General Mills (GIS): A High Quality Dividend Stock Changing With the Times

The branded food manufacturing industry is experiencing meaningful change as consumers’ health consciousness and eating habits evolve, impacting all of the major players including General Mills (GIS).

 

Several of GIS’s major product categories, such as cereal, have seen growth decline in recent years, weighing on the stock’s performance. Like many of its peers, GIS is shifting its mix to better align with new consumer trends that could shape the market for the next several decades.

 

We believe in GIS’s business strategy, financial strength, and high quality dividend. For these reasons and more, GIS is a holding in our Conservative Retirees dividend portfolio.

 

Business Overview

GIS maintains a diversified sales mix of packaged meals, cereal, snacks, baking products, yogurt, and more. The company’s key brands include Cheerios, Yoplait, Pillsbury, Totino’s, Nature Valley, FiberOne, and Annie’s.

 

While natural and organic food accounted for less than 5% of total revenue last year, GIS is the third largest organic food manufacturer in the U.S. today and seeks to increase the size of this business by nearly 50% over the next five years. By product category, cereal accounted for 20% of sales last year, snacks 18%, yogurt 16%, convenient meals 15%, super-premium ice cream 5%, dough 10%, baking mixes 10%, vegetables 5%, and other products contributed 1%.

 

GIS primarily sells its products to large retailers such as Walmart (21% of sales), and 71% of its sales last year were made in the U.S. The company has about 690 SKUs per store and has been expanding its product categories organically and via acquisition.

 

Business Segments

U.S. Retail (60% of sales, 71% of profit): sells meals (25% of U.S Retail sales), cereals (22%), snacks (20%), baking products (19%), and yogurt and other products (13%) to a number of grocery stores, mass merchandisers, dollar stores, natural food chains, and other retailers.

International (29% of sales, 17% of profit): consists of retail and foodservice business outside of the U.S. The product categories are mostly the same as the U.S. retail business. Europe is the largest region at 41% of International segment sales, followed by Canada (22%), Asia Pacific (20%), and Latin America (17%).

Convenience Stores & Foodservice (11% of sales, 12% of profit): GIS sells its products in this segment through many channels including foodservice, convenience stores, vending, and supermarket bakeries.

 

Business Analysis

GIS and its predecessors have been around for well over 100 years. Compared to newer companies, GIS benefits from its scale, long-standing distribution relationships, entrenched brands, and decades of marketing spend.

 

With almost any consumer product, marketing and product innovation are keys to long-term success. GIS can outspend smaller players when it comes to marketing campaigns to ensure its products remain in the forefront of consumers’ minds. GIS spent more than $820 million last year on advertising and media to protect the brand value of its products. In addition to customer loyalty, these investments help GIS more easily pass on input cost increases during years of higher commodity prices.

 

When you start to add up the total dollars GIS has invested in marketing over the last several decades, it quickly becomes daunting to think about winning over consumers to your new brand. This spending has helped GIS maintain strong market share in categories such as cereal, where some of its brands have been in place for more than 50 years:

 

 

Similar to what we noted in our analysis of Kimberly-Clark, GIS’s retail customers also have little incentive to try out products from new competitors as long as GIS’s products are selling well. According to Nielsen data, a whopping 85% of consumer packaged goods that launch in the U.S. today will fail within two years. It’s no surprise retailers are reluctant to displace mainstay brands.

 

Given the high failure rate of new products, GIS’s existing portfolio of successful brands is even more valuable. The company’s product diversification and financial strength allow it to maintain its lead and continue experimenting. Few companies have the luxury to invest nearly $230 million in R&D each year like GIS did during its 2015 fiscal year.

 

As we pointed out earlier, GIS is also well diversified by product category, with cereal representing its biggest group at 22% of sales last year. As consumer trends unexpectedly change, GIS is somewhat hedged by playing in so many different ways. When one category changes directions and requires new R&D and marketing investment, another is likely playing to GIS’s existing strengths.

 

While GIS might be late to catch on to certain consumer trends, its product diversification, financial firepower, and distribution relationships ensure that it can evolve to remain relevant for years to come. Introducing Greek yogurt and gluten-free cereals are two examples of recent trends GIS has successfully followed.

 

The company’s size can cause strategic shifts to take longer to impact overall sales mix. In these instances, GIS has not hesitated to acquire its way into faster-growing markets or divest declining businesses to sharpen its focus.

 

The company announced an agreement to sell its struggling Green Giant brand (frozen vegetables; 4% of GIS’s overall sales) for $765 million earlier this year, and it meaningfully extended its reach in the natural and organics space with its $820 million acquisition of Annie’s last year. With U.S. industry sales for natural and organic foods growing at a double-digit rate, it’s no surprise GIS wants to continue growing its share in this category (GIS claims to be the third largest natural and organic food manufacturer in the U.S. today).

