Kellogg (K) is the leading cereal and convenience food company in the U.S., with annual revenues of $14 billion. Lately, the company has been struggling to grow its revenues and volumes due to competitive market conditions and sluggish consumer spending. K has been making efforts to lower its costs; however, restructuring charges will adversely affect the company's earnings in the near term. Also, the company's core business operations are expected to remain challenged in the near term. The ongoing tough industry and business conditions have taken a toll on the stock price, and the stock is trading at a discount to its competitors; the stock is down approximately 10% since mid-July. I believe the stock will continue to trade at a discount and is unlikely to experience multiple expansion in the near term, therefore, I believe K will underperform its competitors.
Financial Performance 3Q2013
K delivered mixed results for the recent third quarter. The company reported an adjusted EPS of $0.95, beating consensus estimates by 7%. K also beat revenue consensus estimates of $3.7 billion by posting quarterly revenues of $3.72 billion; however, revenues for the quarter were down 0.1% year-on-year. Revenues for the quarter were adversely affected by soft performance of the company's cereals and snack segments, and foreign currency movements. It has been tough for K to increase its sales volume in recent times; sales volume was down 0.3% in 3Q2013, and has been relying on price increases to grow its top-line numbers.
The company's North American segment, which comprises approximately 65% of the total company sales, experienced a decrease of 1.3% in sales led by a 1.3% drop in sales volume. In Europe, K experienced an increase of 3.3% in sales, driven by a solid performance of Pringles and Nutri-Grain in Western Europe. K was also able to deliver decent performance in Latin America and Asia, where it experienced sales growth of 6.7% and 3%, respectively.
During the 3Q2013 earnings call, K once again lowered its sales guidance for the full year, 2013. The company now expects reported net sales to grow by 4%-5%, down from the prior guidance range of 5%. Earlier, in 2Q2013, the company lowered its sales growth guidance from 7% to 5% due to sluggish performance of core brands and foreign currency movements. K reiterated its cash flow guidance for the year, as it continues to expect cash flow to be between $1.1-$1.2 billion, along with capital expenditures equal to approximately 4% of sales.
Cost Structure, Margin and Restructuring
The company has been working to improve upon its cost structure by lowering its overheads, and has been undertaking strategic acquisitions to enter into fast growing markets. However, K's restructuring programs and strategic acquisitions are still to have a positive impact on its bottom line results. K has slightly better gross margin in comparison to its competitors, however, the company has been struggling to maintain the figures and has been experiencing continuous declines in margins in recent times. The following table shows gross margin for K in comparison to its competitors.
General Mills (GIS)
Kraft Foods (KRFT)
Source: Companies Report
Due to a competitive industry environment, rising costs and soft consumer spending, K has been experiencing drops in gross margin in recent times. The following table shows the declining gross margin trend for K in the last three years.
Source: Company Report
As the industry environment remains competitive, K is working on adopting a volume-to-value strategy, by focusing on high margin products. Due to the adoption of the strategy, the company might experience a further drop in sales volume as more focus will be set on selling higher margin products rather than maximizing sales volume. The strategy remains a risk to K's top and bottom line results as it might not be able to bring the desired results due to the soft consumer spending environment. I will recommend investors keep an eye on the company's sales and margin in the future in order to evaluate the outcome of the value strategy adopted by K.
Also, the company recently initiated the $1.2-$1.4 billion 'Project K' restructuring program to lower its costs in the long term. Due to the recent restructuring program initiated by the company, I believe 2014 will a tough year for K, as the company will register higher restructuring charges and lower savings than in later years. K expects that it will be able to realize annualized savings of $425-$475 million by 2018.
The positive aspect of the restructuring program over the long term for the company could be reinvestment of savings to strengthen its core markets presence, expand its footprint in developing and emerging markets, and building its global category teams. If the company is able to tap growth opportunities in fast growing developing and emerging markets, it will portent well for the company's long term financial performance and stock price.
The company's core businesses, including U.S. Snacks and U.S. Morning Foods, which comprise approximately 50% of its total revenues and operating profits, are likely to remain challenged in the near term due to sluggish growth. Also, I believe restructuring charges and weak sales growth will have an adverse impact on K's fiscal year 2014 earnings growth. Moreover, the stock is trading at a discount as compared to its competitors due to the sluggish performance by the company in recent times; the stock is down more than 10% since mid-July. Currently, K is trading at a forward P/E of 14.8x, in comparison to Kraft's and General Mills' forward P/Es of 16.4x and 16x, respectively.
I believe that due to prevailing tough times, there is limited core earnings growth for the company in the near term. Also, the stock is likely to continue to trade at a discount to its competitors, and K won't experience multiple expansion, which limits upside price potential. I believe K will underperform its competitors in the upcoming year, 2014, and therefore, I have a bearish stance on the stock.