"Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated. We have witnessed many bouts of repurchasing that failed our second test."
-- Warren Buffett, 2011
If you own shares of packaged-foods giant General Mills (NYSE:GIS) or are considering buying shares, it's probably a good time to evaluate whether management and the board of directors are committing this infraction right now. General Mills produces gobs of cash, and its management has limited options at its disposal for allocating all that cash. They are essentially the following:
- Pay a higher dividend.
- Make acquisitions or other investments to grow.
- Repurchase shares.
For a company like General Mills with limited organic growth prospects, a significant amount of investors' future returns will be dependent on how effectively the people running the company allocate capital. The question we will explore today is whether General Mills' share buyback program -- which has repurchased more than $3 billion in shares since FY2012 -- is a good use of excess capital, or whether management is overpaying and therefore wasting shareholder money.
Let's take a closer look.
Significant efforts to return cash to shareholders; strategic growth investments
Let's start with this. There's no doubt that General Mills CEO Ken Powell and his team are making a concerted effort to give as much of the company's excess cash flows as it can back to shareholders. Since 2009, it has paid out $4.6 billion in dividends, and increased the payout every year:
The company also spent around $1 billion in 2011 to acquire a controlling interest in the Yoplait brand's international operations. This acquisition is the kind of growth that makes sense for General Mills, since the company is intimately familiar with the brand, as it already controls U.S. distribution and production of Yoplait.
Businesspeople as investors: Did General Mills management miss the mark?
Another famous Buffett quote describes how being a businessman makes him a better investor, and vice versa. Buffett is renowned for his history of investing at reasonable prices and getting fantastic returns, but a lot of other corporate leaders fall well short on this measure when it comes to share repurchases. Here are General Mills' buybacks since FY2010:
The dip in FY2012 corresponds to the Yoplait acquisition. While it's evident that management acted with fiscal responsibility when it chose to temper share buybacks at the time of the acquisition, it also led to a missed opportunity to buy shares at a lower premium than we're seeing today. Here's how the company's valuation -- as measured with price-to-earnings and price-to-sales -- lines up with these buybacks:
The buyback program has been accelerated since the CY2011 acquisition of a controlling interest in Yoplait's international business. And that acceleration has corresponded with a market premium for General Mills stock.
In short, the acceleration of buybacks in FY2013 and '14 corresponded to when the stock market commanded a premium for dividend payers like General Mills. The two most recent years' buybacks total $2.8 billion. Of that total, $751 million took place in the second half of CY2012. The average share price for repurchases was $38.86 in Q1 and $39.92 in Q2, which corresponds to a P/E ratio between 15.5 and 16.5 at those times. That's a pretty decent value, and a wise use of capital by management.
However, the $2.1 billion that has been spent on share buybacks since then has come at a 15%-20% premium, as investors looking for predictable yield have pushed General Mills' P/E multiple above 18. That's expensive for a company growing sales at less than 5% per year.
Two questions: Do those share buybacks at a P/E multiple above 18 really make for a bad deal -- i.e. is management wasting money paying today's premium? Will the actual share price paid -- when measured years down the road -- still turn out to have been the best use of that capital even if management paid a big premium?
Here's General Mills' P/E multiple over the past 30 years:
General Mills' stock has spent significant time trading at a P/E multiple above 18. But the company also grew a lot over this period, and investing in that growth came at a premium. Today's General Mills doesn't have the same growth prospects, and today's P/E could be artificially inflated by unsustainable market dynamics. That's my concern.
Paying for yield: Is the premium sustainable?
Since the economic crisis, low interest rates have been great if you're buying a home, car, or some other durable good. But if you're trying to get income, traditional sources such as bonds, savings accounts, and CDs don't even keep up with inflation. This has brought a lot of money to dividend stocks, and it's possible that a lot of that money will flow out of dividend stocks as interest rates creep back up.
The result? Supply and demand tells us what happens: Prices fall. There's one catch, though -- interest rates aren't shooting up overnight. It's probably going to take a couple of years for interest rates to return to "normal" levels, and frankly it's unclear what will really happen when they do. We've never seen an interest-rate period like this, ever. Besides, more acquisitions like the recent Annie's (UNKNOWN:BNNY.DL)could be a surprise source of growth.
Wrapping up: wasteful premium, or reasonable use of capital?
I've been chewing on this one for a while, and not just in regard to General Mills. Only time will tell us whether it was the best use of capital at the time. Today, we can only make projections and operate in probabilities, not absolutes.
With that in mind, it doesn't strike me that General Mills' repurchases have been particularly wasteful. Management has also increased the dividend yearly and acted responsibly with the Yoplait acquisition. While it has paid a relative premium for the shares acquired since 2012, it's not likely an egregiously high price that's harmful to long-term shareholders. It's more likely that the repurchases will continue to support further capital returns to shareholders who choose to keep their shares.
Looking for market-crushing growth? This isn't the company for you. But even at today's valuations, General Mills isn't a terrible place to start if it's income you're looking for. You're paying a premium versus historical multiples, but you're also getting a quality business that pays an almost guaranteed dividend that's likely to grow.
[Editor's note: Corrected reference to Annie's being General Mills' first foray into branded organics.]