General Mills (GIS) has dramatically underperformed the market in the last two years. During this period, the stock has lost 30% whereas S&P has rallied 22%. As a result, General Mills is currently trading at a 5-year low and is offering a dividend yield of 4.6%. This is the highest yield the stock has offered in the last 30 years. As the market does not offer such attractive yields for free, the big question is how safe the dividend of General Mills is.

First of all, one of the most important parts of a dividend growth strategy is to avoid dividend cuts. A growing income stream is paramount for investors to offset the effect of inflation and reach their financial goals. Moreover, a dividend cut usually goes in tandem with significant capital losses so it has a double negative effect on a portfolio. Overall, one cannot overemphasize the importance of avoiding dividend cuts.

Reasons for General Mills' Underperformance

The main reason behind the disappointing performance of General Mills is the secular decline of its flagship products. As consumers have become increasingly health-conscious in recent years, the company has failed to grow its revenues and its earnings for five consecutive years. In addition, it is facing more intense competition than ever, as there are numerous products on the shelves of supermarkets, both branded and private-label. The fierce competition exerts great pressure on the margins of General Mills. Its margins are also pressured by large retailers, which have engaged in a price war and thus exert pressure for lower prices on their suppliers. All these factors have adversely affected the business performance of the food stalwart in recent years. Even worse, they are likely to remain in place for the foreseeable future.

The performance of the stock has also been affected by the environment of rising interest rates. Most of the shareholders of General Mills are holding the stock for its attractive dividend and its exceptional dividend record. As interest rates rise, investors can find decent yields elsewhere. Consequently, rising interest rates exert downward pressure on the valuation of General Mills. It is not accidental that the stock peaked in mid-2016, when interest rates were still around record-low levels.

Finally, the stock of General Mills has also been negatively affected by the acquisition of Blue Buffalo for $8 B. As this amount is 32% of the market cap of the stock, this acquisition is obviously a transformational one. In other words, General Mills is a different company after this acquisition. Moreover, the market fears that such a large acquisition signals that management is not confident in turning around the core business anymore. Furthermore, this acquisition pronouncedly increased the debt load of General Mills. The interest expense has almost doubled, from $302 M in 2017 to $593 M in the last 12 months.

Management’s Guidance

When General Mills announced the acquisition of Blue Buffalo, management stated that it would freeze the dividend until it reduced leverage to a comfortable level. It also reassured investors that the dividend was safe. While this is an important statement, there have been plenty of cases of dividend cuts, in which management was reassuring investors for the safety of the dividend even a few weeks before the dividend cut. Therefore, while the above statement of the management of General Mills is important, investors should also perform their own due diligence to examine how safe the dividend is.

Growth Drivers

While the acquisition of Blue Buffalo has burdened the stock of General Mills, it is likely to be the major growth driver in the upcoming years. The U.S. pet food market is a $30 B market that has grown by 5% per year on average over the last decade. As this business has not shown any signs of fatigue, it is likely to continue to grow at a meaningful pace for the foreseeable future. Blue Buffalo is the market leader and has a reliable growth record, as shown in the chart below.

Source: Investor Presentation

In the most recent conference call, management reiterated its confidence in the prospects of Blue Buffalo and stated that it expected double-digit top and bottom line growth from the leader in the pet food market.

Moreover, General Mills exhibits positive momentum in its yogurt segment. The company suffered from intense competition in this segment in recent years. However, its R&D department is trying to turnaround this business, with promising signs so far. After the 20% plunge in yogurt sales in 2017, the company has improved its performance with sale declines of 11%, 8%, 5% and 2% in the last four quarters. Thus yogurt shows signs of turning around and hence it may be a significant growth driver in the upcoming years.

Payout Ratio

When checking the safety of a dividend, it is always important to check the payout ratio. As the annual dividend is $1.96 per share and General Mills is expected to earn $3.06 per share in this fiscal year, its payout ratio is 64%. On the one hand, due to the absence of earnings growth in the last five years, the payout ratio currently stands at a decade-high level. On the other hand, it is very far from a level that would force the company to cut its dividend.

It is also critical to note that General Mills has an exceptional dividend record. To be sure, it has not cut its dividend for 118 consecutive years. As a result, its management will do everything possible in order to defend this impressive streak. Moreover, as the food stalwart is likely to grow its earnings thanks to the above growth drivers, even at a lackluster pace, it will see its payout ratio improve. Therefore, the current dividend can be considered safe for the foreseeable future.

Balance Sheet

As mentioned above, the acquisition of Blue Buffalo pronouncedly raised the debt load of General Mills. The interest expense has almost doubled while the net debt has climbed from $15.9 B a year ago to $22.2 B in the most recent quarter. Nevertheless, the company still has a decent interest coverage ratio around 5 while its net debt is about 10 times its annual earnings and hence it is manageable. Overall, while the balance sheet of General Mills has certainly weakened this year, the company is not likely to have any problem servicing its debt.

Final Thoughts

General Mills has greatly disappointed its shareholders with its poor business performance in the last five years and the dramatic underperformance of its stock in the last two years. However, thanks to its healthy payout ratio and the promising prospects of Blue Buffalo and its yogurt segment, the company is not likely to cut its dividend. As a result, investors can initiate a position in this food stalwart at a 30-year high dividend yield and rest assured that the dividend will not be cut.