When General Mills ( GIS) proposed the kinky marriage of the Pillsbury Doughboy and Betty Crocker with Hungry Jack and the Trix rabbit two years ago, executives bubbled over with enthusiasm about all the hot synergies they'd be cookin' in the kitchen. Chief Executive Stephen W. Sanger vowed that the $9.7 billion purchase of Pillsbury from Diageo ( DEO) would help to cut costs and fatten net income, vaulting the Wheaties maker into the topmost ranks of U.S. food companies.

But Sanger has had to eat his words in recent months as profits have slipped backward in each of the past three quarters and revenue growth has ground virtually to a halt amid business-integration setbacks, stagnant marketing and a voracious attack by fortified competitors. Meanwhile, a mountain of debt and goodwill stemming from the acquisition rest like a gut bomb on the 136-year-old company's balance sheet, threatening its credit rating and net worth.

Brokerage analysts have nevertheless upgraded General Mills' stock in the past week on grounds that it has held up relatively well amid the market downturn, offers a 2.8% yield, trades 25% off its all-time high, has stable cash flows and perches near a historically low valuation. No matter what happens in the economy, they add, people gotta eat.

Yet investors also gotta study the books, and no amount of relative charm and childhood nostalgia may ultimately distract them from concluding that the price of General Mills shares fails to account for the heap of trouble the company faces. Its plight is sadly emblematic of so many large industrials, as the lack of real growth has led the company to use a variety of additives to make earnings and cash flow appear healthier than they might really be. A close look by forensic accountants at MSN Money stock-research partner Camelback Research Alliance and work by other analysts suggest:

  • Core earnings as roughly defined by the measure proposed by Standard & Poor's are lower than reported net income in recent periods, due primarily to pension and insurance-settlement gains.
  • Reported revenue growth in the most recent quarters has come almost entirely from the Pillsbury acquisition, which virtually doubled General Mills' size. Once the impact of the acquisition is accounted for, sales growth has actually declined and is close to zero.
  • Management's recent emphasis on earnings before unusual items essentially overstates profitability in relation to core earnings.
  • Goodwill from the Pillsbury acquisition represents a significant portion of total assets and is more than 2 1/2 times stockholders' equity.
  • General Mills' credit ratings are poor and worsening. That will make the refinancing of billions in short-term debt, due in 2003, difficult and expensive, affecting earnings.

    Why has the stock held up so well if the company's financials are soggy? Largely because most media and brokerage analysis of General Mills focuses on its undeniable food innovations rather than its underlying business methods. Reports typically begin with a glowing account of the way the company has leveraged its Big G cereal brands such as Wheaties, Chex and Cheerios into shelves full of bizarre mutations, such as Chex Morning Mix Honey Nut, Milk & Cereal Bars Chex, Wheaties Energy Crunch and Apple Cinnamon Cheerios. Any company innovative enough to turn a kid-unfriendly food like yogurt into squeezable Go-Gurt Cool Cotton Candy or Yoplait Whips Strawberry Mist, bulls say, must have a solid game-plan to reward shareholders.

    Books Behind the Marketing

    But the dot-com frenzy proved in spades that cool products and snappy marketing alone do not pay the bills. At the end of the day, if you've spent and borrowed too much to fulfill your vision, it doesn't matter if you run a lemonade stand or sell Green Giant Create-a-Meal Lemon Pepper Chicken: You are in trouble. Carrying a lofty price-earnings multiple of 30, investors appear to expect earnings per share growth at General Mills to fulfill its promise of 50% in fiscal 2003 over fiscal 2002 -- an amount that seems far out of reach. Unless the company can significantly boost volume growth or slash expenses over the next year, shares -- now trading around $41 -- could get cut by a third.

    Problems at General Mills start with the income statement. Core earnings -- basically net income with all special items stripped out -- are considerably lower than reported net income because of pension-plan gains and money from insurance settlements. During fiscal 2001, General Mills reported $69.2 million in pension income, representing 10.4% of reported net income. (Pension gains for 2002 have not been reported yet; they will be in the annual report scheduled for release in mid-August. The company's fiscal year runs basically from May through April.)

