This morning, General Mills (GIS) reported deeply disappointing quarterly results that have to make investors question whether they should stay long the stock (press release available here). Sales were flat at $4.88 billion, which is a significant deceleration from last quarter when sales growth was 6%. EPS excluding one-time items was $0.83, which was down from last year's $0.86. Analysts had been looking for much more with EPS consensus at $0.88 on $4.94 billion in sales. Shares of General Mills are down more than 2% on this news after what has been a strong year with shares up 20%. Is this quarter a sign that shares have moved too far too fast or is this dip an opportunity to buy shares at a discount?
In the United States, pound volume actually declined 2% year over year while pound volume growth contributed 2% in General Mills' international segment. However, that pound volume growth is a dramatic deceleration from earlier in the year with six-month pound volume growth of 14%. Declining volume in the United States was very disappointing while I was surprised that international was up a meager 2%. Europe was also problematic with sales down 2% while 5% growth in China isn't that great.
Now on the bright side, management did maintain guidance of $2.87-$2.90 in earnings this year. Based on this guidance, General Mills has a 16.8x multiple, so it is hard to construe valuation as cheap, especially after this quarter. Investors need to consider the possibility that GIS' core cereal business could be facing secular decline. For a generation, cereal was the main breakfast food, but that is changing among young people, increasingly focused on healthy and organic options with many just as happily grabbing a muffin at Starbucks (SBUX).
With cereal not the consumer staple it once was, General Mills is going to struggle to generate meaningful revenue growth in the United States. This quarter was a disappointment, plain and simple. Revenue growth was nonexistent. The U.S. market is fully saturated, and cereal will simply not be a driver of growth. Now, General Mills has moved to diversify beyond cereal with Yoplait, Nature Valley, and Progresso. However as we heard from Campbell's Soup (CPB), even the soup business is challenged, which doesn't bode well for Progresso. Consumer eating and spending habits are changing. We see this in the fast food market, organic and premium grocery stores, and at the food manufacturers. After this quarter, investors have to think General Mills is getting hurt by changing tastes and trends.
Now, this is not to say that all is doom and gloom at General Mills. Thanks to international and some product diversification, we are not at a point where GIS is shrinking. Rather, the company is at a point where it is struggling to grow. Those are two far different phenomenon. Moreover, the company is a cash flow machine. The company has generated $1 billion in operating cash flow in the first half of this year. While this is down $300 million from last year, that drop is driven by temporary working capital fluctuations that should reverse going forward.
In the first half of the year, the company has spent $317 million on investing projects, leaving it with $700 million in free cash flow. The company has been aggressively returning cash to shareholders. Management raised the dividend from $0.33 to $0.38, giving the stock a 3% yield. General Mills has also repurchased $870 million in stock, roughly 2% of the shares outstanding. Now, the company has been levering up thanks to these shareholder-friendly activities. Liabilities have risen $500 million this year while shareholders' equity is down $340 million. As a consequence, liabilities to shareholder's equity has risen from 2.18 to 2.27.
At this point, I am not concerned about increasing leverage at General Mills as it is nowhere near the danger zone. Moreover, I expect a decelerating pace of buybacks in the second half of the year given previous guidance as to the size of the program. As a consequence, the company will be net cash positive in the second half of the year, bring leverage back down. Over the long run, General Mills will be able to continue returning cash to shareholders because it generates annual free cash of at least $1.4 billion.
Investors should continue to expect a growing dividend and opportunistic buybacks as the company returns its excess cash to investors. While GIS will provide a solid income stream to investors, I think shares are a little expensive after this weak quarter, which brings future growth potential into question. I would be more comfortable paying 15-16x earnings of $43-$46. While General Mills is one of the best run food companies in the country and a better investment than more expensive peers like Kellogg's (K), I do think shares have moved too far in 2013. With limited growth, investors should wait for a 5-10% pullback for buying.