Kellogg Back In Its Groove

By Stephen D. Simpson, CFA | February 08, 2013 AAA

Once a dependable performer in the food category, Kellogg (NYSE:K) has had some challenges and stumbles of late. Management hasn't just tossed around buzzwords and waited in the hopes of things getting better on their own. Instead, the company moved ahead on an aggressive deal in acquiring Pringles and has been actively restructuring the business and investing in brand-building. The Street has already rewarded these efforts to some extent and the shares aren't exactly cheap, but increased confidence and a return to past multiples could offer some further gains from here.

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A Small Beat in Fourth Quarter, but a Beat All the Same
Kellogg reported somewhat mixed, and definitely confusing, results for the fourth quarter. On balance, the company seems to be all-in on the idea that in order to make money, it must spend money.

Revenue rose 18.2% as reported, with Pringles making up a large percentage of that. Even so, organic growth being in excess of 5% was surprisingly strong - particularly given the year-ago organic comps of 6%. Every reporting segment showed organic growth. North American net internal sales increased 5.5% on a near-even split between price and volume, while Europe saw growth of nearly 3%, Latin America a growth of more than 9% and Asia-Pacific a growth of less than 5%.

Margins get a little goofy and convoluted, but Kellogg definitely gave back some ground here. Adjusted gross margin seems to have fallen about a point and a half, coming in about a half-point lower than expected. Although adjusted operating income rose about 4%, the underlying operating margin was also lower than expected, as the company made large commitments to marketing and sales expenditures. All other things being constant, operating income would have been down more than 7% without Pringles (though I doubt management would have spent as aggressively in that scenario).

SEE: Analyzing Operating Margins

Some Good in North America, but Challenges Still Remain
Looking at the breakout of fourth-quarter North American results, there was both good and bad news. The strong 6% plus growth in morning food was a positive, even if the sales seem to exceed store takeaway numbers; with General Mills (NYSE:GIS) set to introduce new products later this year, it will be interesting to see how that growth continues to track.

On a more negative side, snacks were up less than 1%. This business is nearly as large as morning food for Kellogg, and it's an area where Kellogg still needs to step up its game relative to Mondelez International (Nasdaq:MDLZ), General Mills and PepsiCo (NYSE:PEP).

Ending on another positive, I was surprised to see how strong Kellogg's frozen foods business was this quarter (up 12.8%). Kellogg is certainly more of a niche player here, but that growth is impressive relative to the likes of Nestle (OTC:NSRGY) and Heinz (NYSE:HNZ), and I'm very interested to see if this is an area that Kellogg will commit to building over the coming years.

Still Plenty to do Overseas
If Kellogg is serious about stepping up its global brand-building, it has a lot of work to do. For too long, the company was content to focus on niche local brands and a few global products that were often premium-priced for the market. (Kellogg's boxed cereals are pretty expensive on a relative basis in markets like Mexico.) Along the same lines, I think Kellogg has underinvested in demand creation - not many countries eat as much (or more) cereal as the United States, and changing those tastes would go a long way towards lifting its global sales.

I still believe the Pringles acquisition will pay dividends over the long term. Pringles has strong global distribution and is present in many areas where other Kellogg brands have been weak. If Kellogg can piggyback with other company brands through Pringles' channels and complement it with supporting marketing/advertising, I think the company can do a lot overseas in the coming years.

SEE: Analyzing An Acquisition Announcement

The Bottom Line
Institutional investors are slow to give up on their go-to favorites, so I believe there was a sizable base of investors just waiting for a reason to like Kellogg again. Consequently, the expectations built into the stock's price are already pretty generous. Assuming that Kellogg can continue to grow revenue in the mid-single digits and accelerate free cash flow growth into the mid/high single digits (with improved margins and free cash flow conversion), fair value would seem to be in the low to mid-$60s.

While that's not great appreciation potential on a fundamental basis, Kellogg is likely to stay popular so long as the revenue growth stays strong and the margins don't disappoint too seriously. Stocks like Kellogg often carry premium multiples, and increasing investor confidence could push them higher still this year.

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

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