Wednesday, January 9, 2013

General Mills Equity Research Analysis

It’s been a tough couple of years for the US food sector, but slowly things are starting to get better. For example, General Mills (NYSE: GIS) reported a pretty decent set of results despite ongoing challenges. I’m not the biggest fan of the stock but if you can generate operating profit growth from lower inflationary costs, then why care if organic growth remains difficult? General Mills remains a stable yield play. It’s not the sexiest stock out there but it serves a purpose as a proxy for low government bond yields. It could go on doing that long after skeptics like me have given up wondering why anyone is buying long-dated US debt at these yields.

How General Mills and Other Food Companies Played 2012

Management declared that the results were ahead of internal expectations, and full year guidance was raised in line with market estimates to $2.65-$2.67. In essence GIS is seeing pretty much what everyone else in the food sector is seeing.  Companies like Heinz (NYSE: HNZ) and Campbell Soup (NYSE: CPB) are finding growth hard to come by in the US  (the mass consumer remains muted and price conscious while sales channels are shifting in importance towards the discount stores), but  within emerging markets there are good growth prospects.

The big idea of 2012 has been to try to stabilize market share in the developed world while trying to expand in emerging markets. This argument also applies to the fast food companies like Yum! Brands (NYSE: YUM) and McDonald's (NYSE: MCD). Unfortunately the fast food companies have seen some disappointing numbers with growth in China recently, which were presaged in an article linked here. Nonetheless, there seems to be no let up in their intent to expand stores in China. They better hope for a rebound in growth in China! McDonald's has been weak in China for a while now and it's hard to share Yum's belief that things will snap back.

As for the food companies, things appear to be fine for now, although I would caution over Heinz’s expected growth from baby nutrition. This is a very competitive market right now. In addition, Campbell Soup's performance continues to disappoint. Soup appears to be a difficult category right now, and Campbell and Heinz must be hoping for a cold winter.

General Mills, Generally Okay

All of which leads me back to GIS because the food companies look like a better bet going forward. They are also less exposed than the food retailers are to the kind of tit for tat cultural boycotting that can take place when trade wars erupt. If you think I am being alarmist then I suggest you take a look at what’s happening with China and Japan. Japanese consumer electronics companies are seeing slower sales right now due to political friction. We are still not rocking in a totally free world.

GIS continues its path of acquisition-led growth with the addition of Yoki and Yoplait contributing 4 points of the 6% increase in net sales in the quarter. The other big story with these results is how lower input costs helped margins in the US Retail and Bakeries & Foodservice segments.

This chart tells the tale of the quarter.

The big increase in international sales was due to the acquisition mentioned earlier, and the big increase in operating profits in the other two divisions was thanks to margin improvements. Within the largest segment (US Retail) there were continued declines in net sales for Yoplait yogurt (-5%) and its breakfast division, which it calls ‘Big G’ (-2%), while snacks and Small Planet Foods recorded 15% and 30% sales growth respectively. This is somewhat of a concern because GIS is trying to stabilize sales in yogurt and cereals.

I’ve broken out operating profits to demonstrate the importance of US Retail.

It’s clear that GIS’ fortunes will remain tied to what it does in the US. Conditions are improving but, for now, profitability will be guided by where commodity prices for things like wheat and corn go.

Where Next for General Mills?

In conclusion, input costs are expected to rise in the second half following the drought in the US, and this means the kind of profit increase generated in the first half will not be matched. Consequently GIS is forecasting mid-single digit growth in both earnings and revenues, much of which is coming from acquisitions.  Organic growth looks to be quite low, and there are still concerns with the core yogurt and cereal categories. Is all of this enough to justify a PE of 16 and an EV/EBITDA multiple of around 10?

For me the answer is no, but then again I’m not the market and the market is saying that it wants a stable yield payer like GIS right now. I get my yield fix from large cap pharma because I think stocks in the sector are undervalued, but its hard to argue that GIS is

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