General Mills Inc. – "Steady as She Goes"

General Mills Inc. (GIS, Financial) is one of the world's largest producers of branded and unbranded consumer and commercial food products. The company's products are primarily comprised of ready-to-eat cereals; convenient meals, including meal kits, ethnic meals, pizza, soup, frozen breakfast, and frozen entrees; snacks, including grain, fruit and savory snacks, nutrition bars, and frozen hot snacks; yogurt; super-premium ice cream; baking mixes and ingredients; refrigerated and frozen dough; and frozen and shelf-stable vegetables.

The company manufactures its products in 16 countries and markets them in more than 100 countries. In addition, it has 50% interests in two strategic joint ventures through which it markets food products in more than 130 countries worldwide. GIS's primary customers are grocery stores, mass merchandisers, membership stores, natural food chains, drug, dollar and discount chains, commercial and non-commercial foodservice distributors and operators, restaurants, and convenience stores. It generally sells to these customers through its direct sales force. It also has broker and distribution arrangements for certain products and markets. As of May 25, 2014, GIS had approximately 43,000 full- and part-time employees worldwide and generated almost $18 billion in sales. U.S. retail sales accounted for 59% of revenues, international sales accounted for 30% of revenues, convenience stores and food services sales accounted for 11% of revenues.

Purchase considerations and reasons for caution

What we like most about GIS are its phenomenal brand positions. Some of its most well recognized cereal brands include Cheerios, Wheaties, Lucky Charms, Total, and Chex. Other well recognized consumer food product brands include baking mixes such as Betty Crocker and Bisquick, Progresso soups, Green Giant frozen vegetables and mixes, and Nature Valley snack bars. Some other well recognized GIS brands include Hamburger Helper, Pop Secret popcorn, Bugles, Old El Paso, Haagen-Dazs ice cream, Pillsbury dough products, and Yoplait yogurt. The company controls leadership market share positions in most of its product categories.

GIS's brand strength provides it with substantial pricing power and has allowed it to achieve a high rate of inflation pass-through. It has also allowed it to operate very defensively, with net earnings barely impacted during the recession/financial crisis. Recent stability in commodity input prices has provided further margin support. What we also like about GIS are international trends in cereal consumption, with cereal demand expected to rise over the next 5 years by about 5% per year in China, 10% per year in India, and 6% per year in South Africa. We think that GIS is well positioned to benefit from these growth opportunities. We also like management's commitment to rewarding shareholders, with a dividend payout rate of approximately 50% and a steady share repurchase plan.

What concerns us most about GIS is slowing cereal demand in its critical North American market, which is forecasted to decline by about 2.4% annually over the next 5 years. The growing propensity of consumers to switch away from brand name products towards generic substitutes is also a concern, especially given the rapid improvement in the quality of generics over the last decade. We greatly dislike GIS's dependency on Walmart (WMT), which now accounts for 21% of the company's revenues. The consumer foods industry is also highly competitive, with numerous manufacturers of varying sizes in the United States and throughout the world exerting downward pressure on prices.

Financial performance

About $17,910M in revenues moved through GIS's door in 2014. GIS’s revenues for the May 2005 to May 2014 period clocked in at an average annual rate of growth of 5%. Revenues grew at an annual rate of 6% over the last 3 years and by 4% annually over the last 5 years. Year-over-year GIS continues to make substantial sums of money off revenues after subtracting costs of goods sold, with gross profits reaching $6,370M in 2014. Gross profits have grown by 5% per year over the last 10 years and 2% per year over the last 3 years.

GIS's production costs appear well under control, with COGS rising by 5% per year over the last 10 years against revenue growth of 5%. GIS does not appear to be experiencing any difficulties passing on the cost of inflation to consumers. Gross margins have remained stable at about 35% over the last 10 years. The level of gross margins is also reasonably strong. As a general rule, we want to see consistent gross profit margins above 35% for firms in the sector. GIS has been able to meet this requirement in each of the last 10 years. This is, in our opinion, indicative of a firm with a strong competitive advantage and substantial pricing power.

