Description

Summary

General Mills (GIS) was an outstanding stock during covid and through 2022 but is now trading at an elevated valuation on estimates that assume the company returns to its pre-covid margin structure.  The outperformance makes sense as the company benefited from strong at home consumption trends, significant pricing with minimal volume degradation and a favorable competitive landscape as private label was supply constrained during covid.  The bigger, branded companies that could maintain supply to retail were effectively given preferential status.  More tactically, staples like GIS benefited last year due to their defensive nature and stable/rising earnings estimates versus the rest of the market… for example, GIS’ valuation multiple expanded on better than expected earnings which drove the stock +24% in 2022.  GIS had the added benefit of being largely domestic so foreign exchange was not a significant drag on the company.  Many of these tailwinds are now set to reverse or at least moderate.  In addition, if the pace of moderation is more gradual than expected and/or a recession drives a continued bid to staples, GIS’ valuation is already elevated creating a favorable risk/reward skewed to the downside.

Performance

GIS significantly outperformed the S&P and XLP last year and since early 2020.  The bottom chart highlights how much the valuation multiple expanded in the last year.  The company is now trading at an 11% premium to the S&P versus a 9% discount over the last five years on average.  The relative discount to the XLP is 7% now versus a 16% discount over the last five years on average.

Business

GIS has four businesses - North American Retail (NAR), International, Pet and North America Foodservice (NAF).  The NAR segment is 60% of total revenue (FY22), Pet is 12%, NAF is 10% and International is the remaining 18%.  NAR is the primary profit contributor at nearly 85% of total operating profit.  The segment also has the highest operating margin at 23%... pet is a close second at 21% while NAF and international have below corporate operating margins.

The company’s average organic growth rate for the five years through FY19 was -1%.  The average organic growth rate was flattish for the 10 years through FY19.  These trends clearly changed in FY20 with covid which drove an acceleration in volumes due to at home consumption and then price due to significant inflation.  Organic rev growth was +4% in FY20, +4% in FY21, +6% in FY22 and is guided at +8-9% for FY23.  These trends are clearly not sustainable though timing to revert to historical is more difficult to forecast.

In the five years through FY19, pricing averaged +2%.  Pricing has averaged +13% for the last four quarters including +17% in FY2Q, +15% in FY1Q.  GIS will start lapping this very elevated pricing in its FY2H this year.  In the five years through FY19, volume averaged -2.5%.  This trend changed during covid as volumes were +HSD %... however, volumes have started to decline over the last few quarters.  The declines were at first relatively modest given the magnitude of pricing but have started to pick up.  E.g. -6% volume in FY2Q and -5% in FY1Q.  To management’s credit, GIS has done a good job reshaping its portfolio in the last few years… it has expanded into pet which is higher growth and has divested lower growth/margin, non-core businesses.  That said, it is hard to think the company has a significantly different growth and margin profile going forward relative to pre-covid given NAR is such a large component of the business.

More recently, the volume pressure has accelerated on a 2 and 3 year stack basis.  In FY2Q, volume was -3% on a 3 year basis so versus pre-covid.  The offset has been much higher pricing.  The pricing on a 3 year basis was +25%.  Pricing will likely be harder to come by going forward as retailers and consumers pushback.  In addition, private label was supply constrained during covid but this has been improving and will be a lever that retailers can use in their discussions with GIS and others.  Most retailers (e.g. Kroger) are talking about how well their store brands are performing.  Pricing is generally not rolled back but companies and retailers can increase the level of promotion to offset list price increases.  Promotion levels have been below trend in the past couple of years given industry supply constraints and strong demand… i.e. why promote when you either do not have the product on shelf because of supply constraints or because demand is already strong.  This dynamic likely changes as volumes remain/become more pressured as consumers feel the inflation pinch.

GIS acquired Blue Buffalo in the spring of 2018.  The business grows at a +HSD rate so has been a favorable contributor to GIS’ total organic revenue growth rate.  The most recent quarter highlighted some weakness within the segment as organic revenue growth was flat (volumes -11%).  Part of the issue was likely short term but it is worth monitoring given Blue Buffalo is a premium priced brand and recent data/commentary points to potential trade down in the category (SJM last quarter discussed trade down in pet).

Valuation

GIS is trading at 18.7x FY23 EPS and 17.9x FY24 EPS.  This is an elevated valuation relative to history.  The company’s average P/E over the last 3, 5 and 10 years has been 16.8x, 15.9x and 16.7x, respectively.  It is also important to consider these valuations are on estimates that reflect a recovered margin structure.  Most staples have seen margins compress in the past couple of years due to elevated cost inflation and lagged pricing.  Pricing has started to catch up to cost inflation so margins should recover but the timing is still uncertain.  In any case, GIS averaged a 17% operating margin in the five years pre-covid and forward estimates reflect a similar margin in FY24 (17.2%) and higher margin in FY25 (17.5%).  Many companies, including GIS, reduced opex and marketing investment during covid to offset gross margin pressure from higher inflation.  SG&A as a % of revenue is down by 100 bps relative to a few years ago.  As a result, gross margin improvement will not fully flow through to operating margins and earnings because companies will need to catch up on opex investment.  In summary, GIS is trading at an elevated valuation on normalized margins which creates a favorable risk/reward to the downside.  These stocks also tend to trade on estimate revisions so decelerating organic revenue growth over the next 12-18 months and moderating earnings revisions should pressure the multiple.

Risks

GIS will outperform in a recession, the company’s organic revenue growth can sustain higher for longer and profitability can be structurally higher post covid due to portfolio changes and a reduced need for promotional spending.  There is also a timing risk if inflation falls faster than expected and promotional spend takes longer to come back.

Catalyst

Earnings, FY24 guidance.