Consumer Staples

[EricL]

I thought this comment from Ted Fischer on one of Chowder's threads on Seeking Alpha was worth sharing. Ted talks about the debt/cash flow metrics for a few popular consumer staples stocks.

Quote:One of the problems in analyzing stocks is that people tend to focus on principle rather than the numbers, and can easily end up applying the principles at the wrong times to the wrong examples.

I pulled EBITDA (TTM) and Debt (ST + LT) numbers from Morningstar for six different Consumer Staples companies to illustrate this principle. Four of the six carry a BBB credit rating. People have raised questions about five of the six. The last is considered the "gold standard" for stability.

Keep in mind that this is a superficial analysis. Because I am working from TTM EBITDA, any recent acquisitions that shift the needle will affect the results. Finding solid EBITDA projections is a little trickier to do on a consistent basis, so I will leave that exercise to your own due diligence rather than attempting to get it right here...

PG is the gold standard of quality in the sector. It carries an Aa3 credit rating, and has not used leverage to nearly the same extent as its peers. It has $16.8B EBITDA vs. $31.3B total debt, for a 1.86 Debt/EBITDA ratio. This is very strong. In fact anything under 3x is strong!

GIS is at the other extreme, with a Baa2 credit rating and $15.6B debt vs. $3.1B EBITDA for a 4.97 ratio. The Blue Buffalo acquisition may boost that EBITDA a little going forward (I believe only the latest quarter includes the acquisition), but it isn't immediately going to move the needle by much. They are going to need growth to dig out of this debt hole, especially since their dividend eats up 37% of EBITDA. I am comfortable with GIS only as long as I anticipate 5% forward growth. If that stalls again for an substantial period of time, they are in trouble. I consider this speculative quality, because they don't have much margin for error.

KHC has 4.83 Debt/EBITDA and a dividend representing 46% of EBITDA. The debt is not significantly different from GIS (keep in mind that this is a superficial analysis) but the higher dividend leaves them even less wiggle room. I do not follow KHC closely, as it fails my quality checks.

MKC has 4.85 Debt/EBITDA, but a dividend that is just 26% of EBITDA. The difference between this and the two previous is that the dividend is lower -- and thus EVEN WITHOUT GROWTH they have the cash flow to aggressively address the debt burden. Of course it doesn't hurt that their projected EPS growth is a solid 8%. They may presently hold a similar credit rating, but I have a very high degree of confidence that they will resolve this within the next 1-2 years and return to A-grade credit.

SJM actually has a little less debt than the others, just 4.33x EBITDA. Moreover, the dividend is just 27% of TTM EBITDA. The concern there isn't so much the debt (which is admittedly substantial) but the deteriorating outlook. FCF is projected to drop by 15%-20% from FY18 to FY19, and while the impact on earnings may be smaller, a DECLINE in earnings can start to push the debt ratios into the danger zone. I want to emphasize that the major concern isn't the debt. It is the debt combined with operational weakness. They could survive operational weakness if they had less debt, or they could survive the debt if they had stronger results. It is the combination that is potentially deadly.

People often cite "debt concerns" at KMB, but that is in my opinion foolishness. If you are looking at debt metrics for KMB that cause you concern, then toss those debt metrics because they are meaningless in this situation. KMB has a Debt/EBITDA ratio of 2.37, thus despite a 44% Div/EBITDA they EASILY have the financial flexibility to manage that debt. They do carry a little more leverage than PG, but the other four listed have literally TWICE the debt burden that KMB does.

Similarly, T has debt of just 3.5x EBITDA, much of it with very long maturities. Their debt is not a concern. The concern is that FCF is only half of EBITDA, and thus the payout ratio is pretty high. Because their debt is not unreasonable, they don't actually need much growth to manage this. They do need to avoid shrinking earnings. A risk, but not a concern at this time.

If you want scary numbers, check out CVS -- Debt/EBITDA of 7.12!!! Of course they just closed the Aetna deal, so that will bring the ratio down immediately. I would put them in a similar category with MKC -- elevated debt but the financial flexibility to bring that down quickly as long as they don't hit too many road bumps.

Chowder talks about good debt and bad debt. I don't like that characterization, preferring instead to think in terms of manageable debt and dangerous debt. The difference between the two often comes down to operational strength. In each of these cases, if you are confident that revenues and earnings will grow, the debt will not be a problem.

[DividendGarden]

(11-30-2018, 11:55 AM)EricL Wrote:

Quote:Chowder talks about good debt and bad debt. I don't like that characterization, preferring instead to think in terms of manageable debt and dangerous debt.

