General Mills (NYSE: GIS) reported strong Fiscal Q1-2023 earnings on September 21 despite macroeconomic headwinds. In fact, among the multitude of negative earnings surprises as of late, General Mills beat expectations regarding both EPS and revenue. While this is impressive, I’m neutral on General Mills due to its valuation being too high.
Diving into its Q1 results, General Mills’ net sales increased to $4.7 billion, an increase of 4% year-over-year, facilitated by a 10% increase in organic net sales compared to the previous year. It is important to note, however, a 5% decrease in organic volume.
While seemingly concerning, a 15% increase in organic pricing and mix offset this decline, illustrating the apparent pricing power of General Mills and the consequent acceptance of price increases by the consumer.
Similarly, diluted EPS increased 32% year-over-year to $1.35, with adjusted EPS following suit, increasing 13% from the prior year to $1.11 and coming in above expectations of $1.00.
The company certainly didn’t achieve this without any challenges, however, as inflation continues to plague producers in the form of input costs. General Mills faced an approximately 14% to 15% increase in its cost of goods sold, causing its gross margin to only advance 0.2%, from 34.7% to 34.9%, compared to the previous year.
This isn’t necessarily surprising, as the PPI, a measure of inflation from the perspective of producers, came in at 7.3% in August, above expectations of 7.1%. Regardless, this was offset by the aforementioned pricing power of the firm, which sustains this still impressive margin.
Wall Street liked this news, sending shares up 5.72% on Wednesday despite downward market pressures after the Federal Reserve’s announcement of a 75 basis point interest rate hike.
What’s even more appealing is the 32% gain of General Mills over the last year, compared to the -16% return of the S&P 500 (SPX), thanks to solid fundamentals and significant barriers to entry.
General Mills was founded in 1928 and has grown to manage a diverse selection of consumer staples, including brands such as Cheerios, Blue Buffalo, and Pillsbury. With commitments to drive shareholder value through its Accelerate strategy, the company pledges to constantly innovate and capitalize on its scale.
General Mills Has Solid Fundamentals
General Mills’ success in Q1 can be partially attributed to its respectable fundamentals, though they may come at a premium to investors.
The company’s Fiscal 2022 gross, operating, and net margins are 33.71%, 17.14%, and 14.25%, respectively. While these values themselves contain some insight, it’s important to compare such metrics to previous performance or fellow competitors for a more effective ratio analysis. Accordingly, General Mills’ gross margin is superior to about 67% of companies in the Consumer Packaged Goods Industry, and the operating and net margins are superior to about an impressive 88% of companies in the same industry.
Furthermore, its return on equity, which can be interpreted as the amount of net income produced by $1 of shareholder’s equity, is 40.34%, better than about 96% of companies in the industry. In a similar manner, but with respect to assets instead of shareholder’s equity, its return on assets is 8.52%.
It is also vital to consider the economic profit or “economic value added” of the company by finding the difference between the return on invested capital and the weighted average cost of capital, determining how efficiently and effectively the company manages shareholder money.
Currently, GIS’s economic profit is 5%, which has been generally stable over the past 10 years. While not extremely high, it does outperform competitors such as the -3% economic profit of The Kraft Heinz Co. (NASDAQ: KHC) and the 4% economic profit of Kellogg (NYSE: K).
While General Mills’ capital management may be positive, attention should be drawn to its management of debt through the form of liquidity ratios, which are measures of how easily a company can satisfy its short-term debt.
General Mills’ current and quick ratios are 0.63x and 0.4x, respectively, which are quite low. These metrics place General Mills below about 90% of fellow companies in the industry.
A cursory glance at the balance sheet would reveal a decrease in cash and cash equivalents since last year, with considerable increases in accounts payable and the current portion of long-term debt; monitoring this is a necessity as more long-term debt becomes current, which could detract from future cash flow.
