General Mills May Need a Breather

General Mills (NYSE: GIS  ) reported its fiscal 2014 second-quarter earnings on Wednesday, Dec. 18. "The General" is up more than 23% this year, excluding dividends. While some investors consider this stock a "buy and hold" name, no stock is a "buy and forget."

The quarter itself wasn't bad, nor was the fiscal-year first-half performance. In a nutshell, sales were flat, earnings were down slightly versus tough year-ago comps, and margins eased a bit. U.S. sales, which comprise about 60% of total revenue, were up about 1%. International sales are up more than 10% for the fiscal year, but most of that came in the previous quarter.

I won't go into more detail here, as you can read about it in the earnings press release.

Instead, let's analyze some important metrics beyond the P/E multiple that will help you better understand what's behind the headline numbers. The selected measures are particularly useful when gauging consumer staples stocks: typically slow-growth, value-oriented, dividend-paying securities.  

Common shareholder equity
Common shareholder equity, also referred to as net book value, is what's left after all liabilities are subtracted from total assets. Investors like to see long-term shareholder equity growth for any corporation. For slow-growers like General Mills, it's a key metric. Here's a five-year chart:

Net book bounced back nicely post-Great Recession. Since 2012, equity has trended up in fits and starts. Nonetheless, the first half of fiscal year 2014 saw General Mills' book value per share climb to $10.90; this marker gets a passing grade.

Price-to-book
The price-to-book ratio relates share price to book value per share. If net book is growing but the stock price is bid up even faster, this ratio will point toward the shares getting too hot.

As shown above, General Mills' price-to-book is higher than it's been since before the Great Recession. This is a clear valuation yellow flag.  The corporate business model does not justify a "new normal" price-to-book ratio. The stock looks hot.  

Return on equity 
Return-on-equity measures how well management generates net income on the book value of the business. ROE above 15% is generally considered the benchmark for well-run companies. The chart below outlines General Mills' returns over the past 10 years.

The General has long maintained an outstanding return on equity -- historically above 20% a year. In 2012, the return slipped a little, though it remained above a 20-handle. The most recent annualized ROE is 28.5%. This is down just a little from the fiscal year 2013 first-half number of 29.3%. No problems here. 

Cash flow and share buybacks
Earnings growth drives stock prices. However, when analyzing capital-intensive industries, wise investors often look closely at related cash flow metrics. At its heart, General Mills is a manufacturing company. In addition, "The General" sponsors a generous 3% dividend yield and an aggressive share repurchase program. These activities impact cash flows. Let's review several per-share measures for the first half of fiscal 2014:

  • Earnings per share: $1.54
  • Cash flow per share: $1.55
  • Free cash flow per share: $1.14
  • Dividends per share: $0.76
  • Share buybacks per share: $1.33

EPS and cash flow are nearly identical. This is good; it demonstrates that management is not only generating profit, but that 100% of the profit is converted to hard cash. 

Free cash flow, or operating cash less maintenance capital, is nearly three-quarters of operating cash. That's excellent. If the dividend is subtracted, $0.38 per share remains.

However, the strong share repurchase plan results in a cash-negative bottom line. General Mills had to borrow funds to cover both the dividend and stock plan. 

While the buyback reduced year-over-year diluted shares by some 2.2%, the company had to increase its debt to do this. Indeed, long-term debt has jumped $1.17 billion year over year. The 0.95 long-term debt-to-equity ratio is high: To sustain the dividend, management must ultimately pare back the repurchase plan or continue to borrow funds. Perhaps a high-grade problem, but nonetheless another yellow flag.

Bottom line and business models
General Mills reported a lackluster quarter, and the underlying financial metrics paint a mixed picture. 

Long-term investors may even ask, "Are U.S. consumers calling the business model into question?" For years, General Mills has been a market leader for ready-to-eat cereals and other packaged food products. However, if Americans are truly gravitating toward fresher, organic, and less-processed foods, then the venerable "General" must morph with the times. 

Fortunately, these same thoughts have not gone unnoticed by management. General Mills has been emphasizing emerging markets and new products successfully. Incremental revenue growth is coming largely via Latin America and China. Here in the U.S., strong advertising for Greek yogurt is helping to keep the bottom line tracked.   

Major competitors Kellogg  (NYSE: K  ) and Post Holdings (NYSE: POST  ) face the same issues within their U.S. businesses.

Kellogg's management's focus on overseas expansion has been similarly aggressive compared to General Mills. However, Kellogg lacks the cost discipline and supply chain excellence of the General. Only recently has "Big K" initiated a significant program to cut overhead. Meanwhile, General Mills has kept a tight leash on expenses all along.

Upstart Post Holdings, revitalized by a bevy of sharp ex-execs from larger industry peers, has taken a different approach: Diversify away from cereals altogether. Post management has recently acquired Dymatize, a protein powder and nutritional supplement company, as well as Golden Boy, an organic food maker. Senior leaders recognize these markets are growing faster than processed foods. Since Post is far smaller than rivals General Mills and Kellogg, such corporate purchases can "move the needle" quickly. Nonetheless, investors should note that small size means more risk. The shares carry no dividend, either. Therefore, the well-known company may hold promise, but the shares are far more speculative.

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