3 Intelligent Moves By Kellogg Management

Mar.11.13 | About: Kellogg Company (K)

Here's a fun fact about Kellogg (NYSE:K) stock: At no point during the 2002-2012 period did the company ever trade at more than 20x earnings. You would have to go back to the bubble years of 1997-2001 to find the last time that Kellogg's valuation appeared quite high, regularly trading at multiples in the 22-28x earnings range. If you consider historical P/E ratios for a blue-chip stock as part of your valuation process, it should seem pretty clear that Kellogg is overvalued compared to the typical market prices of the company since the tech bubble burst.

If you pull up a stock screener, you may see that Kellogg is currently trading at almost 24x earnings, at a price of $61.43 per share relative to $2.57 in earnings.

The earnings are a bit understated due to one-time events, and it looks like Kellogg will have the earnings power of $3.30 per share once the one-time expenses are removed from the picture (suggesting a valuation shy of 19x earnings going forward).

I mention these facts not to state the obvious (that Kellogg stock is probably overvalued), but to frame the context to illustrate how Kellogg management has been making intelligent decisions with allocating the surplus profits once the dividend and reinvestment needs are accounted for.

About this time last year, Kellogg had been slated to spend $2-$3 billion buying back Kellogg stock as part of an ongoing plan that would terminate 2014. Of course, as we all know now, Kellogg management decided to strike and seize the opportunity to buy the Pringles division from Procter & Gamble (NYSE:PG) after the mess at Diamond Foods (NASDAQ:DMND) caused the original purchase agreement to fall through.

Responding to this favorable opportunity, Kellogg management made three maneuvers that are starting to look quite intelligent now that we have a year's worth of hindsight:

1. First of all, Kellogg decided to spend $2.7 billion to buy Pringles. This move was intelligent on two fronts: (1) it added a high-quality asset to Kellogg's stable of brands that actually moved the needle in terms of present earnings, and (2) it significantly bolstered Kellogg's role in the snack industry, granting management more opportunities for future growth beyond the cereal industry options. Now that we have some data that takes into account the Pringles acquisition, we can see that Kellogg has already increased top-line earnings per share growth by almost 13% compared to last year (this figure takes into account both the Pringles acquisition and the organic growth of Kellogg's existing businesses).

2. Because of this $2.7 billion acquisition, Kellogg management decided to suspend the stock buyback program for the next two years, having decided to dedicate those funds to the Pringles acquisition instead. Although the full effects of this maneuver cannot properly be assessed for a couple more years, the view one year out looks promising. If Kellogg did not buy Pringles, it would currently be paying somewhere around 19-24x earnings (depending on how you calculate Kellogg's current earnings power) to buy back shares. If historical P/E valuation tools are any guide, this would be a value destructing activity. Instead, Kellogg decided to use those funds to purchase Pringles, a move that has grown earnings significantly (although the 13% figure also includes the organic growth of the Kellogg business).

3. Kellogg management decided to use the remaining money that had been allocated for buybacks (which did not go towards the Pringles purchase) to pay down the company's heavy debt burden. And in particular, Kellogg has done a good job of removing high-interest debt from its balance sheet. As of now, almost $7 billion worth of the company's total $9 billion debt can be classified long-term debt that has been refinanced at low rates. While this total debt level may alarm many conservative investors, the fact that the debt is carried at a low interest level should bring some solace to investors.

I welcome these moves by Kellogg management. I can't tell you how happy I am for the shareholders of this company that they are not having their precious capital wasted repurchasing shares at $61 per share. That plan would likely result in value destruction for Kellogg shareholders. Instead, Kellogg took those funds and made two moves that I believe are beneficial to shareholders. First, the company bought Pringles which has already contributed substantially to the company's top line. And secondly, the company has paid off a large chunk of high-interest debt. Both of these moves should facilitate the company's growth in the years ahead, especially in comparison to the buyback program that management shrewdly chose to terminate.

Disclosure: I am long PG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.