Firm overview
According to the Form 10-K, General Mills is, “…a leading global manufacturer and marketer of branded consumer foods sold through retail stores…a leading supplier of branded and unbranded products to the foodservice and commercial baking industries.” Major product categories include ready-to-eat cereals, refrigerated yogurt, ready-to-serve soup, frozen dough products, and a wide variety of organic products. Key brands include Cheerios, Wheaties, Lucky Charms, Yoplait, Pillsbury, Betty Crocker, Nature Valley, and Progresso.
Growth strategy
Strategy
The firm strives to come up with new food ideas and brand them uniquely, so ensuring brand identity is important. Per the Form 10-K, there are four key parts to the growth strategy:
1. Low digit annual growth in net sales
2. Mid single-digit annual growth in total segment operating profit
3. High single-digit annual growth in EPS
4. Improvements in return on average total capital
To achieve these goals, GIS intends to adapt to demographic changes in the U.S. economy, in addition to expanding product lines in emerging economies with a growing middle class. For example, in the U.S., GIS is targeting the baby boomer generation and rising number of Hispanics. To target baby boomers, GIS is focused on emphasizing the health benefits of foods it produces, in addition to offering healthier products. To target Hispanics, GIS is increasing advertising; the firm is the leading advertiser in the Hispanic media.
GIS is also targeting emerging economies with growing middle class populations by introducing products and creating marketing materials that suit these local populations. One key growth area is China. To target the Chinese consumer, GIS is focusing on ice cream through the Haagen-Dazs brand, frozen foods through the Wanchai Ferry brand, and snacks like Bugles and Twix. For example, GIS has focused on building the Haagen-Dazs brand by creating ice cream shops that are experiences. Local consumers can order anything from a simple scoop of ice cream to an elaborate dine-in creation.
A final area of strength is the strong relationship with Wal-Mart. Currently, Wal-Mart represents approximately 20% of all frozen food sales; over 20% of GIS’s sales are through Wal-Mart. The firm will need to be able to continue to meet Wal-Mart’s price demands; this may decrease margins. Having this close relationship with Wal-Mart will be important in the future, as Wal-Mart seeks to expand in emerging economies.
Risks
Key risks to the strategy include failure to create products that meet customer’s desires, failure to manage the relationship with Wal-Mart effectively, and future food prices. Consumer’s tastes are always changing; consumers in the U.S. want healthier alternatives. This will be a group the company needs to effectively target and keep as the firm continues to grow. In addition, rising input costs through higher commodity prices might limit the firm’s pricing power. Higher input prices may lower margins, as the firm may not be able to effectively pass on higher input costs to consumers.
Profitability
From 2006 to 2010, GIS was profitable on all levels. Total net profit increased from $1.0 billion to $1.5 billion; profit per share increased from $1.34 to $2.32 per share. Profit per share increased at a greater rate than total net profit due to share repurchase.
Overall, management appears to have effectively managed costs. The cost of goods sold was approximately 64% of sales in each year other than 2010; cost of goods sold fell to 60% in 2010. Selling, general, and administrative expense has risen in total from 19% of sales in 2006 to 22% of sales in 2010. Net profit margin has fluctuated was in the 9%-10% in four of the five years; in 2007, net profit margin was only 7%.
Leverage
Balance sheet metrics
Debt-to-total capital is a good proxy for a firm’s ability to increase debt and service debt. From 2006 to 2010, GIS’s debt-to-total capital ratio increased from 47% to 53%, peaking at 57%. The change is attributed to the increase in the total amount of debt, in addition to the decrease in equity from share repurchase. Total debt increased from $6.0 billion to $6.4 billion, while peaking at $7.0 billion in 2009. It is important to note these share buybacks may not give a true picture of what a company’s equity is; transactions made at market value mixed with historical entries may lead to negative equity.
Coverage metrics
While looking at traditional leverage metrics is important, analyzing debt coverage metrics in relation to income and cash flow is also important. From a balance sheet perspective, GIS’s leverage worsened; from a coverage perspective, GIS’s leverage improved or was flat. This indicates the increase in earnings and free cash flow is greater or equal to the increase indebtedness of the firm.
Return on capital
Return on equity
GIS’s return on common equity improved from 2006 to 2010; return on common equity increased from 14% to 27%. The firm has higher than average return on common equity. Return on common equity increased because of improved profitability, improved asset efficiency, and increased leverage.
