Focus Stock: General Mills, a Top Pick for Tough Times

In a difficult economic environment, we expect General Mills (GIS; recent price, $65)—the name behind well-known brands like Cheerios, Betty Crocker, and Green Giant—to benefit from a shift toward cost-conscious consumers eating more at home. This should particularly help the packaged food giant's product categories such as cereal and soup, which offer relatively inexpensive per-serving costs to consumers. We expect that the company's marketing support of its diversified portfolio of brands will help General Mills to withstand competition from lower-priced private-label competitors.

Given concerns about economic weakness ahead, we expect this stock to benefit from investors seeking defensive or lower-risk shares. Also, we look for the company's important U.S. retail segment to benefit from consumers eating more at home. We believe the company has opportunities to bolster longer-term profit margins through a focus on such areas as manufacturing and spending efficiency, global sourcing, and sales mix. We look for the company to generate future free cash flow, with at least a portion being used for dividends and stock repurchases. Also, we see as positive the company's S&P Quality Ranking of A-, which reflects a solid record of historical stability and/or growth of earnings and dividends.

Based on our 12-month target price of $78, General Mills shares have prospective upside of about 20% from recent levels. Factoring in the stock's recent indicated dividend yield of about 2.7%, we have a 5 STARS (strong buy) recommendation on the shares.
COMPANY PROFILE

General Mills is the second-largest U.S. producer of ready-to-eat breakfast cereals, and a leading producer of other well-known packaged consumer foods. The U.S. Retail segment, which accounted for 66% of net sales in fiscal 2008 (May), consists of cereals, meals, refrigerated and frozen dough products, baking products, snacks, yogurt, and organic foods. The bakeries and food service segment (15%) consists of products marketed to retail and wholesale bakeries and offered to commercial and noncommercial food service sectors throughout the U.S. and Canada, such as restaurants and businesses and school cafeterias. The international segment (19%) includes retail business and U.S. and food service business outside of the U.S. and Canada.

Major cereal brands include Cheerios, Wheaties, Lucky Charms, Total, and Chex cereals. Other consumer packaged food products include baking mixes (e.g., Betty Crocker, Bisquick); dry dinners; Progresso soups, Green Giant canned and frozen vegetables; snacks; Pillsbury refrigerated and frozen dough products, frozen pizza; Yoplait and Colombo yogurt; Haagen-Dazs ice cream; and Cascadian Farm and Muir Glen organic products. Some products may be marketed under licensing arrangements with other parties. General Mills also has a grain merchandising operation that holds inventories carried at fair market value, and uses derivatives to hedge its net inventory position and minimize its market exposures.

During fiscal 2008, Wal-Mart Stores (WMT) (or affiliates) accounted for 19% of General Mills' consolidated net sales.

General Mills' joint ventures include a 50% equity interest in Cereal Partners Worldwide (CPW), a joint venture with Nestlé that manufactures and markets cereal products outside the U.S. and Canada; and 50% equity interests in some Asian-related joint ventures for the manufacture, distribution, and marketing of Haagen-Dazs frozen ice cream products and novelties.

Unconsolidated joint ventures, which are reflected in General Mills' financial statements on an equity accounting basis, contributed an aggregate of after-tax income of $111 million in fiscal 2008, up from $73 million in after-tax income in fiscal 2007. This includes a net benefit of $8.2 million from restructuring, impairment, and other exit-related items in fiscal 2008, vs. a negative impact of $8.2 million in fiscal 2007. In July 2006, the company's CPW joint venture acquired the Uncle Tobys cereal business in Australia for about $385 million. General Mills funded 50% of the purchase price.
CORPORATE STRATEGY

We see longer-term growth opportunities, including new products and international expansion. We expect efforts will be made to expand gross margins in the U.S. retail business, including opportunities for increasing the mix of higher-margin products, trade spending efficiency, discontinuing less attractive products, investment in technology, and global sourcing. In the international business, we expect General Mills to seek profit improvement in emerging markets and a leveraging of its infrastructure.

