally Sound

Liquidity is reasonable, despite a low (0.51) current ratio. Through 2023, Altria has a $3 billion revolving credit agreement in place. The revolver backstops a business that generates enormous free cash flow. Little balance sheet cash is kept on hand. Currently, there's $1.3 billion booked, or about $0.70 per share. This is about half the cash balance recorded in recent years.

MO counters relatively high long-term debt (as evidenced by 165% net debt-to-equity ratio) with a comfortable 14x interest coverage ratio and 2.35x net debt-to-EBITDA ratio. Notably, over the past several years, long-term debt has been drifting down.

Goodwill and intangible assets make up ~31% of the company's total assets. This exceeds my yellow flag 20% marker.

Strong Cash Flows

I favor companies that earn profits in cash, and Altria fits the bill. Since a picture is worth a thousand words, a F.A.S.T. Graph illustrates how, on balance, MO generates operating cash flows per share (the blue bars) greater than operating EPS.

Adding gloss to the record is a general upward trend for both measures.

Margins Are Expanding

The following table highlights the company's 2018 versus 2017 margins:

Altria Margins - FY 2018 and 2017

2018

2017

Gross Margin

62.5%

61.3%

Operating Margin

46.5%

49.1%

Net Margin (adjusted)

38.4%

33.4%

Margins improved year over year, continuing a longer-term trend. In recent years, management countered declining cigarette volumes by raising product prices. By also holding opex down, Altria has been able to boost margins, thereby enabling good profit growth in the face of weaker top lines.

In addition, among the tobacco industry peers, Altria boasts best-in-class margins.

Revenues Drift Up, But EPS Outpaces Smartly

Over the past 7 years, Altria grew revenue at a modest 2% annual rate.

Meanwhile, over the same period, EPS grew a robust 10% a year due to improving margins, good opex control, and meaningful share buybacks.

Management possesses an outstanding track record of setting reasonable Street expectations and then meeting those:

Courtesy of Ameritrade

We see that over the past 16 quarters, company EPS met analyst forecasts 14 times and “beat the Street” twice. There were no misses.

Altria Offers Excellent Returns

For FY 2018, Altria management recorded 13.6% return on assets and 27.6% return on invested capital (EBIT / Total Assets - Current Liabilities - Cash). These figures place the company among the leaders in the tobacco industry. Indeed, on an absolute basis, both return figures are excellent.

Altria Is A Shareholder-Friendly Company

Altria management offers investors a stout dividend: the shares yield 6.5% currently. Over the past 5 years, the payout has been raised by an average 8.4% per year. The company is a longstanding Dividend Aristocrat. The board of directors has approved annual dividend increases for the past 49 consecutive years. Management targets ~80% adjusted EPS for the dividend. The current $3.20 payout is spot on the mark. Bolstering the situation, the dividend-to-free cash flow ratio (which is where the rubber really hits the road) is about 60%. The payout is safe.

In addition, Altria enacts share repurchase plans routinely, and these plans are effective. Since January 2011, common shares outstanding have been reduced by 8.25% - a meaningful delta. A buyback plan remains in effect for 2019.

Altria Corporate Narrative

As the old saying goes, “The numbers tell a story, but the numbers are not the story.” So, what's the company narrative behind the good set of financials?

Here's my take. Altria's management has shown a sustained, demonstrated ability to navigate the business in a tough business climate. Government regulations and regulators hound the tobacco industry, and for good reason. The products are generally considered unhealthy, can be addictive, and can drive up user medical expenses. Regulations and public pressure help push domestic cigarette consumption into secular decline - a trend unlikely to reverse. Management has largely offset weaker tobacco volumes by charging more for its products, thereby improving margins. Tight expense management and strong share buyback programs provide further assistance. This explains how sluggish revenue growth translates into robust EPS growth.

Recently, Altria is moving to diversify its lineup beyond traditional tobacco products. The company has long owned interests in the alcohol business. However, contributions from the Ste. Michelle winery and a 10.2% in Anheuser-Busch InBev (BUD) account for less than 4% of the business.

Therefore, in late 2018, management approved purchasing significant ownership stakes in Canada-based Cronos Group and JUUL Labs, a cannabis and an e-cigarettes business, respectively. It remains to be seen if these joint interest holdings will “move the needle” versus the company's traditional tobacco products. Arguably, Altria overpaid for these businesses too.

Looking forward, investors must decide whether to enjoin management in their vision. How long can margins continue to improve in the face of declining smoked tobacco sales? Will corporate management remain a step ahead of government regulators, the anti-smoking lobby, and ongoing litigation? Will the recent diversification into marijuana and vaping sales be successful?