This is how I think about debt, too.  Not good or bad, it's all debt.  But is it out of control, what is the timing, cost, FCF coverage, etc.

[EricL]

Another excellent post from SeeksQuality (aka Ted Fischer), this time about General Mills.

Solid earnings, a beat-and-raise...
That said, I'm less thrilled with the report than the headline would suggest. Looking at their segments, NA Retail is down in volume, flat in sales. Convenience/Foodservice is down in volume, up 3% in sales. Europe & Australia is down in volume and down in sales, even before forex. Asia and Latin America is up 2% in volume and 4% in price/mix, but that is wholly offset by forex. Overall? Decent improvement in price/mix, but the sole driver of volume growth is the Blue Buffalo acquisition (still less than a year old, so no YOY comparisons there). Growth is growth, perhaps, but they clearly still have operating challenges in 90% of their business.
Profit is in much better shape, likely the result of the aforementioned price increases as well as cost cutting efforts. NA and Foodservice profits are up 12% and 15% respectively, and overall operating profits are up 27% (again boosted by the acquisition). Their nine-month results show 13% YOY profit growth, with NA/Foodservice in the upper single digits, even before the impact of the acquisition.
So....
* Continuing volume challenges. This is a mature business in a mature industry, with few growth opportunities in the US. They may still have some international growth opportunities, but pulling profits out of those is a bit more challenging. The Blue Buffalo acquisition was important to them because it is a growth opportunity in their core market.
* Improved margins and operating results. You can't sell stuff if people aren't buying, but at least you can work on margins. This is a sign of good management. One of my biggest concerns with SJM and KHC has been their inability to show any kind of pricing power. There is a huge difference between flat revenues and improving margins vs. flat revenues and declining margins. Commodity prices have been generally trending up, but it appears that GIS is navigating this challenge better than its peers.
* Expectation that BLUE will accelerate volume in the fourth (current) quarter, as their previously announced initiatives take hold. This was a big piece of the jump on their last earnings report, and should continue to drive the share price higher. Though, of course, the coming quarter will be a "show me" earnings report. Trust management (which has done pretty well with this recently) to deliver on their promises.
* Cash flow (9 month basis) of $2B easily supports the dividend of $900M, with the balance mostly going towards debt. The LT debt has come down $1153M over the last nine months, however "notes payable" has increased by $430M. (Their current ratio is not pretty...) Thus the net debt repayment is in the vicinity of $250M per quarter vs. LT debt of $11.6B. Their debt situation is firming, but they do not at this time have enough cash flow to pay down the debt rapidly. Nor are they showing the kind of top-line improvement that would be necessary to repair the debt ratios through growth.
Conclusion: I would expect the PE rebound to continue on the basis of this solid earnings report. Management is executing well and the immediate danger is passing. That said, they will continue to labor under a heavy debt burden for some years to come, and the YOY impact of the Blue Buffalo acquisition will disappear in the September reporting. I do not expect the dividend to be increased in the next year, and in fact would treat that as a strong sell signal if management were to attempt such a foolish increase. (They need their cash to grow the business and work down the debt.) I see fair value in the $52-$57 range and would consider exiting my own position there -- since the credit quality and limited growth are not a great fit for my personal goals, despite the sweet dividend.

[Otter]

Great analyses of debt/EBITDA and other factors influencing whether a company is using debt in a way that is likely to increase shareholder value long-term.

[fenders53]

Thanks for the excellent thread Eric. In all honestly, I don't have the accounting skills to fully comprehend the difference in the ratios. Sure I "get it" PG's debt/EBITDA ratio is golden and KHC,T And CVS not so golden (I own all three BTW). This may come off as amateurish but all I can do is take the relative ratings, and then add the 30,000 ft big picture view. Most of the staples concern me because they no longer have the guaranteed stability when things get bad with extreme debt. Growth is anemic for most of them already. What if things go bad next year with a pile of debt?

-I once thought the HEINZ ketchup moat was deep and wide. lt's looking a little shallow right now. What are the chances they see a 5% revenue dip? What happens to their credit rating and dividend then?

-I like to pretend CVS/Aetna will be just fine. I don't know that with political banter, and Amazon waiting to disrupt. They don't have much room for disruption from any source at the moment.

-T better get this merger right. It's not a slam dunk. If it was, this stock wouldn't have missed the last few years of the bull run. Everyone says T can pay down their debt. Seems to me the market says this outcome is very much in question.