In September 2008, General Mills sold its Pop Secret microwave popcorn business to Diamond Foods, (DMND) for a price that was expected to be $190 million, subject to adjustment. General Mills said that it expected to receive pretax cash proceeds, net of transaction-related costs, of about $160 million. Also, General Mills said that it expected to have a pretax gain of about $130 million on the sale in the fiscal 2009 second quarter.

Also during the first quarter of fiscal 2009, General Mills acquired Humm Foods, the maker of Larabar fruit and nut energy bars. In the transaction, General Mills issued 0.9 million shares of common stock, valued at $55 million.
FINANCIAL TRENDS

In the first quarter of fiscal 2009, General Mills repurchased 8.2 million shares of common stock for an aggregate purchase price of $519.2 million. In all of fiscal 2008, General Mills repurchased about 23.6 million shares of its common stock for $1.368 billion.

In fiscal 2008, General Mills had costs related to restructuring, impairment and other exit costs totaling $21 million (pretax), and another $18 million of associated costs. In fiscal 2007, the company had $39 million of restructuring, impairment, and other exit costs. Also, in recent years, there have also been other restructuring expenses related to a joint venture in Britain.

In fiscal 2008, General Mills reported earnings per s hare of $3.71, which included a $0.10 a share net benefit related to mark-to-market valuation of certain commodity positions, and a $0.09 per share benefit from reduction of a tax reserve. If these two items are excluded, fiscal 2008 EPS totaled $3.52. Also, fiscal 2008's second quarter included an asset sale gain of about $0.02 a share.
FINANCIAL OUTLOOK

In fiscal 2009, we look for net sales to advance about 11% from the $13.7 billion reported for fiscal 2008, with higher pricing, and bolstered by investments in consumer marketing and product innovation. We also expect sales to receive a boost from a 53rd week in the fiscal year.

We expect margin pressure from ingredient costs, but we think operating margins will receive support from a combination of productivity gains and higher prices.

Also, we think General Mills could benefit, over time, from declines in commodity costs. However, because the company does a significant amount of commodity cost hedging, we do not expect General Mills' manufacturing margins to fully benefit from declines in agricultural commodity prices that have occurred over the past several months.

Excluding some special items, such as impact from mark-to-market valuations related to commodity positions, and an expected gain from the sale of General Mills' Pop Secret microwave popcorn business, we look for fiscal 2009 EPS of $3.90, up from $3.52 for fiscal 2008. In fiscal 2009's first quarter, General Mills had a negative impact of $0.17 a share from mark-to-market valuation of certain commodity positions.

Included in our EPS estimate for fiscal 2009 are expenses related to restructuring, impairment, and other exit costs. In fiscal 2010, we estimate EPS of $4.20.
VALUATION

Our 12-month target price of $78 reflects about an 11% premium over the price-earnings ratio we project, on average, for other food stocks. We believe this valuation is merited by the stock's defensive appeal in a relatively weak economic environment, the company's impressive group of brands, its growth prospects, and its ability to generate cash.

General Mills shares recently had an indicated dividend yield of 2.7%. The quarterly dividend has been raised twice in 2008.
CORPORATE GOVERNANCE

Overall, we have a favorable view of the company's corporate governance practices.

The chief executive officer and chairman positions at General Mills are both held by Kendall Powell, who joined the company in 1979. We would prefer to see the chairman and CEO positions separated, and held by two different people, but we do not anticipate the current management structure being a major problem.

We like that stockholders elect all directors annually. Also, the board has adopted criteria for independence based on those established by the New York Stock Exchange, and all board committees are composed entirely of independent, non-employee directors.
INVESTMENT RISKS

Risks to our recommendation and target price include competitive pressures, disappointing consumer acceptance of new products, higher-than-expected commodity cost inflation, and an inability to achieve sales and earnings growth forecasts.

Also, a strengthening U.S. dollar could have a negative impact on the foreign currency translation of General Mills' foreign sales and profits.