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General Mills (GIS)

General Mills (GIS) was founded in 1866, owning just a single flour mill at the time. Since then, the company expanded into a number of different industries, including restaurants, toys, and even apparel. However, the business refocused completely on consumer foods in 1995. And in early 2018, the company made a big push into premium pet food with its $8 billion acquisition of Blue Buffalo.

Today, General Mills sells a diversified mix of packaged meals, cereal, snacks, baking products, yogurt, and more. The company’s largest brands are Cheerios, Betty Crocker, Yoplait, Pillsbury, Nature Valley, Old El Paso, and Haagen-Dazs. Each of these brands generates over $1 billion in annual sales.
Source: General Mills Annual Report
General Mills is one of the largest organic food manufacturers in the U.S. and seeks to increase the size of this business to $1.5 billion by fiscal 2020 (from $1.1 billion in 2017). Growth will be helped in part by the continued expansion of its Annie’s brand (acquired in 2014) into new categories.

By product category, the company is most focused on snacks (22% of sales), cereal (17%), convenient meals (17%), yogurt (15%), dough (11%), and baking mixes (11%). Following its acquisition of Blue Buffalo, pet food now accounts for around 8% of total sales.

General Mills 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 more than 600 SKUs per store and has been expanding its product categories organically and via acquisition.

The company's business is organized across five operating segments: 

  • North America Retail (61% of sales): sells meals, cereals, snacks, baking products, and yogurt and other products to a number of grocery stores, mass merchandisers, dollar stores, natural food chains, and other retailers.
  • Convenience Stores & Foodservice (12% of sales): General Mills sells its products in this segment through many channels including foodservice, convenience stores, vending, and supermarket bakeries.
  • Europe & Australia Retail: 12% of sales 
  • Asia & Latin America Retail: 12% of sales
  • Pet Food (Blue Buffalo acquisition): 8% of sales

By geography, General Mills is aiming to become more diversified though the vast majority of its sales are still focused on its home U.S. market. 

Business Analysis
General Mills and its predecessors have been around for more than 150 years. Compared to newer companies, General Mills benefits most from its scale, long-standing distribution relationships, entrenched brands, and decades of marketing spend. These advantages have enabled the company to pay uninterrupted dividends for more than 115 years.

With almost any consumer product, marketing and product innovation are keys to long-term success.

General Mills can outspend smaller players when it comes to marketing campaigns to ensure its products remain in the forefront of consumers’ minds. In fiscal 2018 the firm spent more than $575 million on advertising and media to protect the brand value of its products, and even higher spending is expected next year to revitalize growth.

In addition to customer loyalty, these investments should theoretically help General Mills more easily pass on input cost increases during years of higher commodity prices.

When you start to add up the total dollars General Mills has invested in marketing over the last several decades, it becomes daunting to think about the challenge new food companies face in winning over consumers to their less familiar brands.

This spending has helped General Mills maintain strong market share positions. Most of the company’s brands hold the number one or number two share positions in their categories and have proven to be very resilient over the years.

In ready-to-eat cereal, for example, General Mills has the second highest global market share and owns three of the top five U.S. brands. In yogurt the company's 18% market share similarly gives it a commanding presence on store shelves.

Many of the company’s core brands have been on the shelves for decades. For example, Cheerios and Nature Valley were introduced in 1941 and 1975, respectively.

General Mills’ retail customers also have little incentive to try out products from new competitors as long as the company's products are selling well. According to Nielsen data, a whopping 85% of consumer packaged goods that launch in the U.S. will fail within two years. It’s no surprise retailers are reluctant to displace mainstay brands.

Given the high failure rate of new products, General Mills’ 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, too. Few companies have the luxury to invest over $215 million annually in R&D as General Mills has done in recent years.

Combined R&D and ad spending was about 5% in fiscal 2018, and management intends to increase that figure in the coming years, using savings from the firm's ongoing cost-cutting efforts to invest in new products and revitalize its existing brands.

General Mills is also well diversified by product category, with snacks representing its biggest group at 22% of sales last fiscal year. As consumer trends unexpectedly change, General Mills is somewhat hedged by playing in so many different products. When one category changes directions and requires new R&D and marketing investment, another is likely playing to General Mills’ existing strengths.

