From a high level, General Mills' (GIS 1.68%) fiscal 2023 second-quarter results looked very strong. When you dig in a bit, however, the company's pet food business was a notable standout, and not in a good way. Given that the major contributor to that business, Blue Buffalo, is expected to be a growth driver for the company, it's important for investors to understand what's going on. Here's a quick look at what you need to be watching.
A good quarter, sort of
Food maker General Mills posted a sales gain of 4% in the period while organic sales were up a lofty 11%. Earnings per share advanced 12% year over year. It would be very hard for investors to complain about those numbers, which were driven by price increases (which more than offset volume declines) and improving margins.
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The big takeaway from the quarter is that inflation has materially upended the consumer staples space, but General Mills appears to be handling the hit fairly well. That said, every single business line wasn't operating at its best. Notably, the company's pet food business, largely composed of the Blue Buffalo brand, saw flat organic sales and a huge 34% decline in segment operating profit.
This is an important business for General Mills, which bought Blue Buffalo in 2018 with the hope that it would drive growth for years into the future. Up until now, the story has been pretty good. Between fiscal 2018 and 2022, the Blue Buffalo business expanded sales at a 15% compound annual rate. That's very attractive, basically justifying an acquisition that some thought was expensive, and shows that General Mills knows how to succeed in pet food.
What's the problem?
If things have been going so well for Blue Buffalo, exactly why did it stumble in the fiscal second quarter? There are a few problems, all of which are likely to be temporary.
For starters, some of General Mills' customers chose to reduce the inventory they were holding. That's not shocking given that the pandemic resulted in unusual shifts in inventory levels. Now add in the fear of a weakening economy in 2023, and there's even more reason for retailers to try to run a little lean. The good news is that inventory reductions generally only last for a short period before sales start to move back to more normal levels.
Meanwhile, the company is looking to increase support of the Blue Buffalo brand with steps like advertising to help move products in the consumer space. That, in turn, could hasten the need for retailers to start buying again.
The second problem General Mills has faced is what it calls service levels. Basically, logistics issues have made it difficult to get products on store shelves. That's another near-term headwind that is likely to work itself out over time. To deal with the issue, management is adding logistic capacity.
The last problem is likely to be the most difficult to overcome. Blue Buffalo has increasingly fallen short of its production goals, another reason why it's hard to get product onto shelves. The long-term fix is to build new capacity, which General Mills is doing. However, that doesn't solve the short-term problem of a lack of capacity. Thus, management has been hiring contract manufacturers so it can quickly ramp up production of, primarily, dry food and pet treats.
The drawback of using contract manufacturers is that it generally costs more than producing products in-house. So operating profit might look weak for a bit longer, noting that the company is also making capital investments to build internal capacity. However, the long-term benefit of protecting market share and growing sales easily outweighs the up-front costs here. All in, capacity constraints might take longer to fix, but they, too, look likely to be addressed in time.
The benefit of the doubt
Given General Mills' success to date with the Blue Buffalo brand, investors probably shouldn't get too upset at a weak quarter. Or even a couple of weak quarters, so long as the steps being taken to address the problems seem logical. That's exactly what appears to be the case with General Mills right now. Investors should watch the pet food business, but the troubles it faces today aren't a good reason to jump ship.