    Meanwhile, in 2001 and 2002, the company recorded $54.9 million and $30 million in income, or 8.3% and 6.6% of its totals, respectively, from the payoff of long-disputed insurance claims, according to annual financial statements filed with the Securities and Exchange Commission. Moreover, General Mills' financial statements are so rife with what it blandly calls "unusual" or "non-recurring" restructuring or merger-related charges that it's hard to get a firm grip on its real ongoing cost of business. A General Mills spokeswoman on Monday termed its restructuring and unusual charges modest, in line with peers and in conformance with accounting standards.

    On the revenues side of the ledger, General Mills has stated that net sales had increased by 46% in fiscal 2002. But that increase was due primarily to the Pillsbury purchase. Analysis by Camelback suggests that after normalizing for that acquisition, General Mills' sales growth was less than 1%, much lower than the company's long-term average annual sales growth rate of about 6%. The company spokeswoman acknowledged the negative effect of the Pillsbury acquisition on revenue growth to date, but said that estimates of General Mills sales without the acquisition were purely hypothetical.

    General Mills' cash-flow statement looks pretty good if you just look at operating cash flow, as it has exceeded net income in each of the past five years. But free cash flow was much lower than income in those years and was negative in the nine months ended February, largely as a result of the Pillsbury acquisition. Operating cash flow, moreover, is overstated by the tax benefits from the exercise of employee stock options, to the tune of about 6%. It's certainly proper under accounting principles to include such tax benefits in operating cash flow, but it's not a sustainable source of money.

    A key problem at the cereal maker, however, is found on its balance sheet. The company is carrying a high level of goodwill that represents the amount it paid for Pillsbury beyond its book value. New accounting standards require companies to regularly determine whether its goodwill is "impaired," a fancy way of saying it must admit whether it overpaid. If impairment is acknowledged, the company will be forced to write it down during fiscal 2003. Goodwill of $8.5 billion and other intangibles currently make up 52% of General Mills' total assets and 235% of shareholders' equity. While this sounds rather arcane, such low levels of tangible net worth are regarded as signs of poor earnings quality -- and a big writedown could lead to violations of debt covenants and debt downgrades.

    Beastly Debt

    Debt is indeed a beast of an issue at General Mills. The company took on roughly $6 billion in short-term debt in the fall of 2001 to facilitate its acquisition of Pillsbury. During the company's fiscal third-quarter 2002, long-term debt rose sharply, after it issued another $3.5 billion in notes. Some of that money was used to pay down the short-term notes, and General Mills has said it intends to issue an additional $4 billion in long-term notes to "term out," or refinance, its short-term liabilities. Debt-rating agencies openly fret, however, about its ability to do so.

    On July 1, for instance, Moody's cut its outlook for General Mills' senior unsecured debt to negative from stable, citing "soft operating performance," poor sales volume, inadequate debt reduction and weak debt protection. "Should General Mills be unable to generate volume improvements, reduce debt, improve its debt protection measures, and lengthen the term of its capital structure, its ratings could be downgraded," Moody's said.

    Moody's analysts say they expect little or no debt repayment in all of 2003, due to increased capital expenditures ($750 million in fiscal 2002) and high dividend payments ($400 million in fiscal 2002). For its part, General Mills says it intends to pay down $1.2 billion in debt in 2004 and 2005 and notes that the company has bank-credit facilities that entirely back-up its short-term obligations. The rising price of key commodities such as corn, wheat and soybeans, due to the terrible Midwestern drought, isn't helping matters.

    To help spoon itself out of this hole, General Mills has announced that it will come out with 80 new food items over the next six months and dedicate a new retail sales staff to push them. But it will take more than Count Chocula-flavored Hamburger Helper or Lucky Charms Pizza Rolls to keep shares of this American corporate icon from souring.

    Moody's notes that the company "will be challenged to significantly increase volumes, generate free cash flow and improve debt protection in the near term" as competition is "fierce" from Campbell Soup ( CPB), ConAgra Foods ( CAG) and Sara Lee ( SLE). All are also increasing product introductions and marketing support at the same time.

    For all its purported synergies, what might really help this company is unloading a few key assets to raise cash.

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