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Break Your Bowl Of Kellogg’s

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The Kellogg Company (K) has recently experienced falling demand for its cereal and snack products in the US, which is a significant hurdle as these products constitute a major portion of the company’s revenues. While international expansion is still a key driver for Kellogg’s growth, core product categories (cereal and snacks) have been suffering and the lack of funds could hit the company’s international expansion plans. Bidness Etc thinks Kellogg’s stock is a sell.

Introduction

Kellogg operates globally and in the US packaged foods and meat industry. Following its acquisition of Pringles for $2.7 billion in May 2012, Kellogg became the world’s second largest savory snack company after General Mills (GIS). The company specializes in the production of cereal and convenience foods and owns famous brands like Pop-Tarts, Frosted Flakes and Special K.

Kellogg’s Segmentation

Kellogg generated 33% of its revenues from international sales in FY12 compared to 32% in FY10. The revenue share from international markets will continue to increase due to growth in these markets and Kellogg’s acquisition of Pringles.

Kellogg’s cereal brands fall under the US Morning Foods & Kashi segment. Kellogg’s snack brands fall under the US Snacks segment.

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Kellogg’s Fall in Stock Price

The company beat consensus earnings estimates by 2.5% in the second quarter (2Q) of fiscal year (FY) 2013. Its stock price declined by over 10% in just two months though, after Kellogg lowered its revenues and earnings guidance for FY13 due to maturing demand for its cereals and snacks in the US, and negative impact of foreign currency fluctuations.

The company’s Morning Foods segment contributed over 26% to the company’s total revenues in FY12, so maturing demand is having a noticeable effect on Kellogg’s financial performance. This is also affecting Kellogg’s ability to invest in international expansion.

Falling Revenues from US Cereal and Snacks Segments

The company grew its net sales by 6.9% in 2QFY13 but its internal sales* for the same period declined 0.5%. The decline was mainly due to a 3.3% and 3.2% decline in the internal sales of the US Morning Foods & Kashi segment and the US Snacks segment respectively.

*Internal sales: Sales excluding the effects of acquisitions, dispositions, foreign currency translation, and integration costs.

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Lowered Revenue and Earnings Guidance

Although Kellogg’s growth strategies, like its acquisition of Pringles, have supported revenue growth, the declining demand for its core product categories is a concern. The company reduced its sales growth guidance for FY13 by two percentage points, to 5%. Furthermore, it now expects the increased volatility in foreign exchange rates to negatively impact earnings per share (EPS) by $0.09 in FY13, higher than the previous expectation of $0.02.

Pringles is a Major Growth Driver

Pringles provides Kellogg with growth opportunities through its established brand name, distribution network and expertise in both the domestic and international markets. Pringles is a well-known name in 150 countries around the world and its supply chain infrastructure is well developed. Its employees have experience of working under consumer staples giant, Procter and Gamble Company (PG), which previously owned Pringles and this should help Kellogg expand its international operations.

The company’s revenues from Latin America, Europe, and Asia Pacific seem to have benefited more from Pringles acquisition compared to the North American region. Revenue growth in these regions improved in 3QFY12 following Pringles’ acquisition.

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Pringles would Support Expansion of Kellogg’s Snack Sales

Pringles has shown mid-single-digit revenue growth over the last two quarters, due to emerging market growth, and product innovations such as Pringles Xtra. Kellogg plans to increase Pringles’ production capacity in 2014 to further penetrate existing and new geographical regions. However, the integration costs associated with the acquisition of Pringles are estimated to have a negative impact of $0.12 to $0.14 on EPS over the upcoming quarters. These costs had a negative impact of $0.1 on the company’s EPS for 2QFY13.

International Markets Drive Growth

Revenue growth from Pringles and international exposure has not offset the revenue drop due to the falling demand for Kellogg’s cereals and snacks in the US. Kellogg’s revenues from the North American region grew at a significantly lower rate of 2.7% in 2QFY13, compared to an average growth of 13.1% in other regions.

