HRL - General Mills: Below Market Returns Set To Continue

2023-11-03 03:43:32 ET

Summary

• General Mills has underperformed the S&P 500 over the past 10 years, returning only 81% compared to the index's 186% return.
• The company operates in a highly competitive and mature industry, limiting its ability to expand margins and achieve high growth.
• Recent weaknesses in GIS stock can be attributed to rising interest rates and concerns about the impact of weight loss drugs on consumer behavior.
• GIS trades at a below market valuation but also offers below market growth.
• I expect GIS to continue to underperform the S&P 500 going forward unless there is a significant economic downturn.

Shares of General Mills (GIS) have delivered below market returns for investors over the past 10 years returning ~81% compared to a ~186% return generated by the S&P 500 over that time.

While GIS is a high quality company and the stock trades at a low valuation, I believe the stock is poised to continue underperforming the S&P 500 due to secular challenges.

Business Overview

GIS is a food company that has been in business for more than 150 years. The company produces and markets more than 100 different consumer brands. GIS is fairly diversified with nine separate brands accounting for more than $1 billion in sales.

The company's North America Retail segment represents 63% of total revenue and 78% of operating profit. The International segment represents 14% of total revenue and 4% of operating profit. The Pet segment accounts for 12% of revenue and 11% of operating profile. The North America Foodservice Segment accounts for 11% of revenue and 7% of operating profit.

GIS has a long history of delivering steady earnings growth which reflects the mature nature of its business.

Low Growth & Highly Competitive Industry

GIS competes with other food companies such as Kellanova ( K ), WK Kellogg Co ( KLG ), Kraft Heinz ( KHC ), Conagra Brands ( CAG ), Hormel Foods ( HRL ), PepsiCo ( PEP ), and many other leading companies. Moreover, GIS competes with retailers such as Walmart ( WMT ) and Kroger ( KR ) which offer private label products which tend to be priced below brand name products sold by GIS.

As a result of high competition, GIS traditionally has only been able to generate profit margins in the high single-digits.

In addition to being highly competitive, the food industry is fairly mature and is thus characterized by slow growth. As shown by the chart below, GIS and its peers have been able to grow revenue by mid single digits over the past few years which is just slightly above GDP growth.

Lack of Cyclicality

The food business tends to experience a relatively low degree of cyclicality as people generally need to eat regardless of economic conditions. During an economic downturn consumers may trade down from brand products sold by GIS to cheaper private label products sold by companies such as Walmart or Kroger. However, this tends to offset by the fact that consumers tend to eat at home more vs dining out.

Further evidence for GIS's lack of cyclicality can be seen in its relatively low beta compared to the S&P 500. As shown below, over the past 10 year GIS has exhibited an average beta of just ~0.52x.

Recent Weakness Drivers Unlikely to Abate

Since hitting an all-time high on May 12, 2023, GIS shares have experienced significant weakness delivering a total return of ~-27% compared to a return of 2.3% delivered by the S&P 500 during that time.

The sell-off in GIS has been driven by a number factors including rising interest rates and fears that new weight loss drugs will lead to lower consumption of high calorie foods.

Given that GIS and other consumer staples tend to be low growth high dividend type situations, they tend to be highly sensitive to moves in interest rates. As shown below, the move lower in GIS has lockstep with the move lower in bonds. However, GIS's current dividend yield of 3.6% remains well below the 30yr Treasury yield of ~4.8%.

Another driver of weakness in GIS shares has been the growing concern that weight loss drugs such as Ozempic, Mounjaro, and Wegovy will lead to changes in consumer behavior resulting in lower demand for high calorie foods. I do not expect this concern to abate anytime soon as we are still in the early innings of understanding what these drugs may mean for food consumption.

Growth Projections Reaffirmed

GIS recently reported Q1 FY 2024 results and reaffirmed previous guidance for 3%-4% sales growth and 4%-6% Adj. Diluted EPS growth. I believe these growth projections are reasonable. Current Wall Street consensus analyst estimates are also in line with the company's guidance.

Valuation

GIS currently receives a Seeking Alpha quant valuation grade of C-. I tend to agree with this characterization.

GIS is trading at 14.5x FY May 2024 earnings. Comparably, the S&P 500 is trading at ~17x consensus 2024 earnings. While GIS is growing earning by low to mid single digits, I believe the S&P 500 is poised to grow earning by mid-to-high single digits for the next few years. Thus, I do not find GIS's valuation highly attractive compared to the S&P 500.

GIS is currently trading at a middle of the pack valuation compared to peers. GIS is trading at a premium valuation to KHC, inline with K, and at a discount to HRL and PEP. Thus, GIS does not stand out to be as being highly attractive relative to peers.

GIS is trading at the lower end of its historical valuation range but I believe this makes sense given the recent increase in interest rates and slow growth nature of GIS.

Conclusion

GIS has delivered positive but below market returns over the past decade. I believe this is a result of the fact that GIS is a low growth company operating in a highly mature industry. GIS faces still competition and thus is limited in its ability to expand margins.

Despite a relatively low level of cyclicality, GIS has experienced a significant sell-off over the past few months. The sharp move lower in the stock has been driven by rising interest rates and concerns that new weight loss drugs will result in lower demand for high calorie food products.

While GIS shares are now trading at a modest discount to the S&P 500, I do not view GIS's current valuation as highly attractive vs the S&P 500 given its low growth profile. Moreover, I believe GIS could continue to see near-term selling pressure as the dividend yield of 3.6% remains well below the 30 year treasury rate of 4.8%.

I do not believe fears related to sales challenges due to weight-loss drugs will abate anytime soon as we are still in the very early innings in terms of understanding the impact that these drugs may have on food consumption.

For these reasons, I believe GIS will continue to underperform the S&P 500 going forward.

The biggest risk to my view is a major economic downturn. During such a period, I would expect GIS to outperform the S&P 500 due to its relatively defensive business characteristics. I would consider upgrading GIS in the event that I expect the economy to go through a deep recession.

For further details see: