Kellogg Company (NYSE:K) disappointed analysts and investors after it released its third quarter earnings for 2013. Since then the company's stock price has dropped by 1.72%. The stock also had its price objective downgraded by Deutsche Bank from $68 to $65 and its position was downgraded from buy to hold.
In its third quarter, Kellogg experienced a decline in sales in its home market, the United States, where it generates around 55% of its total revenues but the company managed to expand its market share in the Latin American, European and Asia Pacific markets. This brings some hope for the company's ability to meet analysts' expectations in the future. Besides that, the company is also expanding its revenue base by introducing new products into the market and trying to cut the costs through its new initiative, Project K.
Due to these strategies, I expect that Kellogg will deliver higher value to its investors and improve the outlook of the company's stock.
Kellogg's internal sales in three of its U.S. segments declined approximately 1.7% mainly due to decreased volume. The volume decreased in the North American other segment as well but it was partially offset by favorable pricing and mix. The improved pricing and mix also increased the internal sales in the Latin American segment by 7%. The company's strong double digit growth in salty snacks improved its internal sales in the European and Asia Pacific markets by 3% each. The salty snacks also reported double digit growth in Latin America.
To further boost its salty snacks business the company has launched new vegetarian single-serve pizzas in two flavors: Greek Tzatziki and Indian Tikka Masala. The new flavors were developed to appeal to a wider market and help Kellogg expand its customer base in the two markets which currently provide high growth opportunities. Besides Asia Pacific and Eastern Europe, Latin America also represents huge potential for future expansion. The growth from these three regions will offset the slow growth in the U.S. and North America where the market has reached maturity. Almost all of the snack industry giants are facing slow growth in this region.
The company has also announced a global four-year efficiency and effectiveness program, Project K. The program will focus on strengthening the existing businesses in core markets, increase growth in developing and emerging markets and drive an increased level of value-added innovation.
Due to the impact of inflation the company's cost of goods sold as a percentage of sales increased by 38 basis points which resulted in a decrease in the gross margin by 170 basis points. The selling, general and administrative expenses improved slightly as a result of favorable overhead leverage and synergies resulting from the Pringles acquisition.
Kellogg's cost of goods sold is projected to further increase as the prices of its main raw materials: corn, wheat, soy bean oil and cocoa are forecasted to rise in 2014. The prices of the company's principal packaging materials: carbon and corrugated board are forecasted to rise as well. This projected increase in prices could shrink the company's future margins.
To improve its margins Kellogg, under Project K, will cut its labor costs and optimize its supply chain infrastructure. The company intends to cut 7% of jobs under its cost cutting initiative and consolidate the plants to eliminate the excess capacities. Besides that Kellogg commenced two new initiatives designed to improve operational effectiveness in its European segment.
These plans will initially increase the company's operational expenses and capital expenditure but will improve its gross and operating margins in the long run.
In regards to the company's bottom line and net margin despite a 0.1% decrease in YoY revenues and an increase in COGS, the company's YoY net margin improved by 22 basis points. The net margin improved primarily as a result of decreased interest expenses. In 2013, the company reduced its debt by approximately 3% which in turn reduced the interest expense. Dividends per share in this quarter were $0.46 compared to $0.44 in the third quarter of 2012.
Market Perception and Fair Valuation
The current market price of Kellogg's stock is $60.58 whereas the company's equity value per share with zero earnings growth assumption is $42.29 per share. This shows that investors are paying $19.47 per share for the company's future earnings and cash flow growth. On the other hand, the investors at Deutsch Bank are projecting the price to be $65 which assumes that the company's earnings will only grow by 1.4% and the free cash flow will grow by 1.5%. In my opinion this growth assumption does fully reflect Kellogg's potential.
Since the company's revenues are expected to grow and its margins are expected to improve in the future its earnings should grow at a rate greater than 1.4%. If we assume that there would not be any volumetric growth and that the revenues would grow by only inflation rate, even then the earnings growth would be greater than the expected 1.4%.
The company's free cash flow would also grow as its operating cash flow over the last four years (2010 to YTD 2013) has grown by approximately 80%. The company is currently focusing on its core and existing businesses with no plans to expand into any new geographical area so we can say that its free cash flows in the future would also grow considerably. Kellogg's historic net income-to-FCFF growth is 11.5%.
So if I increase the revenues only by adjusting the future global inflation and the earnings by only 1.8% then the free cash flow growth is equal to 2%. Even this rate is quite low for Kellogg and it takes into consideration the expected increase in capex due to Project K. Based on these assumptions, the fair value of the company's stock is projected to be $78.75 with an upside potential of 27.8%.
Although Kellogg's third quarter financial performance could not impress investors the future prospects of the company are still bright. Despite the declining revenues, the company managed to improve its net earnings and paid greater per share dividends on a yearly basis. Its new initiatives would further improve margins and consequently generate higher earnings for investors. The company's improved net profits led to enhanced operating cash flows which add extra value to the stock price.
Therefore, in my opinion, the stock presents itself as a very attractive opportunity to investors and I would recommend buying it.