GIS spends about 55% of gross profits on hard costs associated with selling expenses, advertising, management salaries, payrolls, advertising and legal fees. We consider spending about 55% of gross profits on SG&A an acceptable result. Cost of SG&A have also been increasing at a stable rate, rising by 3% per year over the last 3-year and 5-year periods. We consider this a positive sign when viewed against annual revenue growth of 6% and 4% over the same periods respectively.

GIS has shown continued strength and reasonable stability in its operating earnings picture, rising by 2% per year over the last 3 years and by 5% per year over the last 5 years. The long-term trend in operating income has also been upward, rising steadily from $1,900M in 2005 to $2,957 in 2014. GIS has earned on average about 17% in operating earnings on total revenues over the last 10 years –Â a good result. GIS carries a moderate amount of debt on its books and, consequently, pays out about 11% of operating income on interest payments annually. This is higher than desired but aligned with much of the competition.

Bottom line results show a reasonably strong long-term trend in earnings, with minimal volatility, growing at an average annual rate of 4% over the last 10 years. Earnings are expected to tick upwards in 2014 and 2015 as demand for premium brand cereals continues to recover from the financial crisis/recession and the company pushes sales of its 2012 Yoplait acquisition. GIS’s strong competitive position has allowed it to maintain net margins of 11% and 10% over the last 5-year and 10-year periods. We expect to see stable margins from this company moving forward.

Diluted EPS have grown steadily from $1.54 per share in 2005 to $2.83 in 2014. We dislike seeing that earnings growth has lagged revenue growth by 1% per year over the last 10 years and by 6% per year over the last 3 years. For a firm with fairly table margins, this is a sign of earnings quality weakness.

We like that the firm's share-base continues to fall, with diluted shares outstanding declining by about 175M since 2005. GIS's ROE performance has been exceptional, averaging 25% over the last 10 years. Its ROA performance, has been acceptable, averaging 8% over the last 10 years.

Return analysis

Since 2005, GIS has shown an 84% increase in earnings per share –Â never with a losing year, compounding at a rate of 7%. With EPS of $2.83 in 2014 and a market price of $51.50, it can be argued that GIS is producing an initial rate of return of 5.5%. Since 2005, GIS’s book value per share has grown by 39% –Â having a couple of declining years but growing at a compound rate of 3.7%. GIS continues to hold a dividend payout rate of approximately 50%.

To estimate what rate of return we expect to recieve for holding GIS stock:

(1) We use econometric processes to make long-term projections of what the company will be capable of earning;

(2) We estimate a Bear, Bull, and Normal price earnings multiple by which to multiply our projected per share earnings to estimate the stock price 10 years out;

(3) We estimate cumulative dividend payments over the 10 year period; and

(4) We calculate an annual compounding rate of return based on projected dividend payments and the expected stock price.

Based on our econometric projections, we estimate that GIS’s EPS will grow at an annual rate of only about 3.8%. This means that GIS should have per share earnings of $4.10 in 2024 (Figure 1).

Figure 1: High, Low, and Target EPS Projections

What will GIS’s earnings growing at a rate of 3.8% be worth in 10 years? The answer to this question will depend on what P/E multiple the market is using to value the stock in 2024. It is useful to look at the distributional properties of GIS’s historical P/E multiple.

Table 1: Distributional Properties of GIS's P/E Multiple

If GIS trades at Bear multiples, then the market price for the stock in 2024 will be $53.30. If GIS trades at Bull multiples , then the market price will be $77.90. Based on historical data, in normal conditions GIS trades at 17-times earnings. The price of the stock will then be worth $69.70. Bought today at $51.50, GIS would produce a before-tax compound annual rate of return of 3.1% excluding dividends. Assuming dividends remain at current levels, they would generate $17.58 in additional income over the forecast horizon. Added to the price of $69.70, the before tax compound rate of return estimate jumps to 5.4%.

The question that remains is: is a compound annual return of 5.4% sufficient enough to qualify for investment? For existing shareholders perhaps. For us, we will continue to wait for a better entry point.