Seeking Alpha
Retail investor, long/short equity, dividend investing, medium-term horizon
Profile| Send Message| ()  

Executive summary:

  • 2014 will be an "investment year" for Kellogg
  • Pragmatic guidance calls for weak growth
  • DSD snack marketing to be re-emphasized
  • Increased capex and brand-building investment
  • Valuation reduced until growth restored

_________________________________

Reading Kellogg's (K) 4Q 13 conference call, it is evident that management is aware of slowing growth and declining margins, and has developed a plan of corrective action. Future valuation of the company is dependent on successful implementation.

Pragmatic Guidance

From the conference call:

Slide 12 details our guidance for 2014. We're giving pragmatic guidance for growth for the full year. Project K will provide some funding to increase investment in certain businesses and categories in which we compete. We expect that internal net sales will be up approximately 1% in 2014. This excludes any impact from integration costs, the impact of currency translation and this year's 53rd week. The 53rd week should add a little more than 1 point to reported sales growth. We continue to expect moderate material-related inflation in 2014. Total cost of goods inflation is estimated to be in the range of 3% to 4%. This is before the benefit from productivity, which we estimate to be toward the high end of our long-term target range of 3% to 4% of cost of goods. In addition, we will recognize some savings from Project K in cost of goods sold.

I like the word "pragmatic." It's used 5 times during the call. It indicates a willingness to respond to factual information, stay focused on reality and go with what works. It's helpful when management comes down off the ivory tower.

DSD

Kellogg's North American snacks (other than Pringles) are sold by the DSD (direct-store-door) marketing plan. The delivery man is expected to interact with the customer in ways that generate additional orders and improve the product's in store placement and presentation.

CEO John Bryant's plan calls for the size of the routes to be reduced from 18 stops to 12. In addition, drivers will be equipped with a tablet type computer, with appropriate software. By reducing the size of the routes, drivers will have more time to interact with customers, resulting in superior performance over time.

Bryant acknowledges that there are some problems with this approach. From the conference call:

In addition to that we are reducing the coverage rates, so we're going from -- each route being about 18 stores down to 12 stores, pretty meaningful move there. In terms of our competitive position, we have, quite frankly, the model is split [indiscernible] has occurred. That large sales organization is focused on a much smaller part of business, and that has been a competitive headwind for us, and we are looking to ensure that we have the right resources in store to drive that business forward.

It's possible that DSD is no longer the best way to gain access to the customer's decision maker. In addition, it's expensive, particularly when the number of employees and trucks is increased by 50%, as the 12:18 ratio implies. Hostess Brands delivered to stores in company trucks, with union employees, and ultimately wound up in bankruptcy.

Probably it's better to find out if the approach is workable, by applying a full complement of resources, before proceeding with alternatives. Mishitting on a change of this magnitude could be expensive.

Capex

Kellogg's long term goal for capex is 3-4% of revenue. In the coming year, that has been increased to 4-5%, in a tacit acknowledgement that previous investment in plant and equipment has not been sufficient to promote efficiencies and reduce cost of goods sold.

Looking at gross profit over the past 10 years, it decreased from 44.4% in 2003 to as low as 38.3% in 2012, before recovering to 41.3% in 2013. Unless the improvement is sustained, Kellogg will not have the resources to invest in growth and continue to return capital to shareholders by increasing dividends and buybacks.

P&L Investment

The entrepreneurial approach interprets advertising expense as an investment in brand-building. Advertising is booked in the income statement, but if the money is well spent, it results in increased revenue in future periods. Other expense items, such as increased sales salaries, can also be thought of as investments.

Advertising expense, as a percentage of revenue, declined from 8.4% to 7.9% of revenue from 2007 to 2012. The conference call features 60 instances of the word "(re)invest" and variants thereof. The issue has management's full attention.

Project K

When 3Q 13 earnings were announced, the company also announced Project K, a 4 year program aimed at increasing efficiency and effectiveness.

The accompanying slide presentation was brief, long on abstract generalities and short on concrete specifics. Bryant has seen fit to clarify by stating that it's not a headcount reduction program. A good thing, since the increased resources devoted to DSD can only increase headcount.

As noted above, the company has to invest not only in the balance sheet by capex but also in the income statement, in the form of increased advertising and DSD personnel.

What Has to Happen

Some combination of increased revenue and reduced cost of goods sold has to increase operating earnings. These increased earnings, before they can flow to the bottom line, have to be invested in sufficient brand-building and promotion to drive future revenue increases.

In addition, property, plant and equipment have to be upgraded or relocated to generate maximum efficiencies in manufacturing. It's difficult to determine if an increase from 3-4% to 4-5% will be sufficient.

Finally, changing trends in consumer preferences have to be met by innovation in the product area. That will entail increased R&D, and most likely R&D in the target markets.

Normal Analysis of Value Situations

As a general rule, I advocate investing in value situations when it's possible to ascertain that management: 1) understands the problems/opportunities, 2) has a plan to a) fix what's broken and b) exploit what's open, and 3) has the human and financial resources required to implement corrective action as planned.

While additional details on Project K, and actual results from additional resources dedicated to DSD, would be cause for increased optimism, I'm investing on the basis that Kellogg will be able to return to meaningful growth by implementing current plans. Progress is unlikely to be visible before 2015. 2014 will be an "investment year."

Thoughts on Valuation

My original analysis concluded that Kellogg is a high quality iconic brand and valued the company accordingly, at a PE5 of 20. The need for additional investment going forward, and the implied past inadequate investment, raise questions as to the company's stature.

With that in mind, I'm reducing the PE5 multiple I consider appropriate here from 20 to 17.5. Adjusting for the change in AOCI accounting and adding 22 cents for the Pringles acquisition, 5 year average EPS comes in at $3.70. Applying a 17.5 multiple, shares will be fairly valued at $65.

Source: Kellogg Is Now Investing To Restore Growth