Kellogg Looking Pretty Stale For Now

By Stephen D. Simpson, CFA | April 27, 2012 AAA

Cereal and snack food giant Kellogg (NYSE:K) has taken a very sharp turn from one of the best (and most reliable) food company stocks out there to a "what the heck is wrong here?" story. With European sales down double-digits and share losses in the core cereal group, to say nothing of the challenges of integrating and building up Pringles, Kellogg has a lot to prove before it becomes a dependable food stock again.

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Poor First Quarter Results
Kellogg warned the Street a few days before earnings, so that took some of the sting out of the final report on Apr. 26, 2012. Still, a 1% reported sales decline and flat organic sales was a disappointing result. Overall, the company pretty much balanced volume and price.

North American revenue rose more than 1%, as stronger snack and specialty revenues offset lower revenue from cereal and breakfast products. International was a wreck, though, as sales dropped 4% on a 10% drop in European sales. Latin America and Asia saw growth, but are smaller contributors at this point.

Ironically, the lower sales volume in Europe may have actually helped gross margins a bit. Nevertheless, gross margin fell about a point from last year, while operating income dropped more than 6%. By region, North American operating profits fell 5%, while international profits fell almost 11% on a 20% drop in Europe.

SEE: Earning Forecasts: A Primer

Share and Share Alike
While it's worth mentioning that Nielsen share data does not always translate directly to sales numbers (due to inventory management and sales channels outside the Nielsen system), Kellogg does seem to have some issues with its cereal business. Although the company saw some volume share gains in the last quarter, the company is losing dollar share in both Europe and the United States, with General Mills (NYSE:GIS) and private label brands.

Much of the same seems to be occurring in crackers and cookies, where Kellogg is seeing some volume growth, but losing dollar share. That said, Kellogg is still a relative small player - about twice as large as third-place Campbell Soup (NYSE:CPB), but far smaller than Kraft (NYSE:KFT).

Building or Buying the Future?
It's increasingly obvious that Kellogg management really needs to make something of the Pringles deal. In the short term, the company is taking on a fair bit of debt for not much incremental profit growth. Keep in mind, though, that Procter & Gamble (NYSE:PG) under-invested in this business - I was surprised to learn that the market share for all of Pringles is below that of both PepsiCo's (NYSE:PEP) Cheetos and Doritos lines.

Longer term, it's worth wondering what Kellogg's plans are for building growth. The company needs to stem its share losses in cereal, but it's unlikely to be a growth market. At the same time, Kraft's split is likely to make it even more focused on growing its snack brands. So what does Kellogg think about acquisitions - including names like troubled Diamond Foods (Nasdaq:DMND), Snyders-Lance (Nasdaq:LNCE) or J&J Snack Foods (Nasdaq:JJSF) - or does the company go the route of internal product development? The latter is arguably more cost-effective, but it takes longer.

SEE: Analyzing An Acquisition Announcement

The Bottom Line
It's easy to overreact to some bad quarters at companies with solid long-term records and over-correct on the cash flow modeling. That said, it's hard to see how Kellogg is especially cheap right now, given that the enterprise multiple is still close to 10. What's more, a cash flow growth projection that assumes 8% compound growth over the next decade (well ahead of the growth rates of the past) still only points to a fair value close to today's price.

Much as I want to believe that Kellogg is still a quality company, I'd rather own Kraft or even perhaps PepsiCo than Kellogg stock today.

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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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