General Mills More Attractive After Market Overreacts

The challenges plaguing the packaged-food industry have been well documented: an outsize focus on driving efficiencies that have failed to ignite sales; intense competition from branded players, small niche operators, and lower-priced private-label offerings; heightened inflation; and a consolidating retailer base that is struggling to boost traffic.

In light of these pressures, narrow-moat

As such, we think the recent decline in the stock price creates an interesting opportunity for long-term shareholders, particularly income-oriented ones, given the 3.8% dividend yield. The shares now trade more than 10% below our fair value estimate.

While we don’t expect recent headwinds to abate in the near term, we view the company’s strategic initiatives to extract excess costs as a means of funding more effective innovation and marketing as prudent. General Mills targets $700 million in cost savings (around 6% of fiscal 2017 cost of goods sold and operating expenses, similar to peers), which we expect will be funneled to research and development (1.6% of sales over our 10-year forecast) and marketing (more than 5% of sales annually). We forecast the pressure on the top line will persist in fiscal 2017 to the tune of a nearly 2% decline, but we anticipate the combination of innovation and expanded penetration of its fare into its core international markets, which are around one fourth of sales, will lead to 2%-3% total sales growth in the longer term, driven by slightly more benefit from increased volume and the remainder from higher prices and favorable mix.

From a category perspective, yogurt (around 15% of total sales) remains an outsize laggard, with first-quarter sales in the United States tumbling more than 20% on top of a 15% decline in the year-ago period. Over the past few years, efforts to more effectively align new products with evolving consumer trends have failed to yield measurable improvement in the face of intense competitive pressures. However, management qualitatively referenced some modest positives that could suggest these trends are reversing. For one, despite Yoplait Light and Greek 100 remaining out of favor (reflecting consumers’ opting for products they perceive as healthier, as opposed to those that make them feel like they are on a diet), General Mills said its recent launch of Oui by Yoplait is exceeding internal expectations. Given that this product just launched in July, it will take a few more quarters before we can assess whether these gains will prove sustainable. Further, the company referenced distribution wins surrounding its Yoplait Original line, partly due to on-trend innovation, including easier-to-open pouches for Go-Gurt.

Management isn’t letting this innovation speak for itself. Rather, it is touting these launches in front of consumers with marketing efforts. We still believe a heightened focus on brand investment is necessary, and therefore we view the 6% uptick in advertising spending in the first quarter as a plus. In our view, companies throughout the space need to bolster brand spending to withstand competitive pressures and ultimately ensure that their brand intangible assets persist in the longer term. Because we didn’t expect General Mills would be able to turn the corner on its sales trajectory, we see little impetus to alter our long-term outlook, which calls for low-single-digit annual sales growth and operating margins around 20%, about 300 basis points above fiscal 2017.

Valued Retail Partner We assign a narrow economic moat rating to General Mills, resulting from its intangible assets and cost edge. Operating as a leading packaged food manufacturer with around 30% share of the domestic ready-to-eat cereal aisle, 70% share of refrigerated baked goods, and more than 40% share of grain snacks, General Mills is a valued partner for retailers, supporting one aspect of its intangible asset moat source. We believe that with resources to launch new products and then market them to consumers to drive customer traffic, General Mills enhances the stickiness of its retailer relationships. We think trusted manufacturers like General Mills that maintain a product set spanning the grocery store (including cereal, soup, snack bars, and yogurt) are critical to retailers reluctant to risk costly out-of-stocks with unproven suppliers. Despite the bargaining power of a consolidating base of retailers, leading brands--like those in General Mills' portfolio--still drive store traffic, supporting our contention surrounding the advantage resulting from the company's brand intangible asset. Returns on invested capital (including goodwill) have averaged 12% annually over the past 10 years, exceeding our 7% cost of capital estimate, and we think the company can continue to outearn its cost of capital over the next 10 years. However, General Mills falls short of a wide economic moat as it faces intense competitive pressures from lower-priced private-label offerings and other branded players in a space where switching costs are nonexistent for consumers.

Commodity Volatility a Risk Input costs (such as for oats, wheat, corn, soybean, and oil) have proved volatile. For instance, after incurring mid-single-digit cost inflation in fiscal 2011 followed by 10% raw material inflation in fiscal 2012, the company realized 4% higher costs in fiscal 2014 (propped up by dairy inflation) and 2% inflation over the past few years. Offsetting cost pressures with higher prices may hinder sales volume growth if consumers balk at these higher prices--particularly in places where unemployment remains elevated and austerity measures are constraining discretionary spending. In addition, 20% of total revenue is concentrated with Wal-Mart, indicating that General Mills has exposure to retailer consolidation, which could also weaken its pricing power.

General Mills continues to face tough category trends. As an example, cereal consumption remains in decline, falling at a low- to mid-single-digit rate on average over the past several years as consumers have sought out alternatives like yogurt and snack bars, which have posted low- to mid-single-digit growth in the aggregate, far in excess of the less than 1% growth chalked up by center-of-the-store categories overall.

Despite seemingly more favorable category trends, the company’s Achilles’ heel from a product perspective remains U.S. yogurt. Even beyond the stepped-up initiatives by competitors to amass share gains, we think this lagging performance points to the fact that General Mills’ efforts to more effectively align new products with evolving consumer trends have failed to yield measurable improvement.

In a bid to offset lackluster sales, we think General Mills could use its robust cash flow to expand further into the faster-growing natural and organic channel, which claims mid- to high-single-digit growth prospects versus low single digits in center-store categories. We also think General Mills will look to free up resources to extend its distribution in emerging markets like China and Brazil.

Beyond acquisitions, we expect General Mills to reinvest any excess cash in the business or return it to shareholders in the form of higher dividends or additional share repurchases. General Mills has paid a stable or growing dividend to its shareholders for around 120 consecutive years. In addition, it has repurchased about 1% of its shares annually over the past five years. We forecast that it will raise its shareholder dividend at a mid- to high-single-digit rate annually over the next 10 years while also repurchasing 1%-2% of its shares annually between fiscal 2018 and 2027.