Narrow-Moat General Mills Is Managing Industry Challenges Admirably, but Shares Fully Valued | GIS Message Board Posts

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Msg  81 of 91  at  12/22/2021 7:30:53 PM  by


Narrow-Moat General Mills Is Managing Industry Challenges Admirably, but Shares Fully Valued

Morningstar Investment Research Center
Narrow-Moat General Mills Is Managing Industry Challenges Admirably, but Shares Fully Valued 
Rebecca Scheuneman
Equity Analyst
Analyst Note | by Rebecca Scheuneman Updated Dec 21, 2021

Inflation and supply chain disruption continued to plague General Mills in its fiscal 2022 second quarter, causing North American shipments to lag consumer demand by 2 points. As in the first quarter, service levels were in the mid-80s, well below the high-90s typically realized. Even so, we think the company is managing the challenges admirably, with its U.S. on-shelf availability at 94.2%, compared with the 92.8% category average, per Nielsen. General Mills’ second-quarter organic sales rose 5%, entirely driven by increases in price/mix. Volumes were flat as lower retail food units were offset by a recovery in food service and strong pet food demand. Adjusted gross and operating margins contracted 330 and 200 basis points, respectively, to 32.2% and 16.3% as price/mix benefits and cost savings were more than offset by inflation and inefficiencies from supply chain disruptions.

We plan a mid-single-digit percentage increase to our $64 fair value estimate, as further price increases should more than offset the $500 million in incremental cost headwinds management has identified since the beginning of the fiscal year. Specifically, we plan to increase our fiscal 2022 organic sales forecast to 4.7% from flat previously, as another round of price increases will hit shelves in January (on top of the 9.4% increase in General Mills’ U.S. average unit retail price realized in November). Volumes are holding up well in the face of these increases, given the firm’s strong brands (which underpins its narrow moat) and similar price increases from competitors. That said, we’re lowering our fiscal 2022 gross margin by 100 basis points to 33.5%, given ongoing supply chain disruption, although profit margins should recover in the next few years as the labor market normalizes. Despite the 4% pullback in the shares, the stock appears fully valued and we suggest investors consider wide-moat Kellogg instead, which trades at a 25% discount to our $85 fair value estimate.

Business Strategy and Outlook | by Rebecca Scheuneman Updated Dec 22, 2021

As at-home food consumption remains elevated during the pandemic, consumers are finding favor with General Mills' offerings, as shown by increases in household penetration and repeat purchase rates in most categories. Even so, we expect this lift will largely be temporary, with consumers gradually returning to activities outside of the home, returning away-from-home food expenditures to half, as it was prior to the pandemic. But we do expect a lasting benefit for General Mills' pet food business, given the high-single-digit increase in pet adoptions during the crisis.

General Mills has earned a narrow moat rating for its preferred status with retailers, strong brand equities, and cost edge. The firm is the market leader in cereal, dessert mixes, refrigerated dough, and natural pet food and is number two in snack bars and soup. In fiscal 2021, the firm gained or maintained share in all five of its global platforms and its brands continue to command price premiums. These strong brands have resulted in solid relationships with retail partners and a scale-based cost advantage, and we think the brands' pricing power will allow the firm to pass through the current inflation.

Even so, due to evolving nutritional preferences, consumers have been shifting from processed fare to fresh, natural options, causing General Mills’ categories to slow. In response, the firm laid out its Accelerate strategy in 2021, which calls for the company to overhaul its marketing and innovation processes. Specifically, the firm will shift media investments to digital formats to better align with consumer media consumption, it will launch bolder innovations with a faster speed to market, it will be a force for good--with purpose-driven brands--and it will invest in data analytics (leveraging proprietary data from its Box Tops program and brand websites) to drive growth. Further, the firm will reshape its portfolio by divesting 5% of sales that dilute growth and will acquire growing businesses that strengthen its five global platforms (cereal, pet, ice cream, snack bars, Mexican) or its positioning in its eight core markets (U.S., Canada, France, U.K., Australia, China, Brazil, and India).

Economic Moat | by Rebecca Scheuneman Updated Dec 22, 2021

We believe General Mills possesses a competitive edge stemming from its strong brand equities, preferred status with its retail partners, which allows the firm to secure valuable shelf space, and a cost advantage. We think these advantages will allow the firm to report economic profits (ROIC in excess of the firm's cost of capital) for at least the next 10 years, as generally required to secure a narrow moat rating.

