It isn’t easy to find strong growth in the consumer staples sector these days. After years of run-ups, analysts admit it’s difficult to uncover opportunities that are large enough to impact these typically very large companies.
But that doesn’t mean the stocks aren’t improving. Over the past year, the Standard & Poor’s 500 index of large consumer staples moved up 10 percent. General Mills (ticker: GIS), however, blitzed that mark, jumping 26 percent despite seeing sales fall 6 percent in 2015.
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Somehow, despite the decline in demand for many of General Mills’ most important segments, including cereals and yogurts, the company hasn’t lost a step in the market. What’s driving this push forward and can it continue? The answer isn’t nearly as clear as investors might hope.
The taste for cereal has waned. The cereal market in the U.S. has hit a wall. Over the past year, demand for cereals have fallen 2 percent and General Mills has felt the shift since it owns a 30 percent share in the ready-to-eat cereal market. Its sales in the space fell about 1 percent last year.
But they’re not alone on this. Kellogg Co. (K) revenues fell 7 percent last year, largely due to the same trend. “On a high level, you want your competitors to be strong,” says Pablo Zuanic, an analyst for Susquehanna International, based in Stamford, Connecticut. “A strong Kellogg helps them.”
That’s because a thriving Kellogg indicates that the cereal industry has growth again, which is where General Mills gains about 23 percent of its U.S. retail sales. To make matters worse, the yogurt segment, spearheaded by Yoplait, has also begun to decline, falling 7 percent a year after it rose 5 percent in fiscal year 2015.
To tackle these trends, General Mills has looked toward organic offerings as a way to entice consumers back. In 2014, it bought organic and natural food maker Annie’s for $820 million. “A lot of traditional food companies are trying to diversify their portfolios to get more naturals organics in them,” says Jack Russo, an analyst for Edward Jones.
“Annie’s has been pretty successful,” he adds, but “it’s too small to move the needle,” on General Mills’ $16.6 billion in sales.
The Kraft-Heinz merger has put every company on notice. Last year, Kraft Foods merged with H.J. Heinz to create one of the largest food companies in the world in Kraft Heinz Co. (KHC). One big reason for the merger was that the companies struggled to find organic growth in the U.S. market. This has fueled speculation that other mergers will take place in the food segment, after Kraft Heinz has climbed 21 percent in 2016.
“The fact that Kraft Heinz is doing well, delivering on targets,” Zuanic says, “that assumes more transactions down the road.”
There’s currently a major potential merger in discussion within the sector, as Mondelez International (MDLZ) has pursued Hershey Co. (HSY), although it’s unclear if those talks will move beyond a conversation. Hershey has denied Mondelez’s initial $23 billion offer.
[Read: Mergermania: Why Mergers Could Make for Big Winners in 2016.]
While General Mills hasn’t faced as much direct heat, in part because “given their size, few companies can buy them,” Zuanic says, it has become a popular buyout choice for forecasters. Zuanic says that KHC could look at General Mills because there’s not a lot of overlap in products, for example. Plus, to affect its performance, Kraft Heinz would need to buy a very large company.
Guessing who’s next to be bought out has become a game, Russo says. But this talk has pushed up the company’s stock price, even though it’s unclear if any merger will materialize.
Cutting costs has been General Mills’ answer. General Mills’ U.S. sales account for 60 percent of its revenues. In an effort to counter the 6 percent fall in U.S. retail sales over the past two years, it has undergone a cost-cutting effort. It plans to find $600 million in annual savings by the end of 2018.
These cuts have come in a variety of forms, including layoffs, advertising reductions and decreases in travel budgets. Last week, the company announced it would reduce its employee count by about 1,400 workers by closing a number of manufacturing plants around the globe, including potentially the original Progresso soup plant in Vineland, New Jersey.
There are limits, however, to what General Mills can do. In order to keep prime shelf space in retailers’ stores, for example, there are certain expectations to maintain a high level of advertising to promote the products. This means Betty Crocker products land at eye-level when walking through Wal-Mart Stores (WMT), in part because Wal-Mart knows the advertising will support the placement. “It costs a lot of money to maintain this,” Russo says.
This limits how much it can grow profits through cuts alone.
It’s near the height of its historical range. When it comes to the stock, the recent rise in the company has left it expensive. With a 24 price-earnings ratio, it’s at the high end of its historical range of 16 to 25 P/E, according to Russo’s analysis.
The main reason it has risen so high is because of the prediction of a merger at some point. However, it’s also because the company throws a large portion of its cash — typically more than 90 percent of its free cash flow — back to investors, including a 2.5 percent dividend yield.
[See: 7 Stocks to Buy When a Recession Hits.]
But without a clear avenue for growth, it makes buying into General Mills at this price point difficult, except for those dividend chasers out there.
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GIS Stock: 4 Things to Shelve About General Mills originally appeared on usnews.com
