Seeking Alpha
Long only, value, special situations
Profile| Send Message|
( followers)  

Kellogg Company (NYSE:K) is an international brand with a major chunk of revenue attributed to North America. The company's products are segregated among packaged foods, meat products, cereals and convenience foods like breakfast bars. In this article, I will highlight the changing industry trends, underlying drivers causing the decline in the sales of the company, and I will compare the company's reported earnings for the fourth quarter of 2013 with analysts' estimates.

As per the fourth quarter earnings release, Kellogg beat the earnings estimate by a penny. The company reported revenue of $3.50 billion for the fourth quarter of 2013 barely beating the analyst estimate of $3.52 billion. For the fourth quarter ended, net earnings of the company were $818 million, up from a loss of $32 million last year. This led to per share earnings of $2.24. The performance of the top and bottom lines of the company over the past five quarters is shown in the graph below.

Source: Bloomberg

Comparing the company's revenues with the last quarter of the previous year, Kellogg experienced a loss in sales of about 1.7% owing to a drop in demand for its breakfast products. North America alone stands liable for a 2.80% decline in the revenue base. Since North America is responsible for generating 63% of the company's revenues the sluggish demand in the region had a significant impact on the company's top line. Consumers are increasingly shifting from unhealthy junk foods to healthier food choices like GMO-free products. This has forced Kellogg to introduce new products to meet the changing consumer demands but the new products of the company yielded revenues below expectations.

Other than the shift towards healthier food alternatives, cafes and restaurants are posing a threat to the future revenues of the company as well. McDonald's (NYSE:MCD), Chipotle, Starbucks (NASDAQ:SBUX) and Burger King (NYSE:BKW) are all looking forward to attracting breakfast consumers. Although cereal products are not expected to evaporate from the industry their sales are likely to drop significantly. As of November 2013, cereal sales had dropped by 2.5% (nominal) compared to the revenue generated last year. Leading cereal manufacturers are bringing innovative products to the market like yogurts and energy bars that cannibalized some of their cereal sales.

In the wake of a declining revenue base and rising competition, both from its major competitor General Mills and small scale private companies, Kellogg began to restructure its operations. As part of the restructuring, Kellogg is expected to slash its global workforce by about 7% in the next four years in order to bring the company back to a profitable level. Moreover, the company has recently reduced its overhead costs by 55%. Kellogg also made a mark-to-market adjustment to its pension liabilities and commodity contracts that led to a pretax gain of $1 billion thus boosting the performance of the company. The reduction in the operating costs and the pension liability gain combined counterbalanced the declining revenue base of the company. It is important to highlight here that Kellogg's EPS was inflated by $1.83 per share due to the beneficial impact from restructuring and the mark-to-market adjustment. Excluding these two, EPS for the company was $0.83 compared to $0.70 in 2012. Analyst expectations for the quarter stood at $0.82 per share.

With regards to the company's performance from a geographical perspective cereal sales of the company have shown a continuous decline for the past three quarters in the North American region. In particular, the adverse performance of the US mornings foods and US snacks segments is of huge concern to the company considering that they generate almost half of its revenues. Kellogg does expect growth from geographical expansion into other regions but the fact that the company's key products are showing a weakening performance is worrisome. Geographic expansion can benefit the company only for a limited time period unless the company's core operations come back on track. To add to the challenges, Kellogg's balance sheet is critically weak at this point and that further enhances the need to strengthen its core operations. The company presently maintains a debt to equity ratio of 261.09 compared to the industry average of 56.48. Furthermore, Kellogg ought to pay off $291 million of its total debt this year in the face of a low cash position ($273 million) and its debt rating stands at the lowest investment grade rating. This puts further pressure on the company to expand across international boundaries through its core operations as the company might have difficulty in raising additional debt.

Kellogg's ROE stands at 37.75 compared to the industry average of 14.62. Breaking down the ROE using the DuPont Analysis to look into its drivers it is apparent that Kellogg's ROE is mainly reliant on the financial leverage of the company.

Source: Quarterly Statements, 2013

This dependency makes the ROE of the company unsustainable as it is crucial for the return on equity to be driven by the core operations of the company rather than its financial policy. Although financial leverage does show a downward trend the company's ROE is still largely driven by it. Moreover, Kellogg's efficiency in managing its asset base has deteriorated over the past four quarters. The profit margin jump in the last quarter shall be ignored as it is a product of the pension benefit observed by the company.

For 2014, the company expects to achieve an EPS growth within the range of 1-3%, coinciding with that of analysts' estimates (3%). However, I find it highly unlikely that the company will be able to meet the growth estimate considering the fact that its balance sheet position is low and the cereal industry demand is facing a decline. The company is bringing forth products targeted toward health conscious people but so are its competitors. Lastly, breakfast menus being offered by a number of cafes and restaurants are a major threat to the company's Mornings Foods segment. Based on all these facts, I wouldn't recommend investing in the company's stock.

Source: Kellogg Doesn't Have Much To Offer