General Mills dominates many of the categories in which it competes, which is a testament to the strength of its brand intangible assets and enables its preferred status with its retail partners, as we estimate the firm is a major player in categories representing over one third of retailers’ food sales. General Mills has the number-one or -two brand in categories that represent the majority of its revenue. In the U.S., where General Mills realized 75% of fiscal 2021 revenue, it has the dominant cereal brand in the highly fragmented ready-to-eat cereal category, Cheerios, with 11.5% share in calendar 2020 per Euromonitor. By company, General Mills holds 31.1% share, essentially tied with wide-moat Kellogg's 31.3% share. Cereal is one of the firm’s largest categories, representing 16% of fiscal 2021 revenue. General Mills is also the leader in dessert mixes (9% of revenue). According to Euromonitor, General Mills' Betty Crocker brand held the number-two spot with 16.7% share in 2020, narrowly behind number-one Jell-O's 16.9% (owned by no-moat Kraft Heinz). But Betty Crocker is the top-selling cake mix brand, ahead of no-moat Conagra's Duncan Hines, with 12.2% share. Similarly, General Mills’ Pillsbury brand dominates refrigerated and frozen dough (10% of sales) with 52.5% share, significantly ahead of private brands’ 16.8% share and wide-moat Nestle’s 11.6% share. For snack bars (we estimate 18% of revenue), General Mills is a top player, with Nature Valley holding the number-two spot with 11.4% share according to Euromonitor, lagging Clif Bar’s 12.9% share. General Mills also holds the seventh spot with Larabar (2.7% share). According to the firm, the BLUE brand (10% of sales) is the number-one brand (and 3 times larger than the number-two brand) in the wholesome natural segment of the pet food category, a segment representing 20% of the broader pet food category but growing significantly faster. The firm’s Progresso brand (we estimate 3% of sales) holds the number-two spot in the shelf-stable soup category with 19.0% share per Euromonitor, after Campbell’s 49.0%.

We think General Mills has adequately supported its brand intangible assets, spending about 5% of revenue on marketing and research and development over the past five years, generally in line with peers. We expect this to move modestly higher over the next few years, in line with management commentary and our expectations for the industry overall. We think these investments will help to ensure the firm continues to develop products that meet the needs of ever-changing consumer preferences and provide for adequate consumer awareness. While brand investment does not always lead to consumer-winning innovation, we believe that it does support the firm’s retail relationships, as product news generally helps drive traffic into retail outlets.

While General Mills has experienced many brand victories, its Yoplait brand has struggled. Over the past decade, the firm was slow to respond to consumers’ growing preference for Greek yogurt, and Yoplait lost significant market share. In 2011, Yoplait was the number-two brand in yogurt, maintaining 29.2% share according to Euromonitor, right behind Dannon’s 30.3%, and well ahead of number-three Chobani’s 13.0%. However, by 2020, Chobani’s share had grown to 19.1%, driven by its dominance in Greek yogurt, and Yoplait’s share had fallen to 14.4%. Although Yoplait’s market share stabilized in the last few years, pricing power appears to be permanently impaired, with the brand selling for $0.08 per ounce compared with $0.24 for the equivalent Dannon product and $0.19 for a comparable Chobani option. This example highlights a broader risk for General Mills: An evolving retail landscape has lowered barriers to entry for smaller upstart brands. The prevalence of e-commerce has eliminated the need to secure expensive shelf space from retailers, and social media has made it more cost-effective to reach consumers with a brand message.

In light of these challenges, General Mills has made some important changes to help protect its brands. First, it has developed a new go-to-market process that dramatically cuts the time it takes to launch new products, from over a year to a matter of months. The firm is further improving its speed to market in fiscal 2022, shortening the time frame to a matter of weeks. This should help the firm respond more quickly so it more effectively responds to emerging trends. Second, it has invested significantly in online capabilities such as e-commerce, websites, digital marketing, social media, and mobile platforms. These initiatives have paid off, with General Mills reporting higher market shares online than in its brick-and-mortar locations. We think this speaks volumes about its digital capabilities, as e-commerce has a more level playing field across the competitive landscape compared with the brick-and-mortar channel, where the firm’s preferred status with retailers brings access to shelf space that smaller players cannot easily secure. While necessary, we aren’t convinced that these efforts will be enough to entirely insulate General Mills from heightened competition.

Consumers have been shifting away from highly processed fare toward more natural selections. General Mills has responded by reformulating products to include organic ingredients, simple ingredients, non-GMO, or gluten-free options, or to eliminate artificial colors and flavors. In addition, it has acquired several organic and natural brands such as Cascadian Farm, Larabar, Food Should Taste Good, Annie’s, and BLUE pet food. While organic products tend to realize a higher rate of revenue growth as they benefit from this secular trend, we do not believe that organic status guarantees a moat. We argue that building brand equity requires significant investments in research and development and marketing to ensure the products continue to offer consumers compelling benefits and maintain sufficient consumer awareness. While brand proliferation in the cereal and snacking categories makes dominance challenging, we believe General Mills has earned a moat in the natural pet food segment, where its BLUE brand has number-one market share, pricing power, and returns in excess of our estimate of the firm’s cost of capital.

