General Mills: Expected To Outperform The S&P 500

Summary

• Especially in light of the then unforeseeable COVID-19 pandemic, GIS' move into the pet food sector proved to be a shrewd decision.
• The company's balance sheet is improving thanks to the robust and growing free cash flow. The dividend is expected to grow as deleveraging continues.
• With its strong brands, GIS has proven its ability to pass on price increases to customers.
• GIS' future prospects are bright and the stock certainly deserves a position in a diversified portfolio.
• The shares are still slightly undervalued and I expect them to outperform the S&P 500 over the next years.

Urilux/iStock via Getty Images

Introduction

General Mills, Inc. (NYSE:GIS) is a well-known, but not overly large (market cap $39 billion) consumer staples company that specializes in the manufacturing, marketing and distribution of snacks, ready-to-eat cereals, convenience meals, yogurt, ice cream and since 2018 also pet food. The company owns several well-regarded brands such as Cheerios, Häagen-Dazs, Golden Grahams, Lucky Charms, Blue Buffalo, Nudges, Top Chews, Nature Valley, Pillsbury, Old El Paso, Wilderness, Yoki, and Yoplait. Through its "Cereal Partners Worldwide" joint venture, GIS teamed up with Nestlé S.A. (OTCPK:NSRGY) in the ready-to-eat cereal category in markets outside North America. GIS is one of those companies that were in great demand during the onset of the COVID-19 pandemic due to the rather recession-resistant business model. However, as inflation fears arose and excess demand waned, the company’s shares lost some ground but found strong support around $55 as the inflationary impacts are successfully countered by price increases and cost-cutting programs. Since GIS beat earnings in Q1 2022, the shares have been in an upward trend and are now flirting with the COVID-19 high of $65 witnessed in summer 2020. The times of beaten-down GIS stock seem to have passed, same as the critics related to the Blue Buffalo acquisition have fallen silent.

The S&P 500 index has performed very well over the last decade and exceptionally well since the onset of the COVID-19 pandemic. However, taking into account its long-term "line in the sand", the index recently hit its two root-mean-squared (RMS) deviation upper boundary (see below) and is likely due for a correction.

Source: Author’s own work, based on weekly adjusted close data for the S&P 500 index; the colored lines indicate deviations of plus/minus one and two RMSDs from the exponential-fit compound annual growth rate (CAGR).

In this arguably rather hot market, GIS is one of the few companies that have not been bid-up aggressively (as most tech-related stocks) and thus still offer value at a share price of $63 – especially taking into account the company’s successful diversification into the lucrative pet food sector.

Blue Buffalo – Strong Growth Ahead

Through the acquisition of Blue Buffalo pet products in 2018, and more recently the acquisition of Tyson Foods’ pet treats business, GIS diversified its revenue stream while capitalizing on the strong growth prospects of the pet food industry. The COVID-19 pandemic acted as a tailwind, as is outlined in Mars’ 2020 report entitled "The Rising Power of Pets in Pandemic Britain", emphasizing the sheer spending power and recent growth of pet owners (see, e.g., p. 6 of the report).

GIS’ pet food segment posted spectacular normalized (in the sense that the additional month has been accounted for) top-line growth of 16.6% in fiscal 2020. As the business year included the first months of the COVID-19 pandemic, a comparison to fiscal 2021 appears particularly tough. However, the company was still able to grow the segment’s sales by 2%. This appears particularly good, especially given the inflationary effects seen across the industry.

Taking its recent performance and its strong brands into account, GIS is certainly one of those companies with pricing power. Conversely, companies such as Kimberly-Clark (KMB) (see my recent note), have a harder time passing-on price increases while maintaining its customer base since tissues and wipes are more easily exchanged for cheaper substitutes. Also, e-commerce retailers such as Amazon (AMZN) are aggressively – and successfully – promoting their own brands.

