We have maintained our Neutral recommendation on Kellogg Company K) following the appraisal of second quarter 2012 results. Kellogg's second quarter 2012 adjusted earnings per share of 89 cents per share beat the Zacks Consensus Estimate of 84 cents per share due to higher-than-expected revenues. The second quarter earnings however lagged the prior-year quarter earnings of 94 cents per share due to weak revenues in Europe, high commodity costs and investments in supply-chain initiatives.
The world's largest cereal maker reported revenue of $3.5 billion in the quarter, up 2.6% year over year. Revenues improved almost 3% from the first quarter. Improving revenue trends in North America and the addition of Pringles drove the top-line growth in the quarter. Kellogg bought Pringles snacks business from Procter & Gamble (PG) in June 2012. Revenues were also above the Zacks Consensus Estimate of $3.4 billion.
Gross margins declined 190 bps to 40.7% in the quarter due to commodity cost increases, lower fixed cost absorption related to inventory reduction, supply-chain initiatives and the addition of Pringles. The adjusted operating profit declined 5% due to commodity cost inflation, sluggish European results and investments in supply-chain initiatives.
Management maintained its outlook for 2012 as it expects better revenue and profit growth in the second half helped by its brand-building investments and supply-chain initiatives.
We are encouraged by Kellogg's solid brand positioning, its geographic diversity and cost saving initiatives. We like the company's continued focus on brand building and innovation. Management believes the continued investment in brand building will generate substantial sales from new products. In 2011, the company made significant investments in brand building, which led to $800 million in incremental sales from innovation. In 2012, management plans to continue to invest in brand building at a rate equal to or greater than the rate of revenue growth in 2011. In 2012, innovation is expected to generate sales of $900 million.
The Pringles deal has made Kellogg a strong player in the snacks business, second only to PepsiCo, Inc (PEP). Further, we believe the Pringles buyout is likely to reduce Kellogg's dependence on its mainstay cereal business which is currently struggling. The Pringles acquisition will also provide additional growth opportunities in the fast growing emerging nations. Management expects Pringles to fetch a market of another $2 billion. Besides, Pringles is expected to boost revenues by more than $500 million in North America. The combined company is expected to generate more than $15 billion in annual sales and over $6 billion in snacks sales globally.
Further, Kellogg's continued cost-reduction initiatives are aimed at providing greater visibility in achieving its long-term profit growth targets. In 2010, Kellogg began investing in its supply-chain initiatives. In 2011, the company increased its investment in these initiatives by $100 million. Though these initiatives resulted in a slowdown in earnings growth in the first half, but they are expected to be a tailwind in the second half of 2012 to build a stronger foundation for future growth.
The company's efforts to drive profitability and brand equity are however tempered by the more matured and somewhat sluggish cereals business and economic uncertainty in Europe. Kellogg's mainstay U.S. cereal business has grown in the low single digits in the past few quarters. Moreover, the European business has consistently recorded both sales and operating profit declines as the region continues to face difficult economic conditions and competitive activity. The company still expects this region to remain challenging in 2012. Margin headwinds from rising raw material prices and a high debt burden remain areas of concern.