Consumer Staples: One Buy, One Sell

by Will Ashworth | August 2, 2013 2:48 pm

Kellogg’s (K[1]) second-quarter results[2] Thursday morning were a bit of a mixed bag. On one hand, it seems its U.S. business isn’t performing up to expectations forcing it to cut 2013 revenue estimates. On the other hand, it reaffirmed its full-year earnings guidance.

Clearly its future, while generally positive, is still a bit murky.

Also murky is the S&P 500’s consumer staples sector. It’s up 18% year-to-date — nearly identical to the index in its entirety, making it very difficult to predict where packaged goods stocks like Kellogg are headed.

Nonetheless, I’m going to recommend a couple of plays: specifically, buying General Mills (GIS[3]) and selling Mead Johnson Nutrition (MJN[4]). Read on and I’ll explain why:

Organic Growth

During the past two years, General Mills grew its international revenues by 79% to $5.2 billion, largely on the back of two acquisitions. However, during its annual meeting on Tuesday, CFO Dan Mulligan said the company has no M&A plans in 2014, and instead will work on growing organically through the introduction of more than 200 new products. Besides, with the integration of both Yoki Alimentos and Yoplait still ongoing, it doesn’t need any more distractions.

Never say never, but the company appears sincere.

Brands getting busy in 2013 include Betty Crocker, Cheerios, Chex, Progresso, Hamburger Helper and Yoplait. You cannot continue to grow if you’re not introducing new products. Acquisitions might add to the variety of brands you’re able to offer grocery stores, but you need to keep up with consumer trends if you want to stay relevant.

General Mills almost missed the boat when it comes to Greek-style yogurt. Originally delivering a cheaper product that didn’t resonate with consumers, Yoplait’s U.S. yogurt market share dropped from 40% in 2010 to under 30% at the beginning of 2013. GIS went back to the drawing board, coming up with Greek 100. The 100-calorie offering has earned a Weight Watchers International (WTW[5]) endorsement, and it has been so successful it will generate $140 million in its first year of sales. Most new product launches are lucky to do $50 million in first-year sales.

Meanwhile, GIS stock is up 30% year-to-date — easily its best performance in the past decade. That’s not bad, considering General Mills is a remarkably consistent stock with just one losing year in the past 11 — and even then it was only a 1% decline.

I don’t expect you to buy GIS stock just because it’s consistent, but that certainly helps.

No, I think you should buy General Mills because of its financial strength compared to its peers. Levered free cash flow — which subtracts interest and principal payments — as a percentage of enterprise value gives us a pretty good idea whether its stock is cheap compared to its ability to generate cash. Higher is always better.

Company Ticker Levered Free Cash Flow/
Enterprise Value
Kraft Foods KRFT 6.2%
General Mills GIS 5.1%
Campbell Soup CPB 3.3%
Kellogg K 2.1%
ConAgra Foods CAG 1.6%

Of the five peers, only Kraft Foods (KRFT[6]) has a better ratio. You could buy Kraft instead — after all, it has a slightly higher dividend yield at 3.5% compared to 3% for General Mills. But GIS’ two recent acquisitions put it in a much better spot geographically, with 29% of revenue outside the U.S. compared to 16% for Kraft. Remember that Kellogg reported earnings that included slower U.S. business; geographic diversification is important.

Furthermore, although General Mills made some serious mistakes with Greek yogurt, I see Yoplait growing significantly in the next few quarters. It will be the best-performing brand at either company.

It’s a close call, but I like General Mills’ brands more.

Price Fixing

Considering the packaged goods industry is performing just fine on the whole, it’s no easy task to point to a selling opportunity. Nothing appears to stand out except a little price-fixing problem that Mead Johnson Nutrition faces in China.

Mead Johnson, along with other foreign manufacturers of infant formula, are being investigated by the Chinese government for colluding to raise the price of its baby formula. MJN, along with the other foreign companies, have raised prices 30% since China’s melamine crisis in 2008. A distrust of Chinese manufacturers of infant formula led to the foreign competition grabbing almost 50% market share. The resulting profits were tremendous.

In the first six months of 2013, Mead Johnson’s Asia/Latin America segment accounted for 80% of its total operating profits. In 2012, Chinese revenue was $800 million, or about 30% of its Asia/Latin America business. Its Asia/Latin America EBIT margin was 33% in 2012, which suggests China’s EBIT was approximately $264 million, or 23% of its overall profit. With the Chinese government looking to consolidate the domestic infant-formula industry, Mead Johnson’s money machine could be in the early stages of disappearing. With no other businesses to fall back on, a serious dent in its Chinese revenue would have permanent consequences.

Don’t get me wrong — Mead Johnson is an extremely profitable company. It expects 2013 earnings to be at least $3.22 per share. At current prices, that’s about 23 times its 2013 projected earnings — earnings it is growing at 10% annually, so it will take more than 10 years to earn back the price paid for its stock.

And that’s assuming the damage in China isn’t permanent.

If Mead Johnson Nutrition had a global monopoly on infant formula, I might be willing to take the risk on China. With three competitors as large as Abbott Labs (ABT[7]), Danone (DANOY[8]) and Nestle (NSRGY[9]) duking it out in Asia, though, you’re better off owning their stocks rather than MJN.

For this reason … I’m out.

As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.

  1. K:
  2. second-quarter results:
  3. GIS:
  4. MJN:
  5. WTW:
  6. KRFT:
  7. ABT:
  8. DANOY:
  9. NSRGY:

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