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Kellogg (K) hasn't been participating in the recent market euphoria, for the simple reason that it's a cash cow/bond substitute and interest rates seem likely to rise further. At current prices in the $61 area, looking out five years, a combination of dividends and capital appreciation totaling 9% annually comes into view.

Overview

The company describes itself as follows, in press releases:

At Kellogg Company, we are driven to enrich and delight the world through foods and brands that matter. With 2012 sales of $14.2 billion, Kellogg is the world's leading cereal company; second largest producer of cookies and crackers; a leading producer of savory snacks; and a leading North American frozen foods company. Every day, our well-loved brands nourish families so they can flourish and thrive. These brands include Kellogg's®, Keebler®, Special K®, Pringles®, Frosted Flakes®, Pop-Tarts®, Corn Flakes®, Rice Krispies®, Kashi®, Cheez-It®, Eggo®, Coco Pops®, Mini-Wheats®, and many more.

In the 10-K, the company presents 9 operating segments - a mix of product lines and geographical classifications. They also present supplemental information - a 3 way split among cereals, snacks and other. It's useful to note that cereals and snacks, after the Pringles acquisition, are both less than 50% of the mix. It's an over simplification to think of Kellogg strictly in terms of cereal.

Pringles Acqusition

On 5/31/2012 the company completed the acquisition of Pringles from Procter & Gamble (PG). It will have a material effect on EPS, and pro forma data is presented in the 10-K. The acquisition is expected to be accretive by 22 to 25 cents in 2013.

The strategic rationale is good - Kellogg increased its snack business and improved access to foreign markets. The US Cereals segment hasn't been performing well and the company needs to look elsewhere for growth.

The company will suspend its repurchase program (other than mopping up after share-based compensation) until the debt from the acquisition is brought down to the desired level.

Accounting Change

From the 10-K:

Pension and nonpension postretirement benefits. In the fourth quarter of 2012, the Company elected to change its policy for recognizing expense for pension and nonpension postretirement benefits. Previously, the Company recognized actuarial gains and losses associated with benefit obligations in accumulated other comprehensive income in the consolidated balance sheet upon each plan remeasurement, amortizing them into operating results over the average future service period of active employees in these plans. Under the new policy, the Company has elected to immediately recognize actuarial gains and losses in operating results in the year in which they occur, eliminating the amortization. Experience gains and losses will be recognized annually as of the measurement date, which is the Company's fiscal year-end, or when remeasurement is otherwise required under generally accepted accounting principles. The Company believes the new policy provides greater transparency to on-going operating results and better reflects the Company's obligations to its employees and the impact of the current market conditions on those obligations.

I regard the change as favorable due to the improvement in transparency. It reduced Q4 2012 earnings to 2 cents. As such, TTM P/E at 23.28 is not useful information.

Valuation

When increasing pension liabilities are hiding out in AOCI, I frequently adjust the computation of 5 year average EPS to include the missing information. Now that Kellogg has changed their accounting, I still make a small adjustment to account for the change in AOCI over the past 5 years.

Reading guidance on the Pringles acquisition, I see the deal as accretive to the tune of 22 cents per year.

5 year average EPS works out to $3.35 after adding 22 cents for Pringles. Applying a PE5 multiple of 20, typical of high quality companies of this type, I arrive at a FMV and target price of $67.

A Sour Note on Advertising

While advertising is an expense, and booked as such, it's conventionally thought of as an investment in brand equity. Looking at five years financial data, advertising as a percentage of revenue has decreased from 8.4% to 7.9%.

Reading the shareholder letter from the 2012 Annual Report, there is a fairly long discussion of brand-building, very positive on the power of advertising to increase sales. If this assertion is correct, the question comes up, why is the expense declining over the years?

Managing Cash Flow

The shareholder letter also includes an extended discussion of Operating Principles. In order of priority, cash is expended to increase sales and profitability, then comes capex at 3% to 4% of revenue, followed by the dividend and financial flexibility considerations, i.e. reducing debt or doing buybacks.

As mentioned earlier, buybacks will be curtailed until the debt from the Pringles acquisition is reduced to the proper level.

Dividend

The dividend has been increased for 9 consecutive years, most recently by 4.5% to 46 cents quarterly, yielding 3% at recent prices.

The company acknowledges the importance of the dividend, and moderate increases can be expected to continue.

Reservations

In recent years the company has experienced difficulties with high commodity costs, consumer weakness, competitive pressures, and failures of innovation.

Kellogg has ample resources and good market positions. Over time headwinds may be expected to abate. The ability to spend approximately 8% of net revenue on demand creation, and still show very respectable margins, can't be underestimated.

Investment Implications

Buying Kellogg at today's prices, an investor has a reasonable expectation of receiving an increasing flow of dividend income, and eventual share price appreciation.

Estimating future growth at 4% annually, and assuming that applies to the target price, if it takes 5 years for share price to hit target, capital appreciation will amount to 6% annualized, to which the dividend of 3% can be added, for a total of 9%. Sixty month beta is 0.48, producing a favorable risk/reward profile.

Source: Kellogg: Healthy Balance Between Snacks And Cereal