Clearly, the company is very good at what it does, holds a commanding industry position, and is shareholder-friendly.

Author's note: For the purposes of this article, I have no interests in defending, defaming, or politicizing the tobacco industry. My objective is to analyze data from an investment perspective only. If an individual despises the tobacco business, he / she could take the dividends and capital gains associated with a prospective stake in MO and contribute these to anti-smoking organizations or cancer research, or just avoid such stocks altogether. That's a personal call.

Valuation: MO Looks Darn Cheap!

A pair of F.A.S.T. Graphs highlight the potential valuation disconnect between MO price and earnings / cash flow.

Long-term charts highlighting price / operating earnings, and a price / operating cash flow follow. The price-and-earnings chart is first:

The historical valuation multiples are reasonable. However, I believe an adjustment is in order. I premise this for two reasons. First, MO is expected to see modestly reduced forward growth rates as compared with recent years, and second, I envision a downward bias on valuation multiples due to investors bidding up high-yield stocks during a period of unusually low interest rates. These factors could take the multiples down a notch or two.

When coupled with the presumption that the market will only pay for current fiscal year forecasts (not the out years), I place a $62-64fair value estimate on MO shares. Using a $49 bid benchmark, this suggests Altria stock is undervalued by ~28%. A 6.5% dividend yield adds gravy to the mix.

General Mills Investment Thesis

General Mills is another company wrestling with change. However, change can beget opportunity. Indeed, traditional processed carbohydrates (like ready-to-eat breakfast cereals) are in secular decline. Therefore, General Mills' management is operating under the premise that it needs to 1) cut costs, 2) diversify into healthier / organic food offerings, and 3) branch out into the high-end pet food business.

At its core, GIS is a cash-rich business. It has paid uninterrupted cash dividends for 119 years.

The franchise operates and is easily recognized throughout the world. General Mills is a best-of-breed company. The packaged food business is not facing tremendous regulatory or public scrutiny.

A successful business transformation could spell big shareholder returns. After hitting summertime highs in 2016, the stock has fallen 46%, bottoming out last December. Despite a near-term rebound, shares remain at valuations unseen since the Great Recession.

General Mills Financial Performance / Trends

The Balance Sheet Is Marginal

The company's balance sheet, post the $8 billion Blue Buffalo Pet Products acquisition, is marginal at best. Net debt skyrocketed on the deal, pushing net debt-to-equity to 196%. Over the past 5 years, long-term debt doubled. The interest coverage ratio is a manageable 4.3x, but I'd prefer to see the ratio a turn or two higher. Likewise, leverage is also a bit high: net debt-to-EBITDA stands at 4.0x. Currently, the S&P credit rating remains BBB investment grade.

Liquidity is ample, despite a low 0.58 current ratio. General Mills carries little cash on the balance sheet: only ~$600 million as of November 2018. Management states solid cash flow from operations, coupled with a relatively low capital spend, permits the low cash balance and lack of a credit revolver.

Another post-acquisitive manifestation is a high percentage of goodwill and intangible assets relative to total assets. The 70% mark is quite high; the balance sheet indicates negative tangible equity.

On The Other Hand, Cash Flows Are Remarkably Strong

General Mills offers investors outstanding cash flows. Operating cash flows routinely exceed profits. In fact, most years find free cash flow (OCF less capex) eclipses earnings. In the F.A.S.T. Graph below, free cash flow is the purple bar.

Nonetheless, a free cash flow trend line isn't well-defined. After a fiscal year 2018 uptick, free cash flow for the 2019 fiscal year (ending May 31) appears to be shaping up to the downside.

Meandering Margins

General Mills' recent margins are shown in the table below:

General Mills Margins - Fiscal Year 2017 through 1H 2019

1H 2019

2018

2017

Gross Margin (adjusted)

34.1%

34.4%

35.6%

Op Margin (adjusted)

16.5%

15.9%

16.8%

Net Margin (adjusted)

11.4%

13.5%

10.8%

All margins were adjusted for special items. Given the recent acquisitive activity, I accepted management's accounting re-jiggering despite not necessarily agreeing with all of the “yeah buts.”

Revenue Growth Is Faltering, While EPS Trending Up

In recent years, General Mills has failed to grow the top line.

The 7-year annualized growth rate is less than one percent; however, the situation is worse than that. Revenues declined in each of the past 4 fiscal years. This year will show improvement, due to the Blue Buffalo Products acquisition. The underlying core business isn't going anywhere.

Earnings per share have done a little better.

Through the period, the ~3% annualized EPS growth rate is alright but nothing special. This fiscal year isn't shaping up to be a barn burner either. General Mills is stuck in a slow-growth industry, facing secular headwinds, raw material inflation, and considerable competitive pressure.

