Kellogg Looking Like A Better Part Of A Complete Portfolio

By Stephen D. Simpson, CFA | August 16, 2012 AAA

While I'm usually more than willing to grill underperforming company executives, I do have some pity for Kellogg (NYSE:K) CEO John Bryant. Not yet two years on the job, Mr. Bryant's role has more resembled that of an overworked fireman than a Fortune 500 CEO. Still, conditions seem to be stabilizing, and I am curious to see what sort of innovation and evolution he can shepherd at this giant food company.
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Second Quarter Results - Not Good, But Showing a Turn
Kellogg's second quarter was not all that great in strictly objective terms, but it looks like momentum is shifting in a more positive direction.

Revenue rose less than 3%, with organic sales up more than 2%. While volume declined 0.6% on a 2.3% overall price increase, this is a pretty favorable development. As recently as the Q1, the linkage between volume and price was much tighter; whatever Kellogg tried to gain in pricing, it lost in volume. If elasticity is in fact easing, that bodes well for the company.

Looking regionally, North America is a relative source of strength with nearly 4% organic growth. Europe and Asia-Pacific continue to be weak, while stronger results in Latin America must be seen in context with its relatively smaller size in Kellogg's revenue make-up.

Profitability is still challenging. Gross margin fell another two points, and operating income fell 5%. Supply chain and advertising restructuring remain ongoing projects, and a risk looms that this year's drought will weigh on next year's margins.

SEE: Understanding The Income Statement

Cereal Looks Like a Longer-Term Fix
While the company's breakfast segment did show some growth this quarter (up 1%), a quick look around at rivals like General Mills (NYSE:GIS) and Post Holdings (NYSE:POST) shows that all is not well in the cereal aisle. The real question, though, is "Why?"

Looking at data from sources like Knapp Track, it doesn't look as though greater morning traffic at quick service restaurants like McDonald's (NYSE:MCD), Wendy's (Nasdaq:WEN), Subway or Dunkin' Brands (Nasdaq:DNKN) is the primary cause. Instead, it looks more like a combination of excessive inventory levels, generic substitution and demand declines tied to under-innovation.

Inventory levels are a more immediately fixable problem, and like Heinz (NYSE:HNZ), General Mills and Post, Kellogg is looking to work down inventory levels and run a leaner structure in the future. The innovation side, though, will take longer to show results. New products like Krave have done pretty well for Kellogg, but packaged food innovation is a process and not an event. In other words, stay tuned.

Will Debt Limit Options?
Although a company like Kellogg can certainly support more debt than many companies, there is a limit to how far management can stretch this balance sheet. With the Pringles deal taking up a lot of the dry powder, Kellogg has little choice but to build the business it wants to have going forward.

In particular, Kellogg needs to get more active internationally. I've lamented Kellogg's relatively modest international exposure before, particularly relative to companies like Kraft (NYSE:K) and Nestle (OTC:NSRGY), and the company will have its work cut out for it here. While generally solid in English-speaking countries, Kellogg's future growth goals will require better performance in large emerging markets.

The Bottom Line
With business conditions seemly better, and plenty of potential both from product innovation and improving Pringles, Kellogg looks like a better investment prospect than it has for some time. Companies with strong brands seldom sell cheaply, so time may be running short to pick up these shares at any sort of meaningful discount.

SEE: 5 Must-Have Metrics For Value Investors

Assuming that the company can maintain low-to-mid single-digit revenue growth, fair value on these shares lies well into the $50s. That's admittedly not great capital appreciation potential, but considering the company's returns on capital, brand value and dividend yield, this looks like a solid name for more conservative accounts.

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

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