Speaking of cash, operating cash flow increased from $370 million in the prior year to $389 million in Fiscal Q1 2023. 90% of this is expected to be converted to free cash flow in Fiscal 2023, which can proliferate the company’s ability to return value to shareholders in the form of dividends and share buybacks. In Q1 alone, the company paid $325 million in dividends and repurchased $501 million worth of shares, up from only $150 million in the previous year.
Finally, while these fundamentals are strong, they come at a price. Its P/E ratio is currently 19.5x, with a forward P/E of 19.3x and a PEG ratio of 3.48. GuruFocus also assigns GIS an intrinsic value of $64.69, and with shares trading at $80.78, the stock appears overvalued.
General Mills’ Increases Its Fiscal 2023 Guidance
CEO Jeff Harmening was pleased with these results, stating, “We continue to deliver strong performance in a highly volatile operating environment.” As a result, he continued, “Given the strength of our first-quarter results and confidence in our ability to adapt to continued volatility ahead, we are increasing our full-year outlook for net sales, operating profit, and EPS growth.”
Organic net sales growth, which was previously expected to increase by 4% to 5%, is now expected to increase by 6% to 7%. Adjusted operating profit growth, which was previously expected to be -2% to +1%, is now expected to be flat to +3%. Finally, adjusted diluted EPS growth was increased from flat to +3% to +2% to +5%.
Any growth is notable in an inflationary and rising interest rate environment, and increasing such growth is even more impressive, pointing to the sustainable competitive advantages the firm enjoys.
The Keys to Success: Sustainable Competitive Advantages
The goal of any firm is to enjoy above-average profits over the long term, a “sustainable competitive advantage,” and the goal of investors is to subsequently identify such companies. Doing so is quite simple when considering General Mills, facilitating its strong performance.
The majority of these competitive advantages of General Mills are rooted in basic economics. For instance, General Mills has been able to mitigate the effects of inflation. Why? Because of the inelastic nature of its products.
Elasticity is a measure of how consumers’ demand reacts to a change in price. For elastic goods, a change in price provokes a substantial change in demand, and for inelastic goods, a change in price has little effect on demand. Food, for both humans and pets, is inelastic. Regardless of changes in price, consumers and their pets still need to eat, granting the firm the ability to maintain sales despite increasing prices.
On the contrary, dining at restaurants may be decreasingly feasible for consumers as the prices of both food and other necessities continue to climb. Subsequently, many are choosing to eat at home, leading to even more demand for products in the tried and true brands of General Mills.
Moreover, the company also enjoys economies of scale and scope by producing a great deal of a wide variety of products, creating multiple revenue streams. This, along with well-established brands worth $9 billion, create economic moats, or barriers to entry, preventing other companies from entering the industry.
In Q1, General Mills either grew or held market share in 66% of U.S. retail sales. This was due in part to the company’s successful execution of vertical integration, as seen in the acquisition of TNT Crust, a frozen pizza crust producer with double-digit compound annual net sales growth.
The combination of inelastic goods and a substantial market share, along with the numerous barriers to entry established by economies of scale, scope, and brand recognition, has proven to be beneficial for the company, consumers, and shareholders alike.
Is GIS a Good Stock to Buy?
Wall Street enjoyed General Mills’ Q1 Earnings, but it may now be somewhat overvalued. As such, GIS currently has a Hold rating based on three Buys, 11 Holds, and two Sells. The average General Mills price target of $76.81 suggests 2.8% downside potential, with a high price target of $88 and a low target of $57.
Conclusion: General Mills’ Valuation Offsets Its Strong Fundamentals
In an oligopolistic market with a few large competitors, it is apparent that General Mills is able to mitigate the effects of inflation. Along with positive fundamentals and a track record of growth through successful acquisitions, the many competitive advantages and economic moats may create the same confidence in investors as the company has established in consumers regarding quality and loyalty to their products. However, the current valuation is not as attractive.
Upon returning to levels closer to its intrinsic value, this consumer staple stock could also be a staple in one’s portfolio.