Unfortunately, despite the company's diversification into various product offerings, in recent years General Mills has struggled to adapt its overall portfolio to meet changing consumer preferences for fresher, healthier foods.

The result has been shrinking market share and falling sales and operating profits. Cost cutting and buybacks did manage to improve free cash flow and EPS modestly, but the company has admitted it needs to revise its approach to what it sells.
Source: General Mills Annual Report
While General Mills might be late to catch on to certain consumer trends, resulting in short-term periods of pain, its product diversification, financial firepower, and distribution relationships should help ensure that it can evolve to remain relevant for years to come.

Introducing Greek yogurt and gluten-free cereals are two examples of trends General Mills has followed in recent years, though being late on Greek yogurt cost the company significant market share losses it is still working to reverse.
Source: General Mills Investor Presentation

The company’s massive size can cause strategic shifts to take longer to impact overall sales mix. In these instances, General Mills has not hesitated to acquire its way into faster-growing markets or divest declining businesses to sharpen its focus. In fact, management currently plans to sell off lower returning business lines which represent 5% of sales and operate in challenged product categories.

Looking further back, the company sold its struggling Green Giant brand (frozen vegetables; 4% of total sales) for $765 million in 2015, and it meaningfully extended its reach in the natural and organics space with its $820 million acquisition of Annie’s in 2014.

With U.S. industry sales for natural and organic foods growing at a double-digit rate, it’s no surprise General Mills wants to continue growing its share in this category (General Mills is a leading natural and organic foods manufacturer with an 18-year operating history in the industry).

The other major growth opportunity management now wants to pursue is pet food. In February 2018, General Mills announced it was buying premium (and organic) pet food maker Blue Buffalo for $8 billion.

The U.S. pet food market is $30 billion in size, growing at about 5% annually over the past decade, and, according to analyst firm Euromonitor, expected to grow about 6% per year going forward.

One of the biggest secular trends among consumers is spoiling their pets. According to Larry Light, a brand revitalization expert and former Chief Marketing Officer for McDonald's (MCD), "In many parts of the world, people spend more per calorie to feed their pets than they feed their kids."

Blue Buffalo's 2018 annual sales of $1.3 billion (with about 25% operating margins) represent a needle-moving acquisition for General Mills, which hopes to improve its company-wide organic sales growth and profitability in the coming years. And growth potential is certainly there given that in 2017 Blue Buffalo's market share was just 7% and thus has plenty of upside potential.

What's more, in 2017 Blue Buffalo saw 75% growth in e-commerce sales, which is slightly more than General Mills' 70% online sales growth in North America. With consumers increasingly shopping for food online, management has a goal of achieving $1 billion from e-commerce by 2020 (about 5% of sales), and Blue Buffalo is a potentially solid way of helping achieve that goal.

When it comes to deals like Blue Buffalo, the company's acquisition strategy is focused on buying "on-trend" product lines that it can plug into its global distribution channels to get them selling faster.

For example, when it was acquired in 2014, the Annie’s business only had 30% national distribution with its top 33 SKUs. General Mills has been growing that brand's distribution at a double-digit clip, and Annie’s retail sales jumped 40% in fiscal 2016.

As for Blue Buffalo, in 2017 that company's products were sold in just 12% of U.S. pet food retailers, but distribution penetration hit 30% in mid-2018. General Mills hopes with its resources those figures can climb much higher in future years.

In fact, management of Blue Buffalo (which remains with the company post-acquisition) expects sales and earnings growth in the double-digits in 2019, making this business among the fastest growing (though off a relatively small base) in the General Mills family.

From a productivity standpoint, General Mills has a company-wide initiative known as Holistic Margin Management (HMM), which it uses to combat the 5% annual input cost inflation it typically faces.

HMM relies on productivity savings, mix management, and price realization to protect gross margins. HMM is on track to generate cumulative $4 billion in savings over the decade ending in 2020 and has kept gross margins relatively stable over time.

