EUR 850.00 For Business Accounts Only

Morningstar | General Mills' Pricing Remains Solid in 2Q, Supporting Profitability; Shares Undervalued

We’re encouraged by wide-moat General Mills' second-quarter results, which included 5% sales growth (a 1% decline on an organic basis) and a 2% improvement in organic price/mix. Year to date, price/mix has contributed around 2 points of sales growth, standing above the 1% contribution in fiscal 2018 and our roughly 1% full-year expectation, as the firm bolsters innovation across its categories. This supports our contention that consumer goods companies can leverage pricing to help offset broader secular declines in their categories, so long as they are able to bring new, value-added products to market (justifying a price premium) and ensure their portfolio of brands continues to resonate with evolving consumer preferences. This improvement in pricing, coupled with the firm's ongoing cost-saving initiatives, also had a favorable impact on profitability, with adjusted operating margin increasing 40 basis points to 17.3% despite input cost inflation. Year to date, this metric is tracking at 16.5%, in line with our full-year outlook.

We plan to adjust our near-term outlook to incorporate modest foreign exchange headwinds and a slightly higher degree of volume degradation in the North America retail segment, which should be largely offset by a stronger contribution from price/mix. We expect these revisions will shave about a dollar off our $58 fair value estimate. However, we're holding the line on our longer-term outlook for low-single-digit pro forma sales growth (with a 1% average contribution from price/mix) and gross margin in the mid-30s. Even with the mid-single-digit percentage uptick in the share price after the earnings release, we continue to think the name offers an attractive entry point.

International markets and the pet segment (Blue Buffalo) have the most promising growth prospects, in our view. Organic sales in Asia and Latin America (10% of revenue) grew 7%, as General Mills continues to develop offerings that appeal to local consumers and expands its distribution network abroad. While pro forma sales in the pet business (8% of revenue) declined 7%, we attribute this to challenging comparisons in the prior-year period (25% sales growth, as Blue Buffalo first launched its fare in the food, drug, and mass channel) and were heartened by high-single-digit growth in retail sales (30% in the e-commerce channel) and 40 basis points of share gains in the first half. We appreciate General Mills' ability to leverage its entrenched retail relationships (which underscores our view of its wide moat) to expand Blue Buffalo's distribution. According to management, household penetration has increased 27% since 2017 and distribution (as measured by ACV) nearly doubled between October 2017 and October 2018 to 32%; management expects this metric will double again by the second half of the year.

We see evidence that industrywide pricing remains healthy, with management citing that 8 of the top 10 food and beverage manufacturers have obtained positive price/mix this year. We think the market has been too pessimistic about the ability of consumer goods firms to take pricing in response to declining traffic in the center of the store and ongoing commodity cost headwinds. Concerns also abound that leading branded operators may increase promotional activity or compete on price (especially as the threat of private label, which accounts for 15%-20% of domestic food and beverage sales, remains pervasive). However, we think these results suggest that companies that maintain strong investments behind their brands and entrenched retail relationships can restore top-line growth longer term as they refresh their offerings and become more responsive to consumer tastes. We expect General Mills' combined spending on marketing and research and development to average above 7% of sales over our forecast, versus a five-year historical average a touch below 6%.