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Falling Demand for US Cereal and Snacks

Lower growth in North America was primarily due to a fall in internal revenues of Kellogg’s Morning Food and Snacks segments. One reason for the fall is the shift in consumer preference towards more healthy food products. The other factor is the loss of market share to its main competitor, General Mills, (GIS) in the last quarter which has been spending more on promotional activities and has been offering discounts.

Kellogg’s Product Innovation Efforts

Although Kellogg has been introducing new brands to improve revenue growth in its Morning Foods and US Snacks segments, results are lower than company expectations. For example, Kellogg launched two new Special K branded products, Special K Protein last year and Special K Chocolate Strawberry this year. Yet the innovations resulted in just 2% growth in consumption of its Special K brand during 2QFY13.

Furthermore, the company also introduced products to boost demand among adults and baby boomers who prefer healthy food. These include Raisin Bran Omega-3, Kashi Cheer Heart to Heart, Multi-Grain Special K, and Special K Nourish Hot Cereal. Despite the introduction of these new products, internal revenue growths of the Morning Food segment and Snack segment were negative in 2QFY13.

To further catalyze sales of its new products the company increased its advertisement spending. Kellogg’s expenditure under this head has shown an annual increase of 1% over the last five years. However the increased ad expenditure in 3QFY13 will negatively affect the company’s EPS for the quarter by $0.02, according to sell-side estimates.

Falling Gross Margins:

The company’s gross margins have shown a year-over-year (YoY) decline over the last two quarters. Its margins in 2QFY13 declined 160 basis points (bps) compared to 2QFY12. The company stated that net inflation in the cost of raw materials caused a 90bps fall in gross margins and the acquisition of Pringles caused a 50bps fall in gross margins. The rest of the 20bps decline was due to mark-to-market adjustments.

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Although the company expects raw material costs to decline in 3Q and 4Q of FY13, it estimates a decline in its gross margins of 75 to 100 basis points for FY13. The acquisition of Pringles is also expected to cause a 50bps decline in gross margins. An expected decline in margins, despite the fall in raw material prices reflects Kellogg’s inability to sustain margins through productivity improvements.change in price

Source: Company data

Valuation – Stock is Over-Valued:

Kellogg is trading at a one year forward P/E multiple of 15x, only slightly lower than General Mills’ 16.5x and equal to Kellogg’s five year average. The factors against Kellogg can lead to a contraction in its  P/E multiple to 5yr low of 12x. Although analysts estimate EPS growth of 8% over the next four quarters, lower than the 8.8% estimate for General Mills, we believe it would be difficult for Kellogg to meet this estimate.

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Conclusion:

Kellogg faces maturing revenue growth in the North American region and declining margins. The expansion into international markets might suffer due to low or falling growth in its core product categories, cereals and snacks. Kellogg has a low cash balance of $262 million, with $291 million of debt maturing in 2014. This makes it difficult for it to invest heavily into expansion in international markets.

It also has a high debt-to-equity ratio of 297% with low investment grade ratings of Baa1 and BBB+ by Moody’s and Standard & Poor’s. This weak balance sheet further makes international expansion dependent on earnings from core categories as the company will face trouble raising additional debt.

We further doubt Kellogg’s ability to keep paying dividends and maintain its current 12-month yield of 2.85% as it’s free cash flow to equity (FCFE) of $669m for last twelve months is significantly lower than 2,998m in FY12. It has paid over $600m annually in dividends during FY11 and FY12. The low FCFE, low cash balance and maturing debt obligations would affect its ability to pay dividends. Therefore, we do not even recommend that dividend investors buy the stock.

If Kellogg’s core categories keep falling and put downward pressure on international growth, there is a risk that P/E multiple will contract to its five-year low of 12x causing the stock price to drop to $47 (using low end of analysts estimates for FY14).

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