Currently, management is targeting $750 million in savings over a multi-year effort ($450 million in 2019 alone, or about 2.7% of annual sales) that should significantly reduce operating costs and help protect margins.
Source: General Mills Investor Presentation
Altogether, the company’s leading market share, entrenched brands, large marketing and R&D budgets, long-standing distribution relationships, product diversification, and continuous cost savings efforts create a solid moat, albeit one that is currently under some pressure due to evolving market conditions.

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

But while General Mills’ business probably won’t fade any time soon, profitable growth is no guarantee for such a large company operating in mature markets.

Key Risks
Growth is the biggest challenge facing General Mills, which saw its sales peak in fiscal 2014. Even the major acquisition of Blue Buffalo will merely bring the company's revenues back to near those record highs.

At the heart of the company's problems is that its legacy product lines continue to face pressure from changing consumer tastes, especially in the U.S. (market share for packaged foods is down about 3% since 2016). Specifically, U.S. cereal consumption continues to shrink steadily at about 2% per year. That's improved from 3% to 4% annual declines over the past few years, but negative growth is still negative growth.

Another example of the company's U.S. troubles is in yogurt. By being late to the major Greek yogurt trend, General Mills' market share deteriorated rapidly in this large market and didn't return to positive growth (just 0.1%) until late 2018.

As a result of falling sales and market share, the once strong pricing power the firm's household brands enjoyed is now weakening. This is why, even with management guiding for 2% price increases in 2019, the company expects organic growth to be flat to up 1%. In other words, virtually all of General Mills' expected revenue growth in 2019 is projected to be driven from the Blue Buffalo acquisition.
Source: General Mills Investor Presentation

Equally disappointing, the company expects flat or even slightly negative earnings and free cash flow growth. This is because General Mills is facing rising logistics and commodity costs that are expected to largely offset its cost savings for this year.

To help architect its turnaround, the company appointed Jeff Harmening as its new CEO in June 2017. Harmening has been with the company for 24 years and most recently served as the COO. 

In January 2018 he also became chairman, replacing Ken Powell who had been the former CEO and spent over 35 years with the company. In other words, General Mills has a deep bench, with its top executives well accustomed to the need to continuously adapt to changing consumer tastes. 

However, the risk here is that the current corporate culture appears to be struggling more than it has in the past, especially in converting the firm's historical track record of creating and maintaining dominant product lines in new markets. 

According to analyst firm Packaged Facts, Amazon already controls 55% of the online pet food market, which means that Blue Buffalo may not have as easy of a time growing its e-commerce sales (or total sales) as management hopes. 

Speaking of Blue Buffalo, we can't forget that one of the big positives General Mills had going for it was its strong financial flexibility in early 2018. In 2017, the firm's net debt/EBITDA (leverage ratio) was 3.0, slightly above the industry average of 2.6 but well below the 4.0 level that we consider reasonable for the industry. 

The Blue Buffalo acquisition, which was debt funded, pushed the firm's net leverage ratio to 4.9. With a more urgent need to protect the balance sheet by paying down debt, management opted to freeze (but not cut) the dividend. Share repurchases have also been suspended until management can get leverage down (2020 goal of 3.5). 

Moody's and S&P both downgraded the company's credit rating by one notch (from BBB+ to BBB) due to the dangers represented by taking on so much debt while facing stalled profit and cash flow growth, plus the potential of rising interest rates. 

And with Blue Buffalo planning on starting or ramping up construction of two new factories in 2019, General Mills' capex is likely to rise, making strong free cash flow growth more challenging. 

Ultimately, General Mills paid a steep price for Blue Buffalo (about 6.2 times trailing sales and 25 times trailing EBITDA) and took on a lot of debt in the process. That has exhausted its financial flexibility for at least the next few years. A time during which the negative headwinds its core products are facing seem likely to persist, making near-term dividend growth prospects weak. 

Once the company restores its balance sheet and hopefully sees some success with its turnaround plan, mid-single-digit earnings and dividend growth is a possibility in the long term. However, such a reality may not be realized if General Mills' growth efforts continue to struggle.

Simply put, consumers are increasingly concerned with what they are eating. They want natural, healthier, fresher foods that contain more protein, fiber, and whole grains rather than gluten, carbs, and artificial ingredients. This a very challenging time for America’s large packaged-food giants, which are losing shelf space to fresh food, prepared hot meals, and healthier items from local upstarts. 