Return on assets increased from 8% to 11% during that time period. This was partially driven by increasing efficiencies in working capital. Day sales in inventories remained flat averaging around 33 days, while day sales in receivables improved from 34 days to 25 days. This increased efficiency will allow the firm to generate more operating cash flow; the firm can use the higher operating cash flow to increase capital expenditures, increase dividends, or repurchase outstanding shares. In addition, the firm can increase leverage with the greater ability to cover debt with cash flow.
So, was the increase in leverage effective? One metric to determine that is the financial leverage index. A ratio over one indicates the favorable effectives of leverage. The financial leverage index increased from 1.9 to 2.5; firm’s management has used leverage to effectively increase return on common equity and return on assets.
Return on unlevered tangible net assets
This is a metric Warren Buffett uses to look at companies. In his most recent letter, Mr. Buffett stated great companies have a return on unlevered tangible net assets of 25% or greater are great businesses; this ratio can exceed 100%. The firm’s return on unlevered net tangible assets increased from 76% to 202%. The increase can be attributed to increased debt and reduced equity as result of the firm’s share repurchase strategy, in addition to higher net income. By Warren Buffett’s standards, GIS is a great company.
Total shareholder return
Dividends
At fiscal year-end 2010, GIS paid $0.96 per share in dividends, or a dividend of approximately 2.8%. From 2001 through 2004, the firm paid a quarterly dividend of $0.1375 per share, or $0.55 per year. From 2005 to 2010, the firm started to increase dividends increasing dividends by approximately 11% annually. With an 11% annual growth rate, the dividend could almost triple from $0.96 to $2.73 by 2020.
Per the Form 10-K, GIS does not have an explicit dividend payout ratio; the firm is seeking to return cash to shareholders. From 2006 to 2010, based on net income, the dividend payout ratio decreased from 51% to 35%. A dividend payout ratio of less than 50% is preferable, as a firm’s management has the ability to increase dividends without risk of it being reduced in the near future. From 2006 to 2010, based on free cash flow, the dividend payout ratio has fluctuated; the free cash flow payout ratio had a low of 34% to a high of 55%. GIS’s dividend appears to be intact and will grow in the future.
Share repurchase
Per the Form 10-K, GIS intends to reduce total shares outstanding by approximately 2% per year, or 100 million shares in total. Committing to share repurchase is part of the GIS’s strategy. Shares were repurchased at a discount when looking at the trailing twelve month price-to-earnings multiple (TTM P/E). In 2006, the TTM P/E was 19.3 decreasing to 15.1 in 2010. In addition, the firm increased leverage to repurchase shares. In each of the years, the ratio of cash spent on share repurchase exceeded or was near 100% of net income and free cash flow. Additional borrowings were needed to meet the cash shortfall to pay for other items like capital expenditures or dividends.
Valuation
To value GIS, I tried to use both a discount cash flow model, in addition to using P/E multiples. Each of these were adjusted to reflect the inherent business risk and financial risk in the firm.
Assumptions
To value GIS, I needed to make several assumptions:
1. Earnings growth will be 8% in 2012 and 10% each year after that. Per the Form 10-K, GIS hopes for high single digit growth. An increasing market share in China and other emerging economies should make 10% annual growth a possibility. I also assume a 10% growth rate to be the growth rate for terminal cash flows.
2. GIS has effectively managed the cost structure for several years. I assumed cost of goods sold would be 63% of sales, in addition to selling, general, & administrative expense as 20% of sales.
3. GIS has improved working capital management over the past five years. Management hopes that working capital increases at a lower rate than sales. Based on this, I used aggressive working capital assumptions. These include 25 days for day sales in receivables, 33 days for day sales in inventories, and 21 days for day sales in payables.
4. For dividends payable, I assumed the dividend will grow at 11% per year and total dividends paid will equal the total forecasted number of shares outstanding. For share repurchase, I assumed the company will repurchase 2% of shares outstanding (per the Form 10-K) at the earnings per share for that year at a 15.9 P/E multiple.
Free cash flow to equity (FCFE) valuation
I hope to earn 15% each year in my portfolio, thus the base discount rate I use is 15%. I adjust the 15% for business risk and financial risk. According to this model, I believe GIS has 85% the business risk as the average firm, but 110% the financial risk as the average firm. Thus, the discount rate is 14.03%.