In addition to its intangible assets, we think General Mills maintains a cost advantage rooted in economies of scale. We contend that its large production volume, given its market-leading positions, allows the firm to leverage its fixed costs over a large revenue base, providing greater supply chain efficiency. Although gross margins are affected by several factors, including category mix and pricing power, they are also an indication of operating efficiency. General Mills consistently reports gross margins in the mid-30s, in line with other broad-based, multiple-category moaty packaged food companies and above the 20%-30% reported by most narrow-moat and no-moat competitors. Furthermore, we think the firm’s scale allows it to better leverage brand investments, such as marketing and research and development expenditures. We expect the firm to spend over $700 million each year on advertising and media, which provides buying power over smaller peers, also contributing to its cost advantage. We awarded the Blue Buffalo company a narrow economic moat (as opposed to wide) as a stand-alone firm because it maintained brand intangible assets but not a cost advantage. However, as part of the General Mills portfolio, the Blue Buffalo business has an efficient operating and distribution system as well as a leveraged corporate, marketing, and research and development organization. This cost advantage solidifies our conviction that the firm’s pet food operation will sustain its edge for at least 10 years, which secures this segment's narrow moat in our framework.

As further evidence of its competitive edge, General Mills consistently reports ROIC well in excess of our 6% estimate of its weighted average cost of capital. Excluding fiscal 2018, when firm carried the capital for the acquired Blue Buffalo business on its balance sheet but none of the revenue and profits, General Mills’ ROIC including goodwill ranged from 9% to 14%. We forecast ROIC of 10%-13% over the next 10 years.

Fair Value and Profit Drivers | by Rebecca Scheuneman Updated Dec 22, 2021

After General Mills’ second-quarter results, we have increased our fair value estimate to $67 from $64 to account for higher fiscal 2022 organic sales (to 5% growth from flat) given another round of price increases, partially offset by a 100-basis-point drop in fiscal 2022's gross margin to 33.5%, with ongoing supply chain disruption. Our valuation implies fiscal 2023 price/adjusted earnings of 16 and enterprise value/adjusted EBITDA of 13.5.

For fiscal 2022, we now expect 5% organic sales growth, driven by a 6% lift in price/mix and a 1% drop in volumes, as consumers return to eating away from home. Over the long term, we expect 2% consolidated organic sales growth, driven by low-single-digit growth in its packaged food segments and 9% average annual 10-year growth for pet food, as the BLUE brand continues to expand its offerings beyond its foundational dry dog food lineup. Our forecast exceeds the flat organic sales General Mills realized in the five years preceding the pandemic, primarily due to the actions the firm has taken to reshape its portfolio (the acquisitions of Blue Buffalo and Tyson's dog treat business and the sale of its yogurt businesses in several international markets).

In the next 10 years, we expect operating margins to increase from 2021’s 17.4% to 19%, driven primarily by improvements in the international segments. As these businesses scale, we expect operating margins will increase from midsingle digits to high single/low double digits over the next decade. We also expect operating margins will recover in the food-service segment from 17.6% in fiscal 2021 (down from 21.3% in 2019 due to the pandemic) to 22% by 2031. We’re holding our long-term gross margin forecast at 36% (an increase from the 35% three-year average, reflecting improved price/mix and cost-saving efforts from its holistic margin management program). We expect advertising expense to increase from last year's 4% of revenue to 5% over the next decade and research and development to hold at 1.3% of sales, in line with other leading operators. Increased investments in marketing and data analytics are being funded with cuts in general and administrative expenses, with global headcount reduction programs being rolled out in calendar 2021. SG&A as a percentage of sales should fall from 8.7% in fiscal 2021 to 7.4% by 2028. Our model continues to reflect our expectations that the U.S. corporate tax rate will increase to 26% from 21% beginning in calendar 2022.

Risk and Uncertainty | by Rebecca Scheuneman Updated Dec 22, 2021

We think the primary risk General Mills faces is the secular headwinds from evolving consumer nutritional preferences toward unprocessed fare, which is pressuring growth for the majority of General Mills’ portfolio. Even for categories not facing these headwinds (such as yogurt), General Mills’ Yoplait brand has lost significant share as it was late to respond to the shift to Greek yogurt, although now this trend is reversing and General Mills’ share in yogurt has stabilized. For General Mills’ largest three categories--snacks (20%), cereal (16%), and convenient meals (17%)--the firm has repositioned the portfolio to offer organic brands (Annie’s and Cascadian Farm, for example), simple ingredients (Larabar), gluten-free (Cheerios, Chex), and products eliminating GMOs or artificial colors and flavors (several brands). While these efforts helped the firm to maintain or gain share in most of their categories, these categories are losing share of overall food spending. In response, General Mills has increasingly relied on acquisitions to drive growth. The fiscal 2018 Blue Buffalo acquisition seems to be benefiting from General Mills’ relationships in the food, drug, and mass channel, as the products have been expanded there. Even so, transactions of this size (a purchase price of $8 billion) can limit balance sheet flexibility for future deals and may strain company resources and distract management attention from time to time.