Nevertheless, to management's credit, we find that over the past 16 quarters "The General" assembled a good track record, whereby the company registered 4 EPS “beats” versus but one miss. Even if earnings trends aren't robust, senior leadership appears capable of managing expectations.

Courtesy of Ameritrade

General Mills Offers Good Returns

Recent returns are solid, though not outstanding. Halfway through FY 2019, the company recorded a 6.2% return on assets and 12.5% annualized return on invested capital (EBIT / Total Assets - Current Liabilities - Cash). These figures place GIS in the second quartile of the food industry average. On an absolute basis, these return figures are acceptable.

General Mills: A Rich Dividend History

General Mills offers investors a stellar dividend history. For the past 119 consecutive years, the company paid cash dividends. Investors enjoyed increases in each of the past 14 years. Over the past 5 years, the GIS board raised the payout by an average of 8 percent a year. The free cash flow payout ratio is barely above 50%. The current dividend yield is material (4.4% yield) and safe.

Similarly, the board of directors authorizes significant share repurchase plans; the number of common shares outstanding exhibits a long-term downward trend. Since 2005, GIS knocked back the share count by ~2.5% per year. The Blue Buffalo acquisition reversed the trend, at least for now. In order to fund the transaction, General Mills issued $1 billion in equity. It diluted the pre-deal share count by a bit more than 3 percent.

General Mills Corporate Narrative

The underlying company narrative is one of an old-line company in the midst of a difficult transition. The market for processed carbohydrates appears to be in secular decline. Recognizing this, General Mills management is attempting to crack the mold by expanding its product lines. In 2011, the company took a major stake in the Yoplait yogurt business. More recently, the outright purchase of Blue Buffalo Products (upscale pet food) suggests a willingness to branch out into a completely new business.

In addition, General Mills is embarking upon a series of cost containment measures. There is particular focus upon improving supply chain efficiencies and reducing raw material costs.

To date, these initiatives are yielding mixed results, or the jury is out. Margins are not yet trending positive but may be stabilizing.

Management is fixated upon stemming easing revenue, sometimes appearing frantic. The Blue Buffalo deal wasn't a bargain, nor is it within the company's wheelhouse. However, given the steady drip-drip-drip losses in the processed cereal business, expanding into new, higher-margin product lines was deemed an acceptable risk.

Investors must decide whether management is up to the task of re-tooling the business. Can it run a pet food enterprise? Will the balance sheet be shored up? Will supply chain and expense reductions evolve into stabilized margins? Certainly, the cash-rich business model enables a reasonable chance of success. However, the core business remains a battleground: competitive and in secular decline.

Patient investors may take solace in a strong dividend track record. Management is committed to the payout.

General Mills Valuation: Discounted!

At today's prices, General Mills stock looks to be a bargain. Two F.A.S.T. graphs help illustrate this view.

Shown below is a price / operating earnings chart, followed by a price / operating cash flow chart:

The long-term 17x operating P/E and a 14x P/OCF reflect good industry benchmarks. The Blue Buffalo transaction offers the potential to be accretive to earnings and cash flow. This may help offset somewhat higher valuation multiples awarded in recent years due to many investors favoring high-yield stocks in an ultra-low interest rate environment. Given management's good track record, I accept FY 2019 estimates. Combining these inputs and adding a small factor of safety, my fair value estimate for GIS stock is $51-52. On a recent $44.50 bid, this suggests a 16% price uplift. The 4.4% dividend yield adds to the total return.

Conclusion

Based upon the foregoing discussion, I believe Altria is a superior potential investment candidate versus General Mills. Both companies are marked by great strengths and considerable risks.

Foundational to this view is the premise that the respective management teams can successfully navigate the businesses' changing landscapes. Both Altria and General Mills are companies whereby the core businesses - cigarettes and processed carbohydrates, respectively - are battling secular declines. General Mills faces critical revenue and margin pressure. Altria must manage ever-increasing government regulation, litigation, and general public backlash against its tobacco products.

Ultimately, investors must decide whether the management teams are up to the challenge. I say they are.

Nonetheless, I differentiate Altria by its superior financial performance. In part, this is due to the company's dominant industry position. General Mills operates within a more competitive backdrop. Though a softer data point, I also contend Altria has somewhat stronger internal momentum.

Furthermore, as evidenced in the article, I believe Altria offers greater capital appreciation potential than General Mills. Shares appear more deeply discounted versus my fair value estimate. Boosting the valuation case is the fact Altria currently provides a significantly better dividend yield.

Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2019 investments.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MO over 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.