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Shares of Kellogg (NYSE:K) jumped upwards following the third quarter results. It was not strong results which drove shares higher, but analysts and investors notably applauded Kellogg's Project K effectiveness and efficiency plan. This plan should address the structural revenue and cost weakness at the company.

Even after factoring in the beneficial effects from the plan, I see little short term appeal for Kellogg's shares. I remain on the sidelines.

Third Quarter Results

Kellogg generated third quarter revenues of $3.72 billion, down 0.1% compared to last year, in line with consensus estimates.

Net earnings rose by 2.5% to $326 million, as earnings per share rose by a penny to $0.90 per share.

Comparable earnings came in at $0.95 per share, up two cents compared to last year, and far ahead of consensus estimates of $0.89 per share.

CEO John Bryant commented on the third quarter developments, "We are excited by the potential and opportunities we see for growth in the categories in which we operate. As a result, we are making the difficult decisions necessary to address structural cost-saving opportunities which will enable us to increase investment in our core markets and in opportunities for future growth. These actions will set a foundation for our Sustainable Growth operating principle."

Looking Into The Results

While reported sales were virtually unchanged from last year, adjusted sales rose by 0.5%, as corrected for foreign exchange movements as well as M&A activity.

Integration costs related to the Pringles deal impacted earnings by $0.02 per share, while costs related to the new Project K growth and efficiency program totaled $0.03 per share.

North American sales rose by a 1.3% fall in sales to $2.4 billion. Lower sales were driven by weak performance at Morning Foods and Snacks, falling by 2.2% and 2.5%, respectively. Strong specialty sales growth of 6.2% could not offset general weakness within the segment.

The international segment reported fluctuating results. Latin American sales were solid, offset by weakness in Europe and Asia-Pacific.

To boost earnings of the company, Kellogg initiated Project K, a four-year efficiency and effectiveness program. The plan will result in $1.2-$1.4 billion charges, but should result in cash savings between $425 and $475 million per annum through 2018. As a result of the program, some 7% of the workforce will lose their jobs. As part of the program, Kellogg will focus on core markets, focus on emerging markets and create global category teams.

Outlook

Kellogg now sees full year earnings towards the lower end of the $3.75-$3.84 per share guided earnings range. This excludes integration costs, Project K costs and the impact of mark-to-market accounting.

Sales growth for the full year is now seen between four and five percent. Note that the company previously guided for five percent growth in revenues. Analysts were looking for earnings of $3.77 per share, on average.

Valuation

Kellogg ended its third quarter with $300 million in cash and equivalents. Total debt stands at $7.40 billion, for a net debt position of around $7.1 billion.

Revenues for the first nine months of the year came in at $11.29 billion, up 6.2% on the year before. Net earnings are virtually unchanged at $989 million.

At this pace annual revenues of around $15 billion are attainable as earnings are seen between $1.3 and $1.4 billion.

Factoring gains of nearly 2% on Monday, with shares exchanging hands at $64 per share, the market values Kellogg at $23.1 billion. This values equity in the firm at 1.5 times annual revenues and 17-18 times annual earnings.

Kellogg currently pays a quarterly dividend of $0.46 per share, for an annual dividend yield of 2.9%.

Some Historical Perspective

Long term holders in Kellogg have seen fair returns. Very gradually, shares have moved from levels around $35 in 2004 to current levels at $63 per share. Shares peaked at all time highs of $68 in July of this year.

Between 2009 and 2012, Kellogg has grown its annual revenues by a cumulative 13% to $14.2 billion. GAAP earnings fell by a quarter from $1.2 billion to $961 million in the meantime.

Investment Thesis

Shares of Kellogg have risen some 14% year to date amidst a favorable market sentiment, the Pringles deal and search for dividend yield.

Despite the positive impacts, Kellogg is facing stiff competition for its breakfast cereals. Its Corn Flakes, Chocos cereal and Eggo waffles brand are competing against private-label manufacturers and the likes of General Mills (NYSE:GIS), among others.

To offset the impact of competition, slower revenue growth and the impact on earnings, Kellogg is cutting its workforce by some 7% or about 2,200 workers by 2017. The $1.2-$1.4 billion costs are quite steep compared to expected savings of $425 to $475 million. This means it will take Kellogg nearly 3 years to make up for the restructuring costs, which is quite long for a cost savings program.

Given the difficulties within breakfast, the deal to acquire Pringles for $2.7 billion from Procter & Gamble (NYSE:PG) is applauded, notably in hindsight. With the $1.5 billion annual revenue deal, Kellogg increases its focus on snacks, away from breakfast food, while boosting its international presence. Despite this deal, Kellogg still relies for roughly three quarters of its earnings on the US, with the remainder of revenues being generated in Europe, Latin America and Asia-Pacific.

Overall the valuation seems fair, as the market is applauding the cost savings programs. While the outlook for revenue growth is bleak, earnings could grow towards $1.5 billion per annum, valuing the business around 15 times earnings. This, combined with a nearly 3% dividend yield is fair. Even after accounting for the cost savings, I see few triggers creating much more upside potential in the near term.

I remain on the sidelines.

Source: Kellogg - No Strong Appeal Despite Project K