Kellogg's Diet Crashes

By Stephen D. Simpson, CFA | October 30, 2011 AAA

English poet William Blake, once said that you never know what is enough until you know what is more than enough. Kellogg (NYSE:K) management and shareholders can sympathize with that viewpoint, now that it looks as though the company cut much too deep with its "K-LEAN" cost-cutting initiatives. Although this is an embarrassing stumble for a sterling company, the bigger issue with the stock may be its valuation and its presently pokey overseas growth.

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A Disappointing Third Quarter
Kellogg stock has long enjoyed a generous benefit of the doubt from the Street, largely because the company was seldom disappointing. This third quarter was a poor exception, though, as both sales and earnings faltered.

Revenue rose just 5% this quarter (or 3% on constant currency), as 5% pricing growth was offset by a nearly 2% decline in volume. On its own, this is not terribly worrisome, as Kraft (NYSE:KFT), General Mills (NYSE:GIS) and ConAgra (NYSE:CAG) have all been tweaking prices and incurring some volume pressure as a result, though most of these rivals seem largely past the volume hits. Odd for this group, Kellogg saw North American growth of 4% but currency-neutral international growth of just 2%, and Kellogg's U.K. business seems to be losing shares to Kraft and Nestle (OTC:NSRGY).

Profits were even more disappointing. The company's lean operating initiative went right through lean and into under-nourished. As a result, the company is backtracking and reinvesting in its supply chain. This led to a two and a half point drop in gross margin, and a 14% drop in reported operating income. Operating income was even worse on an internal basis (down 16%), but a lot of this decline was a product of new supply chain costs and restatements of incentive compensation. For those who want to give the company a break, "core" operating earnings actually looked quite a bit better. (For related reading, see Zooming In On Net Operating Income.)

Where's the New Normal on Costs?
The seeds of a tough cost inflation environment were sown a year ago, when terrible wheat harvests around the world led to price spikes. As I suggested, at the time, what goes up in the farm world can go right back down the next year, and that has proven to be the case. An article in "Bloomberg," reported on Friday, talked about how this year is shaping up as the second-largest wheat harvest on record, and prices are heading down.

Clearly, wheat is not the only cost that affects Kellogg. Corn and soybean prices are still relatively high. Archer-Daniels-Midland Company (NYSE:ADM) is probably going to try to follow Cargill, and push through higher corn syrup prices, and transportation, fuel and packaging prices have not eased off much, if at all.

What About the Overseas Business?
The bigger worry, I have, about Kellogg, today, is the unimpressive overseas performance that the company is currently seeing. Asia-Pacific sales, for instance, grew just 2% on a 5% volume decline, and ,frankly, volume was down in every single geography. Kellogg needs to be gaining on Kraft, Nestle, PepsiCo (NYSE:PEP) and Unilever (NYSE:UL), not falling behind.

About two-thirds of the company's revenue comes from the U.S., and that has to change if Kellogg wants to post the sort of growth it needs to make the stock interesting. Unfortunately, this is not a free call option - it will require investments in supply chains and marketing, and some investors will not like the margin pressure that creates, even though long-term shareholders should be supporting such moves. (For more on calls, see The Basics Of Covered Calls.)

The Bottom Line
Kellogg is often a little expensive relative to other food companies, because of its quality and reliability. That reputation may have a few dings and scratches now, but management can likely smooth it over by limiting the negative surprises in the next few quarters.

That said, and acknowledging that Kellogg is a company I have long liked, it's hard to get excited about the stock right now. It's cheaper (and arguably better-run) than ConAgra, Kraft and General Mills, but still not cheap. For the time being, PepsiCo and ADM may actually be the better bargains in food for investors.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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