While the bull market in consumer stocks has slowed a bit over the past quarter, and Kellogg's (NYSE:K) performance has trailed others like General Mills (NYSE:GIS) and Post (Nasdaq:POST), the stock was still trading quite close to its 52-week high prior to its second quarter report. Unfortunately for shareholders, organic growth came in pretty weak. While the second half should be stronger from a margin perspective, a high valuation and less impressive growth trajectory could put these shares on ice for a couple of quarters.
Where Did The Volume Go?
Kellogg's top line came in weaker than expected, as 7% reported revenue growth was below the 10% average estimate, and the underlying organic growth (0.5% contraction in this case) was likewise about 300bp shy of the target. It would seem that volume was the culprit, as it declined 1.6% while most analysts seemed to be forecasting growth. 

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Sales were particularly weak in the U.S., where revenue contracted 1.6% on an organic basis, as both morning foods and snacks declined more than 3% on an organic basis. It's worth mentioning, though, that Kellogg's “North America Other” category grew almost 4%, and this business includes lines like Eggo Wafflers and Special K Flatbreads that I would think would otherwise be part of “Morning Foods”.
Margins were pretty good, though, and kept the bottom-line result on track. Pro-forma gross margin was down about 140bp from last year, but basically in line with expectations. SG&A spending came in lower than expected (likely due in part to advertising/promotion timing), and reported operating income rose 10%, though organic growth was a much less impressive 3%. I do think it's worth pointing out, though, that the reported operating margin of every reported segment improved other than for Latin America.
Shares Comes, Share Goes
I don't want to make Kellogg's results appear better than they were, but I think it's worth remembering that quarter-to-quarter performance in the packaged foods sector can be more volatile than many investors believe. From the timing of promotions and ad campaigns to product launches and ordering trends, there can be quite a bit of noise.
That said, I expect some concern about the company's cereal business and its share relative to General Mills, though General Mills boosted its ad spending in the last quarter. Kellogg is trying to be innovative here (including new breakfast shakes and product line extensions like peanut butter Pop Tarts), but yogurt, particularly Greek yogurt, seems to be pretty popular with adults these days, and that could drive sales to the likes of General Mills and PepsiCo (NYSE:PEP) (the latter has a yogurt JV between Quaker Foods and Theo Muller).
The organic decline in snacks is a little more troubling to me. Kellogg has been targeting rivals like PepsiCo and Mondelez (Nasdaq:MDLZ) with new cookie, cracker, and chip products, but there's clearly still work to do here. Given how much Kellogg paid for Pringles, underperformance in snacks is likely to get punished disproportionately by the market on a long-term basis in terms of management confidence and the resulting discount rates.
Better Margins, But What About Volumes?
Kellogg analysts and investors have been looking forward to a strong second half for a while, as commodity costs should reverse to effective deflation and the costs tied to the Pringles deal abate. While I do believe the margins will improve, the recent declines in ag prices do have me a little concerned about Kellogg's growth potential. Ag commodity price declines often correlate with weaker economic conditions and if the economies in North America and Western Europe slow, that will likely take a toll on Kellogg's volumes.

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The Bottom Line
The very early reaction to Kellogg's earnings report has been pretty moderate, so I don't see a significant opportunity in the shares right now. Even with my estimate of nearly 7% long-term free cash flow CAGR, it's for me to argue for paying more than about $67 for these shares. That does suggest that Kellogg shares are technically undervalued as of this writing, and very few consumer stocks are. Still, while Kellogg's is one of my favorite consumer goods names, I think valuations in this sector are still high on a historical basis, and I'd be careful about taking long-term positions at these prices.
Disclosure – At the time of writing, the author had no positions in any stocks mentioned.