General Mills is stuck between a rock and a hard place, and the market is finally noticing. Its best dividend growth years have been behind it, but its recent dealings have put it in a rather precarious position heading into the next recession, the timing of which is the only uncertainty. The company has never been a consideration for inclusion in the simulated Dividend Growth Newsletter portfolio.
By Brian Nelson, CFA
On March 21, consumer staple General Mills (GIS) reported better-than-expected fiscal third-quarter results that showed reported net sales advancing 2% and operating profit increasing 9%, both measures over the comparable period last year. Though the top and bottom-line numbers appeared to be solid (adjusted diluted earnings per share leapt 8% in constant currency to $0.79), the market is picking up on concerns related to its gross margin, which fell 250 basis points on an adjusted basis in the quarter, as cost headwinds seem to only be growing. In particular, management noted that the decline in the gross margin was driven by “higher…freight and logistics costs, commodity inflation, and other operational costs, as well as higher merchandising expense.”
It seems as though General Mills is having a difficult time with cost containment in an environment where pricing pressure may only intensify, given Amazon’s (AMZN) recent purchase of Whole Foods, and the food retailing industry’s growing need to keep prices low to retain share. Buyer power from the likes of Walmart (WMT), CVS (CVS), Costco (COST) Walgreens (WBA), Target (TGT) and other food retailers may only increase as they seek to defend their turf against the growing presence of Amazon. Other food products entities, not only General Mills but even Kraft Heinz (KHC) and J.M. Smucker (SJM), may eventually be squeezed on both ends of the gross-margin spectrum (pricing and costs), particularly if commodity inflation starts to pick up, as some are anticipating given the Fed’s contractionary stance.
There are a few things about General Mills that have always been on our radar. For starters, we tend to prefer dividend payers that have large net cash positions on their balance sheets because that net cash gives the company tremendous financial flexibility to keep paying the dividend should exogenous shocks impact operations. At the end of fiscal 2017 (ends May 2017), General Mills’ short and long-term debt totaled $8.25 billion, while cash and cash equivalents were a mere $766 million. A net cash position is not only important in valuation, but it also is important when it comes to assessing financial flexibility with respect to dividend health. General Mills doesn’t have a net cash position. In fact, it has a huge net debt position. All else equal, entities that have more cash than debt are in better financial shape.
But that’s not the half of it. On February 23, General Mills announced it would buy Blue Buffalo (BUFF) for $8 billion in cash. Though strategically the move makes a lot of sense, the price tag is not something General Mills will easily digest, and it might very well put dividend health at risk. The deal price of $40 per share was a 20%+ premium to Blue Buffalo’s 60-day volume weighted average price, and represented an adjusted EBITDA multiple of 22x, including synergies. Quite simply, General Mills overpaid, and the company is financing almost all of this deal with new debt. If all goes well, General Mills expects its pro forma net debt-to-EBTIDA ratio of 4.2x. Already, management has suspended its share repurchase program, and future dividend increases will be limited, if any, as the company only expects to “maintain its $0.49/share quarterly dividend.”
We maintain our POOR rating of Dividend Safety/Cushion and Dividend Growth Potential for General Mills, and we would not be surprised if the company may eventually have to trim its dividend, if things turn sour during the next recession, the timing of which is the only uncertainty. S&P has already downgraded General Mills’ credit to BBB from BBB+, and while we expect General Mills to be successful integrating Blue Buffalo, the transaction puts the dividend at unnecessary risk, though we note the dividend was already at risk without it. In some ways, management may not have had a choice, but to do a deal for growth, with its core business facing cost challenges and its dividend obligations weighing down financial flexibility. The added debt from the Blue Buffalo transaction may not have been the right move, however, but issuing more equity to pay for the transaction would have only increased its dividend obligations. The executive team is stuck between a rock and a hard place, and the market now knows it.
Making matters worse is that General Mills cut its forecast for fiscal 2018 earnings per share when it reported fiscal third-quarter results March 21, implying that fourth-quarter performance is coming in much worse than previously expected, particularly in light of the third-quarter beat. The food product giant expects fiscal 2018 earnings per share of $3.08, below consensus estimates of $3.17, and implying flat-1% expansion (versus expected growth of 3%-4% previously), as input cost inflation rips through margins. Free cash flow generation at General Mills remains solid at $1.7 billion so far through the first nine months of its fiscal year (it expects free cash flow to increase 15%+ for fiscal 2018 thanks to working capital optimization), but the company’s risk profile has exploded:
1) too much debt;
2) too much integration risk;
3) too little dividend security and little growth, if at all;
4) too heavy of cost headwinds;
5) too much potential for product pricing pressure
We’re maintaining our $44 per share fair value estimate at this time. General Mills has never been a top consideration for inclusion in the simulated Dividend Growth Newsletter portfolio.
Food Products (Small/Mid-Cap): CALM, DF, FLO, FDP, HAIN, HRL, JJSF, LANC, MKC, SJM, THS, TSN
Food Products (Large/Mid-Cap): ADM, BG, CPB, CAG, GIS, HSY, K, KHC, MDLZ, NSRGY, UL, UN
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.