The first quarter of fiscal 2022 was another bright one for GIS in general and for its pet food segment in particular. First-quarter organic net sales of the segment increased a sizable 20% (excluding the extra 5% effect due to the acquisition of Tyson Food’s pet treats business). The segment’s operating margin is rather strong and increased - even in light of inflationary pressures - in fiscal 2021 from 23.1% to 24.0%. GIS' management is very transparent, also reporting segment-specific margins on quarterly calls, indicating that the pet food segment continued to perform very well at an operating margin of 23.6%.

Arguably, the segment is still rather small, contributing only about 10% to the company’s top line. However, its exceptional performance and the secular trend related to pet ownership make it an important growth driver.

Even from a more distant perspective, GIS has obviously turned a corner. Upon completion of the Blue Buffalo transaction, the company’s gross margin expanded by 2% and net sales grew at a two-year average CAGR of 3.7%. More importantly, normalized free cash flow (FCF) grew at a staggering CAGR of 10.4% since fiscal 2019 (i.e., by 22% in total since 2019). Note that this figure does not include the bolt-on FCF effect due to Blue Buffalo which occurred in fiscal 2018 (p. 20, fiscal 2019 10-K). Moreover, one-offs, such as restructuring and impairment charges as well as stock-based compensation expenses, have been deducted. Movements in working capital, which arguably boosted FCF by $800 million in fiscal 2020, have been eliminated as well.

Source: Author’s own work, based on GIS' most recent 10-Ks

Obviously, the company took on a lot of debt to fund the acquisition of Blue Buffalo. As a consequence, GIS’ net debt spiked to almost 5.0x EBITDA in fiscal 2018. As a consequence, and to the (temporary) detriment of shareholders, the dividend was frozen and priority given to deleveraging. However, due to the elevated demand for GIS’ products during the pandemic, the successful integration of Blue Buffalo and - most importantly - the strong FCF growth, the company raked-in substantial cash that enabled faster than initially expected deleveraging and resulted in an unexpected dividend raise by 4% in November 2020. Compared to peers, such as Mondelez (MDLZ), Kraft Heinz Co. (KHC) and Kellogg Co. (K), GIS is in a better position in terms of leverage. The company’s maturity profile (see below) is somewhat skewed to the left but this does not appear concerning in light of the low interest rate environment (enabling cheap refinancing should need be) and the strong FCF. At an annualized FCF of $2.4 billion, it would take GIS a theoretical 4.7 years to retire its entire debt, a very acceptable duration especially in light of the company’s robust business model.

Source: Author’s own work, based on GIS most recent 10-Ks

GIS' current dividend of $2.04 per share implies an annual cost of $1.26 billion. In fiscal 2021, the company paid $431 million in interest. With a normalized FCF of $2.4 billion, there remains plenty of room for interest rate increases until the dividend is no longer sustainable. And in fact quite the contrary, I would not wonder if another dividend increase is announced in the near future, given the company's rosy business outlook and substantial excess FCF.

As another sign of confidence in the business’ future prospects, management made use of the previously authorized share repurchase authorization (p. 71, fiscal 2021 10-K) and so far in fiscal 2021 and Q1 of fiscal 2022 has repurchased $450 million worth of shares (i.e., 7.5 million at an average price of $60). The company currently has 615 million shares outstanding.

What’s Not To Like?

Investors should understand that GIS is one of those consumer staples companies with a rather low gross margin (currently 35.2%). While it ranks in line with its closer peers (KHC, K and MDLZ), more distant peers such as PEP and KO exhibit much stronger margins due to their different business models. Companies such as GIS are thus hit in an above-average manner by increased input costs. On a more positive note, GIS is apparently able to pass on price increases to its customers and also in-store brands are required to adjust their pricing to compensate for increased input costs. Also in this context, GIS’ diversification into the pet food sector is a plus, as spending habits of pet owners suggest (see Mars’ report cited above).

