Is General Mills (GIS) a Safe Place in the Storm?

How sustainable is the company’s recent earnings beat?

Fear that the Federal Reserve may not be bluffing about further increases in interest rates, inflation running amok, and many onlookers declaring we are already in a recession have paved the way for stocks in defensive sectors to shine in recent weeks. Case in point- cereal maker General Mills (GIS). GIS shares are selling near an all-time high in the current “play it safe” market environment and the company’s recent fiscal fourth-quarter earnings beat posted a couple of weeks ago certainly didn’t hurt. However, we saw several weaknesses in the quarter that may make earnings beats more difficult to come by in the next couple of quarters.

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Massive Price Increases Led to Huge Volume Declines

GIS reported non-GAAP EPS of $1.12 beating forecasts by 11 cents. One of the biggest drivers of the earnings beat was an organic sales increase of 9% which was driven by a huge 18% increase in prices. Unfortunately, the price increases resulted in a huge hit to demand resulting in volumes falling by an alarming 9%.

The following table shows a breakout of the growth of the total company and its individual reporting segments. GIS recently changed its segment reporting so we can only go back two quarters with the current segment presentation.

Price increases are powerful as the gain from pricing falls mostly to the bottom line. Revenue rises but costs don’t change much. There are no additional variable costs associated with delivering additional units and fixed costs such as depreciation, marketing, and R&D don’t change much if any. We estimate that losing 1% of the price hike would have cost GIS about 6.5 cents of EPS. Thus, we don’t consider this a sustainable or high-quality earnings beat. The company’s guidance would seem to confirm that, calling for sales growth of 4%-5%, operating profit change of -2% to +1%, and EPS growth of only 0%-3%.

The table above clearly shows significant price elasticity in all segments except Pet food- the 18% boost from prices came with a cost. However, the company is expecting to continue to lean on price increases in the future. Guidance calls for 4%-5% organic growth with 14% inflation – that would seem to indicate another round of very high price hikes and lost volume. We see several things that can go wrong with that plan. First, their big customers such as Walmart and Kroger are saying on their conference calls that they expect to keep pricing on food items as low as possible and expect their suppliers to help out in that area too. Also, they are highlighting that consumers are switching away from branded items toward cheaper store-brand substitutes and the stores are enjoying faster growth in that area. As noted above, if customers push back even just a little on price hikes – every 1% GIS doesn’t pull through is about 7 cents per quarter in EPS.

It seems very likely that more volume declines are likely if the company continues to raise prices. It is important to remember that volume declines have the reverse impact on profitability that price increases do. Fixed costs are spread over fewer units. Fewer units go on the truck despite having to pay for the driver and the gas to make the same number of stops as before. As we will discuss below, we expect the company will be adding higher-cost units to inventory which will mean an increase in cost of goods sold per unit. This will offset much of the growth from price increases.

Also key to note is the fact that the only segment that reported positive volume was the company’s Pet division which still benefitted from a 25% boost from higher prices. GIS’s main pet line is the Blue Buffalo brand of premium pet food. While premium pet food sales have remained strong so far, we see this as a key area of growth that could quickly falter if pet owners suddenly and unexpectedly traded down to lower household costs. When budgets get squeezed, Fido will still eat, but he may have to eat a cheaper brand until inflation lifts. As 12% of revenue and the only source of positive volume growth, disappointment in this area could leave a mark.

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Inventory Is Not Growing

GIS is still not growing its inventory at rates that correspond to 14% inflation. Total inventory was $1.87 billion at the end of May vs. $1.82 billion the year before. As shown in the following tables, raw materials are up 29% and grains are up 48% within that total, but total DSIs were down by two days y/y.

Management said after the 2/22 quarter and again after the 5/22 quarter that it didn’t expect to rebuild inventories or to see it build in customer stocks either. They were correct on that. But, adjusted gross margin still fell 70 bps y/y in the 5/22 quarter and the 2/22 quarter saw a decline of 160 bps y/y. GIS blamed inflation and supply chain deleveraging. How does this get better in the near term? Lower volumes should deleverage supply chains more and higher-cost raw materials and grains are working their way into finished goods. We have speculated that gross margins may have been helped already by liquidating LIFO layers and tapping older inventory at lower price points.

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Unsustainable Cuts to Operating Costs

We discussed above how higher prices are leveraging operating costs. However, GIS also cut some expenses in dollar terms too which gives an added boost to cost leverage. Advertising and promotion look like areas that could become headwinds as GIS is guiding to spending more in fiscal 2023:

Lower promotional spending boosts revenue and lower advertising against higher revenue boosts margin. Just looking at lower advertising in fiscal 2022 against higher sales gave GIS 43bp of better margin. Now GIS is guiding to flat operating profit in dollar terms.

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Higher Interest Rates Will Also Be a Headwind to Earnings Growth

GIS has $11.6 billion in debt. Higher interest rates may take a toll sooner than later with $811 million in commercial paper and banklines, $768 million due in the fall of 2022 with rates of 0% and 2.6%, and $1.94 billion due in 2023 with some at 1% and others floating rate. We don’t believe GIS will have a problem rolling this debt over, but 30% of their debt rolls over within 17 months and may well happen at a higher rate. Every 100bp is $35 million or 5 cents of EPS headwind.

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Disclosure:

This article is intended for educational purposes and is not investment advice.

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