 

When GIS acquires other product lines or develops new products, it also benefits compared to smaller players because it can plug these new products into its global distribution channels to get them selling faster. For example, the Annie’s business only had 30% national distribution with its top 33 SKUs. GIS is growing that business’s distribution at a double-digit clip to quickly expand the brand.

 

From a productivity standpoint, GIS has a company-wide initiative known as Holistic Margin Management (HMM), which it uses to combat the 4-5% annual input cost inflation it typically faces. HMM relies on productivity savings, mix management, and price realization to protect gross margins. HMM has generated over $2 billion in cost of goods sold savings since 2010 and has kept gross margins relatively stable over the past eight years.

 

The company took additional actions last year to streamline its North American supply chain and increase its organizational effectiveness. These initiatives are expected to generate several hundred million dollars in cost savings over the next year.

 

Altogether, the company’s large market share, entrenched brands, large marketing and R&D budgets, financial flexibility, long-standing distribution relationships, and product diversification create a strong moat. We can see that GIS has maintained a strong and steady return on invested capital over the last decade:

 

 

As long as GIS is able to continue adapting to changing consumer preferences by introducing relevant new products and pursuing appropriate marketing campaigns, the company will maintain its strong staying power.

 

Key Risks

Consumer tastes and preferences always seem to be changing. Some turn out to be fads, while others can shape demand trends for years to come.

 

Consumers are increasingly interested in natural, healthier foods that contain more protein, fiber, and whole grains. Many are becoming more aware of what they are eating and are turning away from things like gluten, carbs, and artificial ingredients.

 

While your guess is as good as ours, we think this trend is here to stay. As such, it has caused many of the major packaged foods players to scramble. While most food categories are slower-moving in nature, the pace of change can unexpectedly accelerate.

 

Take Greek yogurt, for example. In the mid-2000s, Greek yogurt practically didn’t exist in grocery stores. Today, it accounts for more than one in three yogurt sales and has taken substantial market share from traditional yogurts. With such strong growth, many new players were also attracted to the industry.

 

GIS largely missed the Greek yogurt trend and had to play catch-up. While GIS’s yogurt business is performing well today (7% retail sales growth and nearly 1% market share gain in fiscal 2015), it caused plenty of concerns several years ago. New categories can also result in lower prices and increased marketing costs to defend shelf space, pressuring earnings.

 

The bigger concern that has weighed on GIS over the last few years is cereal. According to consumer research firm NPD Group, cereal consumption peaked in the mid-1990s. While GIS doesn’t break out profit by product, cereal was its biggest sales category (22% of fiscal 2015 revenue) and could be an even larger profit contributor.

 

Many of GIS’s famous cereal brands such as Cinnamon Toast Crunch and Trix are facing headwinds on two primary fronts. First, as previously mentioned, consumers are becoming more health conscious about what they are eating. Second, the breakfast category itself is becoming increasingly fragmented – Greek yogurts, breakfast bars, fast-food sandwiches, and more. With so many choices, on-the-go consumers are sitting down less for a bowl of cereal. When they do, they are opting more for healthier options like granola instead of a sugary bowl of Lucky Charms. Bloomberg wrote an excellent article highlighting the cereal challenges faced by Kellogg and GIS. You can read it here.

 

GIS is doing its best to align more of its product mix with healthier trends, but it is certainly a risk the company faces given its legacy in many products far from the “healthier” category of packaged foods. All GIS cereals will be free of high fructose corn syrup, artificial colors, and artificial flavors by 2017. The company also continues launching gluten-free cereals, with its famous Cheerios brand launching gluten-free this fall.

 

The diversity of GIS’s product portfolio also helps – snack sales are strong, and international growth (excluding currency movements) remains solid. The company continues launching hundreds of new products each year and will be able to leverage Annie’s organic expertise across existing brands.

 

As seen below, U.S. cereal retail sales have shown an improving trend over the last five quarters. GIS’s U.S. retail sales grew nearly 4% last quarter on improvement in its cereal business and new Annie’s products. Perhaps the worst is over.

 

 

Looking out longer-term, Each of GIS’s main product categories are also projected to record decent growth over the next five years:

 

 

Overall, we don’t view changing food preferences as a life-threatening risk to GIS. The company has the funding, brands, talent, distribution, and marketing to successfully enter numerous categories with relevant products over the coming years, and its legacy brands will continue attracting a large group of loyal customers.

 

GIS could encounter rough patches like it has the last few years with cereal as concerns come and go about different product categories, but we think the company has more than enough resources to play catch up and adapt as needed. Input cost volatility and foreign currency fluctuations are also risks, but they should have no bearing on GIS’s long-term profitability.