What is also of slight concern is the fact that GIS has been cutting costs not only by conventional measures (e.g., supply chain optimizations, downsizing, working capital improvements) but also by cutting advertisement expenses. Over the past decade, GIS has reduced advertising expense (as a percentage of net sales) from 5.7% to 4.1% (see below). Brand loyalty goes in line with pricing power and hence, it is of crucial importance to direct a sufficient amount of money towards advertising. It might be argued, however, that even though GIS reduced its advertising expenses, the company was still able to grow its top-line by a CAGR of 2% over the last decade. Since GIS has apparently returned to stronger growth recently, I would give management the benefit of the doubt in terms of the observation of a potential under-investment in advertisements.

Source: Author’s own work, based on GIS most recent 10-Ks

Lastly, the competitive nature of the sector GIS operates in should not be underestimated. On the one hand, it is the in-store brands that have lately gained increasing attention. On the other hand, GIS faces intense competition from Kellogg, Kraft Heinz and Mondelez (snacks and ready-to-eat meals) and Colgate-Palmolive (see my recent note), Nestlé and Mars (pet food products and/or snacks). Especially larger competitors (in particular Mars) benefit from better logistics and scaling effects, directly affecting their margins and hence their pricing power.

Investor Takeaway

Taken together, GIS has apparently turned around and is growing, both in terms of sales and free cash flow. The acquisition of Blue Buffalo was a bold step but its integration appears to have worked out and the company has been deleveraging aggressively. The diversification into the pet food sector certainly was a shrewd step by management and is an integral part of my investment thesis in GIS. The COVID-19 pandemic proved to be a tailwind for the company and GIS is managing inflationary headwinds (so far) very well, partly by exercising its pricing power.

In this rather hot market, GIS is one of the remaining value stocks that represent tangible earnings at a reasonable price, a safe dividend and adequate growth prospects. The company has been in turn-around mode for quite some time but these days appear to be gone for good and accordingly, the shares have adopted a more normal - but still attractive - valuation:

Source: Seeking Alpha – selected valuation metrics

Morningstar has assigned GIS a "narrow moat" and a fair value estimate of currently $64. I find this rather conservative and am confident that GIS will adhere to its long-term trend of a share price CAGR of over 9% (see chart below), thus likely outperforming the tech-rich S&P 500 index from today's perspective. This is certainly a bold statement, but the index has recently touched its + 2 RMS deviations boundary and I fully expect it to mean-revert in the next couple of months or years, as the most significant constituents' earnings expectations can only be termed lofty.

Source: Author’s own work, based on weekly adjusted close data for GIS common stock, the colored lines indicate RMSDs from the exponential-fit CAGR.

At the current share price, I consider GIS a good company at a fair price. A share price of $58 constitutes a one RMSD discount to the average share price CAGR and in theory (assuming normally distributed data), such situations occur 32% of the time. A retreat to $50 (i.e., the share price hitting the dark green dashed line) should be viewed as an extraordinary bargain as such situations are typically (again under the assumption of normally distributed data) observed roughly once in twenty years.

My discounted cash flow (DCF) model (equity-based approach, sensitivity analysis below) suggests a fair value of $68 per share upon input of the following parameters:

• starting FCF of $2.4 billion
• terminal growth rate of 2.2%
• cost of equity of 8.0%
• cost of debt of 3.4%
• resulting weighted-average cost of capital of 6.7%
• working capital 15% of net sales, change in working capital and accruals in line with terminal growth
• remaining input based on fiscal 2021 financial statements

Taking the company's net financial debt and the tax-shield effect into account (entity-based adjusted present value), the DCF model yields an even higher estimate of $81 per share.

In summary, I still consider GIS a BUY even in light of the recent up-tick in share price.

Source: Author's own work, based on own estimates and GIS most recent 10-K

Final Note: Thank you for taking the time to read through my article. If you have any comments or criticism to share, I am happy to read from you in the comments section below or via private messaging.

Disclosure: I/we have a beneficial long position in the shares of GIS, CL, NSRGY either through stock ownership, options, or other derivatives. 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.