Risk unadjusted discount rate | 15.00% |
x | |
Business risk factor | 0.85 |
x | |
Financial risk factor | 1.10 |
= | |
Risk adjusted discount rate | 14.03% |
Given the assumptions stated above, the intrinsic value of GIS is $43.87 per share. At market close on March 14, GIS closed at $36.92 per share, or 18.82% below the intrinsic value of the company.
In addition, I calculated the risk adjusted margin of safety for GIS. The risk unadjusted margin of safety for any company in my portfolio is 30%. After adjusting for risk and future earnings and dividends, the risk adjusted margin of safety for GIS is 15.90%. The company is trading at a deeper value than the amount it is trading below intrinsic value.
Initial required rate of return | 30.00% |
- | |
Earnings growth | 10.00% |
- | |
Dividend yield | 3.00% |
= | |
Risk unadjusted margin of safety | 17.00% |
x | |
Business risk factor | 0.85 |
x | |
Financial risk factor | 1.10 |
= | |
Risk adjusted margin of safety | 15.90% |
Price-to-equity valuation
I also want to calculate GIS value based on a P/E multiple. Similar to the FCFE valuation, I want to first calculate a “fair value P/E” in addition to a “buy P/E” and a “sell P/E.” In a historical context, a firm like GIS with 10% annual earnings growth should have a P/E of 14.5. Since GIS has a 3.0% dividend yield, the fair value P/E of GIS is 17.5. After one adjusts for the business and financial risks, the buy P/E for GIS is 15.63 and sell P/E is 20.47.
Given | P/E adjustments | |||||
Earnings growth | 10% | 14.50 | ||||
+ | ||||||
Dividend yield | 3% | 3.0 | ||||
Basic P/E | 17.50 | |||||
x | ||||||
Business risk factor | 0.85 | 1.15 | ||||
x | ||||||
Financial risk factor | 1.10 | 0.90 | ||||
x | ||||||
Earnings predictability factor | 1.00 | 1.00 | ||||
= | ||||||
Fair value P/E | 18.11 | Fair value P/E | 18.11 | |||
/ | x | |||||
Risk adjusted margin of safety | 15.90% | 115.90% | Fundamental return | 13.00% | 113.00% | |
= | = | |||||
Buy P/E | 15.63 | Sell P/E | 20.47 |
I forecast EPS for GIS to be $2.54 in FY 2011. Given the March 14 closing price of $36.92, the forward P/E is 14.54. This P/E is below the buy P/E signaling to investors that given the risk characteristics and potential earnings power, GIS is trading at a discount to intrinsic value.
Conclusion
I would rate GIS as a BUY for the following reasons:
1. GIS is one of the leading brands in each of the categories it serves. It would be hard for a consumer to shop in any grocery store and not find the key brands like Cheerios, Wheaties, or Pillsbury. This strong brand recognition allows GIS to pass on price increases to customers. In other words, the firm has high pricing power and an “economic moat” around the business.
2. GIS has operations effectively under control. Regarding costs, the largest part of the cost structure includes input costs (i.e. cost of goods sold) that are highly volatile and affected by commodity costs. The consistent margins indicate GIS can pass on higher costs to consumers. Also, GIS has increased working capital efficiency over the five-year period analyzed. GIS will need to continue to maintain current operating efficiency to generate cash to help pay for capital expenditures, dividends, and share repurchase.
3. The one negative for GIS is the balance sheet. With a credit rating near the bottom of investment grade credit, the firm needs to stay focused on maintaining that rating to ensure easy access to credit markets. In addition, the aggressive share repurchase strategy has meant the firm has increased leverage to fund it. Although the firm has improved operating efficiency, dividend increases and aggressive share repurchase strategy means the firm will need to continue to access debt markets, and possibly increase total debt into the near future.
4. The most important factor is GIS is trading at a value below its intrinsic value. According the FCFE model, GIS is trading at approximately 18.8% below intrinsic value, which is greater than the risk adjusted margin of safety. According the P/E model, the buy P/E is below the current market P/E signaling the stock is undervalued.
This information is for educational purposes only, and the opinions expressed do not constitute a recommendation to buy or sell. Author may have a position in the companies discussed, subject to change at any time. Information on this website obtained from reliable sources, but there is no guarantee of accuracy. Please consult your financial advisor before making investment decisions. Past performance is not indicative of future success.
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