 

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. GIS’s long-term dividend and fundamental data charts can all be seen by clicking here and support the following analysis.

 

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

GIS recorded an excellent dividend Safety Score of 98, suggesting its current dividend payment is one of the safest available in the market. The company’s moderate payout ratios, consistent cash flow generation, recession-proof products, and wide moat support the favorable ranking.

 

Over the last 12 months, GIS’s dividend has consumed 82% of the company’s “as reported” earnings and 57% of its free cash flow. We prefer to use the free cash flow payout ratio because it is less noisy than earnings. GIS’s 57% payout is attractive, especially considering the stability of the packaged food business.

 

Looking at longer-term trends in payout ratios can also be helpful to see if growth in earnings per share has kept up with dividend growth. As seen below, GIS’s payout ratios have been pretty consistent in the 40-60% range, providing plenty of safety and room for growth in years ahead.

 

 

For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. GIS’s reported sales actually grew every year during the recession, and reported earnings never declined. Talk about a resilient business!

 

 

Thinking longer-term about growth, we believe management’s low single-digit sales growth target is reasonable. For one thing, it is in line with the company’s historical growth. More importantly, GIS’s key product categories are expanding, and the company has the resources to adapt to changing consumer tastes.

 

High quality companies are able to generate free cash flow year in and year out. Rising cash flow is important because it supports continued dividend growth without expanding the payout ratio. As seen below, GIS has generated very consistent free cash flow in each of the past 10 years.

 

 

While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during recessionary conditions help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well.

 

Companies with high amounts of debt, cyclical business operations, and inconsistent cash flow generation could find themselves in a cash crunch if demand unexpectedly weakens and they have overextended themselves. They will always cut the dividend before missing a debt payment, so monitoring cash and debt levels is important.

 

Looking at the chart below, we can see that GIS has increased its debt to capital ratio over the last decade to hit 59% in fiscal 2015. We typically prefer for companies to keep their debt to capital ratio no higher than 50%, but companies with more predictable cash flows such as GIS and other packaged food manufacturers can comfortably extend a reasonable amount beyond that mark.

 

 

Taking a closer look at the balance sheet, we can see that GIS has about $8.6 billion in debt compared to $451 million in cash on hand. The company’s net debt (total debt less cash) is equal to about 3.7x its earnings before interest and taxes. While we aren’t huge fans of debt, it doesn’t appear that GIS has overextended itself given the stability of its earnings. However, we wouldn’t mind if management started to reduce debt levels a bit to provide flexibility for additional M&A or strategic investments as consumer tastes inevitably evolve over the coming years.

 

 

GIS’s dividend is extremely safe, suggesting the stock is a reasonable candidate for investors living off dividends in retirement to consider.

 

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

GIS’s Growth Score is 70, meaning its dividend’s growth potential ranks above average. While GIS is surprisingly not on the list of dividend aristocrats (yet), the company and its predecessors have paid dividends without interruption or reduction for more than 115 years, an amazing accomplishment.

 

As seen below, GIS has recorded solid dividend growth over the last decade. The company expects to increase its dividend as its earnings grow. Assuming earnings can grow at management’s stated objective in the high-single digits, it seems reasonable for annual dividend growth to remain in the 7-10% range as well. The company’s sub-60% payout ratios, healthy cash flow generation, and stable end markets support the dividend’s predictable growth.

 

 

Valuation

GIS trades at about 20x forward earnings and has a dividend yield of 3%. Management believes the company can generate low single-digit sales growth and high single-digit diluted earnings per share growth over time.

 

We believe these assumptions are reasonable given the underlying growth rates of GIS’s markets and the company’s historical free cash flow growth. We also believe in the company’s strategy going forward and appreciate its product diversity.

 

GIS’s 3% yield combines with its projected earnings growth to generate roughly 10% annual total return potential. For a company of GIS’s quality, we believe the stock is attractive.

 

Conclusion

GIS appears to be a wonderful business trading at a reasonable price. While changing consumer tastes created headwinds in parts of the company’s portfolio over the last few years, we don’t believe these issues threaten GIS’s long-term earnings power.

 

The company’s marketing budget, R&D investments, shelf space, distribution relationships, financial strength, product diversity, and powerful brands are more than enough to help it play catch up when it needs to. Moreover, GIS’s most recent quarterly results showed its cereal business turning the corner and continue success with the expansion of Annie’s organic product lines. Fundamental momentum (aside from currency headwinds) seems to be moving in the right direction.

 

With over 115 years of uninterrupted dividend payments, GIS is the definition of a blue chip dividend stock. We are happy to buy and hold these companies forever, especially when they offer a 3% yield with high single-digit dividend growth potential.