Combined with the rise of e-commerce (cheap and instant distribution compared to securing physical shelf space), this has opened the door for new food companies to launch healthier brands and chip away at the high market share positions enjoyed by packaged food giants, who have largely missed the health trend while cutting costs too aggressively in many cases.

But there is some cause for optimism that General Mills' will eventually be able to turn around its weak growth. For example, in Europe and Australia, three of its four major food lines are seeing market share growth. 
Source: General Mills Investor Presentation

Furthermore, in all product lines except yogurt, General Mills' market penetration (the percentage of households that buy its products) remains low in many countires, meaning it still potentially could achieve further growth in those markets.

Mexico is a good example. In the U.S. General Mills' market penetration is 97%. In Mexico, that figure is just 49%, showing that the company has strong growth potential in that developing country if it can tailor its offerings to local tastes.

What evidence is there that the company can do that? Well, between 2016 and 2018 sales of Haggen-Daz in Europe and Australia grew by 12% annually, representing some of the company's strongest growth. Ice cream is hardly a health food, showing that even in "off-trend" products General Mills still can squeeze growth from strong brands if it optimizes its distribution, marketing, and product mix. 

For on-trend products, like Nature Valley and Fiber One snack bars, the company's Europe and Australia sales grew 30% annually between 2016 and 2018. And keep in mind that Europe and Australia are mature markets.

Asia and Latin America are home to 6 billion people, or 80% of the world's population. They also have much faster-growing economies and large and expanding middle classes who have shown a penchant for premium American branded foods in the past.

However, ultimately it’s hard to say if the company can truly change consumers’ perception of some of its old brands. Certain legacy products just don’t seem to have many options to combat the healthier eating trend (e.g. Betty Crocker desserts).

There is also the risk that General Mills will mismanage its organic brands since that area has not historically been a core competency of the company. And while emerging markets in Asia and Latin America certainly represent huge growth potential, General Mills' success in these regions is far from assured.

In fact, some of the company’s disappointing sales growth is certainly the result of mismanagement. General Mills has been aggressively cutting costs to keep earnings growing despite its top-line decline, and management has commented that the company cut too far in a number of cases, hurting its brand perception and product innovation. While management has promised to increase advertising in the future, in fiscal 2018 it once more cut the ad budget (by about $50 million).

Besides evolving consumer preferences and some questionable decisions by management, food deflation has also hurt growth and made the industry even more competitive. Amazon’s acquisition of Whole Foods could potentially rattle the landscape further (although much remains to be seen), and Target and Walmart have both announced steep price cuts in recent years.

Overall, the company's sales growth has been disappointing due to a combination of factors – a soft food and beverage retail environment, the continued shift to healthier foods, and excessive cost cutting by management.

The company's CEO is increasing investment in an effort to rejuvenate sales growth, but success is far from guaranteed. None of these challenges will be fixed overnight, but hopefully the diversity of General Mills’ expanded and more relevant product portfolio will position it well to survive and eventually adapt.

Closing Thoughts on General Mills
The sales growth challenges facing General Mills could persist for another few quarters or perhaps even longer as the packaged food industry continues experiencing meaningful change.

However, General Mills seems ready to tackle the challenges needed to stay relevant with consumers over the long term, especially under the leadership of its new CEO who has decades of experience with the company. 

General Mills' marketing budget, R&D investments, shelf space, distribution relationships, product diversity, and powerful brands should help the business play catch-up with the latest consumer trends over time.

The biggest near-term risk is that the pricey Blue Buffalo acquisition might not work out as management hoped. While that company's future growth rate could be strong, General Mills' much more leveraged balance sheet means that dividend investors should not expect any payout increases until at least 2020. That's when management expects to achieve a much safer debt level that will hopefully allow it to resume mid-single-digit dividend growth. 

At the end of the day, General Mills is in one of its multi-year turnarounds that won't get worked out overnight.  While the dividend continues to look safe, investors considering the stock need to be patient and have confidence in management's ability to restore profitable growth, especially in light of the firm's higher leverage.

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