Outside of questions regarding the healthfulness of its products, which is captured in our model's modest sales growth, General Mills' other environmental, social, and governance risks (food safety, resource use, human rights in the agriculture supply chain) are well managed, as the firm has one of the most proactive ESG strategies in the packaged food industry.

Capital Allocation | by Rebecca Scheuneman Updated Dec 22, 2021

We rate General Mills’ capital allocation actions as Standard under the current leadership team. CEO and chairman Jeffrey Harmening joined the firm in 1994 and has served in various roles, including COO of the U.S. retail segment beginning in 2014, COO of the company in 2016, and CEO in June 2017. He was named chairman of the board in January 2018. The business has performed well under his leadership. When he took the reins, the business was losing market share in seven of its 10 largest categories; under his leadership, the trend has reversed, with the firm gaining share in most of its categories in recent years.

Given the lackluster growth across most of its categories, the firm uses acquisitions and divestitures to reposition the portfolio. But given General Mills' large sales base, it is difficult for the firm to secure assets sizable enough to impact the firm's consolidated sales growth. In October 2014, General Mills purchased Annie’s for $828 million, paying 29 times trailing EBITDA--a steep price but not unreasonable, given the business’ 12% revenue compound annual growth rate heading into the deal. However, we are unconvinced that the business has meaningfully improved General Mills' positioning, as the firm's consolidated organic revenue growth remained flat for the five years preceding the pandemic. The brand still has not reached $1 billion, indicating it is less than 5% of revenue, and we therefore think it is insufficient to move the needle on the firm’s large revenue base. In April 2018, General Mills purchased The Blue Buffalo Co. for $8 billion, paying 22 times adjusted EBITDA including synergies. This business, reporting $1.3 billion in revenue before the acquisition, is material enough to affect the consolidated revenue trajectory, and we expect growth to improve to a low-single-digit clip. However, the transaction is also sizable enough to affect ROIC. Given the large goodwill component included in the transaction, the firm’s ROIC including goodwill dropped from 13.6% in 2017 to an 8.9% average for the four years since the deal. We expect ROIC to gradually climb to 13% over the next decade, but nonetheless, this narrows the margin the firm has to report economic profits (ROICs in excess of our 6% estimate of the firm's cost of capital), quantitative evidence of a competitive advantage, in our view. This was one of the factors in our decision to revise our moat rating from wide to narrow, as it reduces our conviction in the firm’s ability to report economic profits for the next 20 years. In July 2021 General Mills purchased Tyson's pet treat business for $1.2 billion, representing 4 times sales after tax benefits, above the 3 times four-year average for packaged food deals, but a fair price in our view given the business' three-year average annual sales growth of nearly 20%. The deal represents about 1.5% of sales, and is insufficient to improve General Mills' sales trajectory on its own, but in time General Mills intends to divest 5% of its sales that are dilutive to growth, which should help further improve its growth rate. On this front, in November it exchanged its 51% stake in the European yogurt business (which has been a 25 basis point drag on annual sales the last three years) for Sodiaal's 49% stake in the Canadian yogurt business and reduced royalty fees. Further, in 2022 it will sell its European dough business for an undisclosed sum, which has also diluted sales growth. We expect more divestitures to follow, which should include brands outside of its five focus platforms (cereal, pet, ice cream, snack bars, Mexican) and excluding its local gem brands (Pillsbury, Annies, Yoplait, Totinos, Wachai Ferry, Yoki, and Kitano).

General Mills has a sound balance sheet, and in fiscal 2021 its net debt to adjusted EBITDA fell below 3 times for the first time since the 2018 Blue Buffalo acquisition, removing debt reduction as a top priority for cash. We expect this ratio will average a manageable 2.4 times over the next five years (excluding unannounced acquisitions and divestitures). The firm spends 3%-4% of sales on capital expenditures annually and should return a significant amount of cash to shareholders. General Mills pays out over half of its earnings as dividends, which we expect it will continue to do. While the firm refrained from share repurchases the last few years as it focused on reducing debt acquired to fund the Blue Buffalo acquisition, repurchases resumed in fiscal 2021, and we expect the firm will buy less than 1% to 3% of shares on average annually thereafter, barring additional acquisitions.


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