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Shareholder rewards should increase as GIS leverage drops below target

admin | December 18, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The strong earnings growth at General Mills witnessed so far in calendar 2020 from pantry stocking has enabled the company to drop below its 3.0x net leverage target to 2.9x. Although this bodes well for equity holders, there is little upside to GIS debt spreads as its one of the tightest trading credits in the BBB packaged food space. Down in quality trades look particularly attractive and offer the most value in the back-end of the curve.

General Mills (GIS) fiscal second quarter results reflected the continued “at-home dining” trend as organic revenues were up 7% year-over-year, reflecting total volume growth of 4% and price/mix growth of 3%. The EBITDA growth witnessed so far in calendar 2020 from pantry stocking has enabled the company to surpass its 3.0x net leverage target as management noted that net leverage now stands at 2.9x. Despite the strong top and bottom line growth, GIS stock has underperformed the S&P Index (Exhibit 1) and management will look to normalize its capital allocation priorities to include shareholder rewards. The dividend was just increased 4% and share buybacks are expected to be resumed in an effort to support the equity.

Exhibit 1. GIS Equity vs. SPX Index year-to-date 2020

Source: Bloomberg; Amherst Pierpont Securities

Investors should consider a down in credit quality trade and swap into Conagra Brands (CAG) which offers a pick-up of 50 bp in g-spread in the back-end of the curve (Exhibit 2).

Exhibit 2. BBB packaged food curve

Source: Bloomberg TRACE; APS

Volume Driving Top Line Growth but Margin Growth Stunted

For both fiscal second quarter and the first half of the fiscal year, GIS’ results were driven by volume growth, something the packaged food industry had not been witnessing pre-pandemic. In fact, prior to the pandemic, organic volume growth at the majority of packaged food companies was flat at best, even after recent rounds of M&A activity. In North America, organic volume growth was up 10 points in the quarter and 13 points for the first half. The company also witnessed strong organic growth in the pet food business which was up 15 points and 13 points, respectively. Management noted that they expect demand trends to be generally consistent with recent months, translating to similar organic net sales growth in fiscal third quarter as witnessed in the second quarter.

Management remained reluctant to provide any real guidance for the full year as the magnitude and duration of at-home food demand remains highly uncertain. That said, GIS noted that due to first half adjusted operating profit margin results exceeding expectations, they now expect the full year fiscal 2021 adjusted operating margin to be in line to better than the previous year. Previously they were looking for the adjusted margin to be in line with the year-ago period. While the margin exceeded expectations, we do note that it was down 10 bp year-over-year in the quarter, to 18.3%, reflecting increased SG&A expenses associated with media investments. For fiscal 2020, the adjusted operating margin was 17.3%. Comparisons are expected to get harder in the second have of fiscal year 2021 likely underscoring management’s reluctance to provide any real guidance for the year.

Creating Value for Shareholders

GIS is now below their leverage target of 3.0x as net debt/EBITDA stands at 2.9x. Management noted on the earnings call that with their deleveraging efforts essentially done and the fact that they have already increased the dividend 4% this year, they have other triggers to pull to create value for shareholders. While M&A is a constant theme in the packaged food space, management discussed looking for bolt-on acquisitions that could help reshape their portfolio as one option to create value. If no smaller acquisitions that are accretive can be found, they believe they are in a good position to buy back shares. The company did not provide a specific amount as to how much share repurchase authorization was left under its current buyback program but noted it was a “fair amount”. That said, there are zero hurdles for GIS to resume repurchases and they do not need to wait for the pandemic to be over to do so.

Fitch May Keep Outlook Negative

While both Moody’s and S&P have stable outlooks on GIS’ mid-BBB ratings, Fitch still maintains a negative outlook, which reflects the possibility that gross leverage would remain above 3.5x in fiscal 2021. Fitch noted that in order to revise the outlook to stable, GIS would need to reduce gross leverage to the 3.5x level in fiscal 2021. While GIS’ leverage target is on a net basis, their gross leverage now stands at 3.6x, which is actually up a tick from last quarter. The seven tick differential between gross and net leverage reflects the company’s large cash position which stood at roughly $2.6 billion at the end of the quarter. Unless a substantial amount of that cash is used to reduce upcoming debt maturities in calendar 2021, Fitch may look to keep the outlook on negative.

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