GIS - General Mills: Recent Quarterly Results Highlight Some Important Areas Of Progress

2023-03-24 15:58:30 ET

Summary

• General Mills continues to perform exceptionally well relative to the broader equity market.
• The ability to offset a record high input cost inflation highlights the importance of a strong brand portfolio in strategic areas.
• As volumes return to positive territory, profitability in the pet food segment remains an area of concern.

Earlier this week General Mills (GIS) delivered yet another strong quarter with both revenue and adjusted Earnings per Share )((EPS)) surpassing the consensus estimate.

The business continues to execute well on its strategy, in spite of short-term headwinds related to higher commodity prices. Just a month later since my previous analysis and GIS' share price is already trading with a wide gap between the S&P 500.

For the past two years or so, this performance gap is even more impressive (see below) and as the odds of a recession increase, GIS is likely to remain a solid pick in the Packaged Food space.

What Happened During The Quarter?

On a GAAP basis, however, the earnings actually missed the estimates and came in lower than previous quarters.

On one hand, the reason for the discrepancy between reported and Non-GAAP numbers has been mark-to-market effects (more on that below).

On the other hand, reported earnings per share came in lower to prior quarters largely due to divestiture gains related to the European yogurt business in the third quarter of fiscal 2022.

The mark-to-market effects were due to outside factors largely related to rising commodity prices.

In the third quarter of fiscal 2023, we recorded a $67 million net increase in expense related to the mark-to-market valuation of certain commodity positions and grain inventories compared to a $20 million net increase in expense in the same period last year. We recorded $20 million of net losses related to valuation adjustments on certain corporate investments in the third quarter of fiscal 2023, compared to $11 million of net gains related to the sale of certain corporate investments and valuation adjustments in the third quarter of fiscal 2022.

Source: General Mills Q3 2023 Earnings Release

The main raw materials used by General Mills are grains, such as wheat and corn, dairy products, sugar, etc.

From these, wheat has already peaked in the first half of last calendar year and has cooled-off significantly since then.

Oat prices have come down even more in the past few months.

Nonetheless, the price of corn remained at its peak levels and as we could see down below this also holds true for a number of other major ingredients.

There are different dairy products that are used by GIS, however, the average price for milk has reached its peak around mid-2022 and has stayed at these levels since then.

General Mills sources most of its sugar from local suppliers, however, the global price of sugar is now at its highest levels for the past few years.

Overall, even though some commodity prices have come down from their peaks, the synchronized increase in prices of other materials is likely to continue to weigh on GIS earnings.

Looking past the short-term headwinds, however, the company's strong brand portfolio and strategic positioning should allow management to offset these higher input costs through the recently implemented price increases.

What About The Red Flags?

Two key areas of concern that I highlighted a month ago , were the falling volumes and issues within the company's pet food segment.

During the last quarter, volumes have stabilized with Pet Food and Foodservice back returning to growth.

Thus the overall impact of volumes remained flat for the quarter, but at the same time the effect of price/mix on organic growth remained exceptionally high.

This is now more in-line with other high quality peers and is in stark contrast to the problems experienced during the prior three-month period.

Profitability challenges in pet food, however, remain with the segment operating profit noting a 7% decline during the quarter.

As expected, inflationary pressures were to blame, but capacity expansion is also needed as demand for pet food more broadly remains robust.

On the bottom line, third-quarter Pet segment operating profit declined 7 percent, driven primarily by double-digit input cost inflation , increased costs related to capacity expansion and service improvement , and higher SG&A expenses, including a double-digit increase in media investment.

Source: General Mills Q3 2023 Prepared Remarks

General Mills' major peer in this category - Colgate-Palmolive's ( CL ) Hill's brand also noted a slight decline in margins during 2022, but seems to be getting ahead in terms of capacity expansion in both dry and canned categories.

So far, GIS management does not see a more temporary issue in the category and also attributed recent weakness to broader market dynamics (see below). Nonetheless, capacity expansion, market share and input costs in the pet food segment remain key areas to watch through the rest of fiscal year 2023 and 2024.

And so, we really don't see a lot of trade down to private label , for example, or lower-priced brands. I mean it really is a function if there's a change in the category dynamics is that more people are going back to the office, and so mobility is a little bit higher. And so there's a little bit of feeding of wet dog food, for example, and more dry dog food and maybe a little bit less treating because people, again, are at their place of work more.

Source: General Mills Q3 2023 Earnings Transcript

Conclusion

Uncertainty around future commodity prices and economic activity is likely to remain elevated in the coming months. Nevertheless, GIS is well-positioned to offset the higher input costs through price increases. The only area where this is not yet the case is pet food, hence investors should be laser focused on future profitability in this segment.

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