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CAGNY comments reinforce underperform view on GIS

| February 19, 2021

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.

General Mills (GIS) is one of the tightest credits in the packaged food space, with net leverage now below the company’s 3.0x target. Management discussed further portfolio repositioning at the CAGNY conference, which is likely to consist of debt financed acquisitions as the company looks to build long term top line organic growth. While the pandemic has helped drive organic growth for packaged food companies not witnessed in years, that growth is likely to subside as life returns to a new normal. Conagra and Campbell soup bonds both offer investors better relative value, particularly in the long end of the curve.

General Mills (GIS) continues to trade well through its triple-B packaged food peers and has made good on its promise to delever post the Blue Buffalo acquisition which closed on 4/25/18. Packaged food companies may begin to look at a combination of M&A as well as shareholder rewards to keep the top line growing and to manage EPS.

On a relative value basis investors should swap out of GIS into both Campbell Soup (CPB – Baa2/BBB- (p)/BBB) and Conagra Brands (CAG – Baa3 (p)/BBB-/BBB-), particularly in the long end of the curve. A swap out of GIS 2048 into CAG 2048 bonds provides for a roughly 50 bp pick-up in spread. CAG still remains in debt reduction mode as it looks to delever post its acquisition of Pinnacle Foods. That spread pick up is more than enough to justify the one notch ratings differential between GIS and CAG.

Exhibit 1. BBB Packaged Food Curve

Source: Bloomberg TRACE; Amherst Pierpont Securities

Portfolio Reshaping = Increased M&A Activity

Management noted that portfolio reshaping will increase the level of both acquisitions and divestitures as the company targets long term organic net sales growth of 2%-3%. While management discussed bolt-on acquisitions, there is a potential for larger acquisitions particularly if it is accretive to growth and to shareholders. One thing management did note was that they do not need to wait for the pandemic to end to pursue growth opportunities, particularly since net leverage currently stands at 2.9x. Having leverage below their target provides GIS with the financial flexibility to pursue opportunities and return further cash to shareholders via dividend increases and share repurchases.

Exhibit 2. Long Term Capital Allocation Priorities

* Net Debt to Trailing 12-Month Adjusted-EBTIDA Ratio
Source: GIS CAGNY Presentation

The reason GIS may look to pursue debt financed acquisitions is rooted in the company’s shareholder rewards policy. Currently GIS is targeting converting 95% of adjusted net earnings to free cash flow, with 80%-90% of free cash flow allocated to shareholders via dividends and repurchases. With free cash flow estimates for fiscal 2021 (ending 5/31/21) of $2.4 billion, GIS is only looking at $240 to $420 million for acquisitions. While GIS could use divestitures to allocate further proceeds to acquisitions, the real transformation to GIS’ portfolio has come with larger acquisitions. Also, given the current interest rate environment, GIS could increase leverage up to the 4.0x range with the agencies providing them flexibility (18-24 months) in reducing debt back down to their 3.0x target.

Organic Top Line Growth Likely to Stall

While the pandemic has been a boost to the top line, mid to high single digit growth is unsustainable. In fact, consensus estimates for fiscal 2021 are only calling for 1% net sales growth at GIS, which remains below management’s long-term target of 2%-3%. Looking out further, street estimates put net sales growth in fiscal 2022 in negative territory. Pre-pandemic the packaged food companies were struggling to post top line growth, which is why acquisitions were so prevalent amongst GIS and its peers. Even with GIS’ exceptional growth in calendar year 2020 from pantry stocking, the stock is currently down 1.7% year-to-date. The equity price is largely reflecting the lack of growth expected once the pandemic subsides.

Fitch to Withdraw Ratings

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. We estimate that gross leverage is currently 3.6x. 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. With EBITDA in fiscal 2021 expected to be similar to fiscal 2020, leverage was likely to rise two ticks by fiscal year end, absent any further debt reduction. On February 12, 2021, Fitch announced it plans to withdraw the rating on GIS on or about March 12, 2021. While no reason was cited for the withdrawal, Fitch noted that it reserves the right “to withdraw or maintain any rating at any time for any reason it deems sufficient”. Fitch is providing roughly 30 days’ notice of the rating withdrawal and can change its rating or outlook at any time between now and the actual withdrawal of the rating.

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