- Based on my assumptions in the LR cash flow model, I’m concluding a fair value estimate of approximately $53 per share (20% discount to Kellogg’s July 9th closing price).
- Health conscious consumers question Kellogg’s brands.
- Struggles mount as Kellogg falters in Cornflakes TV advertisement.
- Project K to weigh on Kellogg’s cash flows.
Levered Returns Cash Flow Model
A price target of approximately $53 was concluded using Levered Returns three-year projection model which implies Kellogg (NYSE:K) is trading at around a 20% premium. An Enterprise Value "EV" of $26.7 billion was determined by applying a discounted cash flow approach. A total equity value of $19.1 billion was concluded after deducting net debt, non-controlling interests, and after-tax underfunded pension obligations as illustrated in the model below.
Overview EV Projection Assumptions:
- Revenue reaches $15.9 billion in year three which represents a three-year compounded annual growth rate "CAGR" of 2.4%.
- Operating income margin expands to 15.0% by year three.
- Capital expenditures as a percent of revenue remain at 4.5% throughout the projection period.
- Working Capital as a percent of revenue, excluding cash and debt, remain at 1.9% throughout the projection period which is equal to the company's average level over the last four quarters.
- Tax rate of 31.0%, the company's LTM effective tax rate.
- Depreciation as a percent of capital expenditures remains at 90% throughout the projection period.
- Terminal value concluded by applying a perpetuity formula to the free cash flow in year three using a terminal growth rate of 3.0%.
- Discounting the terminal value and discrete cash flows using a weighted average cost of capital of 9.0%. The WACC determined by the following:
Unable to Capitalize on Health Conscious Consumers
Much of the demand in the food and beverage industry over the last decade has been driven by consumer health considerations. Companies have to expand product offerings to include gluten free, fiber, protein, all-natural, and organic products in order to grow or keep market share. Kellogg bought companies such as Kashi Company and Bear Naked to help expand its offerings into these categories. However, Kellogg seems to have recently run into issues with the health conscious community. According to a May 9th Reuters article, the company agreed to stop using terms such as "All Natural" and "100% Natural" on some of its Kashi and Bear Naked brand product labels and to pay more than $5 million to settle a class-action consumer fraud lawsuit. In addition, this announcement came after management admitted that the company was experiencing challenges within its Kashi brand during its first quarter earnings call. Although the lawsuit will not explicitly have a material financial impact, these incidents can have long lasting residual effects in the memories of consumers. I warn investors to be cautious ahead of the company's second quarter earnings announcement as sales within key brands could deteriorate further.
Kellogg Struggles Continue
Management announced Kellogg's first quarter earnings in February with CEO, John Bryant, proclaiming, "We need to tell our story more effectively." First quarter revenues decreased by 3.1% year over year with the company's flagship US Morning Foods and North American business both declining 5.5%. In an attempt to re-gain its relevance, Bryant said the company planned to unveil a major ad campaign in the second quarter according to a Crain's Detroit Business article. Kellogg then seemed to falter further after a Cornflakes TV ad was accused of ripping off a song by Irish band Kodaline on June 11. The company immediately withdrew the advertisement after hearing of the complaint. I do not expect this to have any material effect on the operations of the business but I do believe it reflects poorly on management and business operations. To that extent, I expect Kellogg to undergo similar challenges under its Project K initiative discussed below.
Project K to Impede Cash Flows
Kellogg announced the Project K initiative in 2013 which is a four-year efficiency and effectiveness program. The company explains the program is expected to generate a significant amount of savings which will be invested in key strategic areas of focus for the business. Such areas include an optimized supply chain infrastructure, the implementation of global business services, and a new global focus on categories. According the Kellogg's 10-K, management anticipates incremental capital investments over the next several years. Such initiatives sound promising, but the company's recent operational woes should make investors skeptical whether management is able to successfully execute these initiatives. I expect Kellogg's capital expenditures will be approximately 4.5% of revenues over the next three years which is illustrated in the LR model above.
Kellogg owns valuable and well recognized brands but is currently facing financial and operational headwinds. The company's Kashi and Bear Naked products are currently taking heat from health conscious consumers which may potentially cause further financial troubles. In addition, the company has experienced recent difficulty in its execution of advertising campaigns which I believe foreshadows the challenges ahead related to its Project K initiatives. The Levered Returns model implies an intrinsic value of approximately $53 representing a 20% discount to Kellogg's July 9th closing price of $66.10. General Mills (NYSE:GIS) currently seems like the better cereal play which I discuss further in my previous article which can be found here.