General Malaise at General Mills

Rivals have been eating its lunch since the Pillsbury deal

It was to be Stephen W. Sanger's crowning achievement. Last November, after a 16-month delay, General Mills's (GIS ) chief executive closed on the biggest takeover in the company's 136-year history: its $10.4 billion purchase of long-term crosstown rival Pillsbury from Diageo PLC. Within months, Sanger promised, the combined company--with sales of $13.5 billion--would produce stellar returns as it bulked up and broke into new fast-growing food categories to supplement its stodgy cereal business, with its familiar Cheerios, Chex, and Wheaties brands.

Unfortunately, the postmerger reality hasn't come close to reflecting Sanger's initial optimism. During the year and a half it took to complete the merger and integration of Pillsbury, competitors have made serious inroads in areas Minneapolis-based General Mills once dominated. Profits in its third quarter, ended Feb. 24 slid 48%, to $82.5 million. In the fourth quarter, which ended on May 26, Prudential Securities Inc. analyst John McMillin predicts a 25% decline from a year ago; he expects an 8.7% drop in full-year earnings from continuing operations, down from last year's $636.3 million. (The company unveils its annual numbers on June 26.) And the merger boosted General Mills's debt load to $9.9 billion from $3.7 billion. In April, its A- credit rating was cut to BBB+ by Standard & Poor's, which noted the softer earnings. "It's obvious that the focus on integration has taken a toll on our sales growth and our earnings growth," Sanger says.

Investors are paying the price. Since January, the stock price, recently at $43.60, has sunk 14%, while the Standard & Poor's Food Products Index has risen 1%. Sanger's record will likely earn him some time to fix things. His expertise in marketing, after all, helped General Mills achieve consistent double-digit earnings gains before the merger. For instance, he turned Yoplait yogurt into the segment leader. But now Sanger is under pressure to deliver. Any reservoir of goodwill benefiting Sanger, who has been CEO for seven years, is likely to dry up if he doesn't produce strong numbers by the fall and winter--prime selling season for Pillsbury's soup and baked goods. "There is a potential for more risk there," says Kevin McCloskey, a portfolio manager at Federated Investors, which has 600,000 General Mills shares. "There's a lot of uncertainty."

The problems started when Sanger badly underestimated how long it would take to resolve antitrust issues arising from the merger, announced in July, 2000. Ultimately, to satisfy regulators, Pillsbury had to sell its desserts and specialty-products businesses to International Multifoods Corp. Moreover, Pillsbury parent Diageo cut back its marketing efforts in anticipation of the division's new ownership. That resulted in lower sales of such core brands as Pillsbury refrigerated biscuits and Progresso soups. By the time the merger was final, General Mills's rivals had eaten into its key markets.

The most embarrassing loss to General Mills was its slide to second place over the past year in the $7 billion cereal category, which it had led since 1999. Taking advantage of the turmoil at General Mills, Kellogg Co. launched a slew of products, including a line of Disney-theme cereals, such as Mickey's Magix. It also heavily promoted adult brands with high-growth potential such as Special K and Smart Start. In the first quarter, those lines saw sales rise by 18% and 70%, respectively. "We're focused on fewer, bigger brands," says Kellogg CEO Carlos M. Gutierrez. Kellogg now has 33% of the cereal market, vs. 32% for General Mills--an exact flip-flop from a year ago. "The war continues," says Gutierrez. "We've just won a couple of battles."

Other rivals have also smelled blood. In refrigerated dough, where Pillsbury has long led the pack, deep-pocketed Sara Lee, with the purchase of Earthgrains, is gunning for more market share. Nestlé is introducing a line of refrigerated cookie dough. And in boxed prepared meals--a category General Mills invented with Hamburger Helper--ConAgra, Lipton, Kraft Foods, and Campbell Soup have all trotted out new products. Even Sanger concedes that ConAgra's Homestyle Bakes, which contain meat, are good. Says Eric Meyers, a consumer-products analyst with Federated Investors: "General Mills was out-innovated by these other guys."

Sanger slashed new products and promotions to concentrate on integrating and strengthening the two companies' sales and marketing forces. Many Pillsbury salespeople had left, unsure of whether they would have jobs, and retailers were unhappy about the lack of support Pillsbury goods were getting. "When you ask a General Mills salesperson about a Pillsbury product, their eyes glaze over," says Rick Bozzelli, a promotional manager at grocer SuperValu Inc. Promotional dollars for Pillsbury had vanished, he says. Faced with either focusing on new products or straightening out its marketing mess, Sanger chose the latter. By the fourth quarter, there were only two product launches, vs. the usual two dozen.

Now, General Mills is playing catch-up. It plans to roll out 80 new products in the six months following June 1. Some are brand extensions, like Banana Nut Morning Chex Mix. Others are new, like Yoplait Nouriche, a liquid meal replacement. Moreover, the company says it will use an additional $100 million in cost savings from the merger to promote these new products as well as the declining Pillsbury lines.

It's a sound plan. But if Sanger fails to follow through, the man who sells the Breakfast of Champions could soon find himself eating crow instead.

By Julie Forster in Minneapolis

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