Thursday, June 30, 2011

General Mills Offers Defensive Growth Prospects




General Mills $GIS is an interesting defensive stock that appears attractive because it offers a few key plus points. I’ve listed a few of them in bullet form below
  • Defensive end markets of food and yogurt
  • Good exposure to lowering commodity prices
  • Strong dividend yield currently around 3%

So is General Mills an attractive stock to buy?
General Mills is ubiquitous name in the US Households through its cereal brands, healthy snacks, ready-made meals (Pillsbury etc), Haagen-Dazs ice cream and Yogurt (Yoplait) offerings. The last of which is growing quicker than the other products and, accordingly, the co is busying acquiring the international business of Yoplait. Next year will be about General Mills increasing pricing in order to benefit from the retention of market share that they fought for (via promotions, discounts etc) in previous years. However, the co is predicting that media spending will track sales growth so the management are unlikely to generate any operating efficiencies there.
This type of stock will always appeal to fund managers and investors because it provides good income and helps balance risk in a long only portfolio. I like the potential for future margin expansion coming from exposure to commodity prices coupled with its defensive nature. Indeed, over the last five years General Mills has grown operating profit every year (CAGR of 7% over the period) and EPS every year (CAGR of 12% over the period).

General Mills Q4 and Full Year Results
General Mills recently gave results and they were pretty good, however the outlook was weaker than the company had previously forecast. The good news is that the market had largely priced this in because the main cause is commodity price inflation. All of which suggests that if these prices continue to moderate-in line with the tightening attempts in many emerging markets-that General Mills could see some ‘upside surprise’ to gross margins. I’ve outlined historical cost inflation and gross margins for General Mills below

General Mills Estimates(%)200720082009201020112012
Input Cost Inflation479-3410 to 11
Gross Margins35.935.136.439.739.4Lower

It is easy to see the inverse relationship between gross margins and input cost pressures. Moreover, this year’s cost inflation push is even more pervasive because commodities are up across the board and from relatively weaker comparables. In fact, the company is predicting lower gross margins as well as a low adjusted EPS growth of only 5% for next year.
Delving deeper into the results reveals that US retail sales were down 2% but international sales (constant currency) were up 16% respectively. This should provide little succour to shareholders because US retail sales still make up over 76% of segmental operating profits but international is only 10.7%. US retail sales were down but this is largely due to less price discounting and promotions. Accordingly, overall, full year operating margins expanded from 15.1% in 2010 to 16.6% in 2011.

General Mills Evaluation
Listening to the conference call, the management are predicting a tough time in 2012 and, gross margins are seen as being lower. Similarly, the forecast adjusted EPS growth of 5% (261c from 248c) is not particularly attractive. However, I think the co could beat this guidance with lower commodity costs; however, my concerns are with the stock’s evaluation and sales growth.
At $37.26 General Mills has a market cap of $23.81bn and an EV of $30.17bn which, in my opinion, is a bit rich for a company which has generated $878m in free cash flow. In addition, the co is forecasting $670m in capital spending next year against $649m in 2011. Given that EPS is predicted to rise by 5% only, then this suggests that next year’s free cash flow generation could be similar to this year’s. A forward PE of (37.26/2.61)=14.3x and FCF/EV of around 3.2% is not particularly exciting for a company with low single digit sales and EPS growth.
In addition, the free cash flow barely covers the dividend which suggests that long term dividend growth will be tough for General Mills. I think there are better ways to play a correction in commodity prices. The bulk of General Mills products are hardly high growth so whilst it is a fine investment for investment managers looking to park cash in a defensive manner, it will not attract GARP focused investors. I took a pass.