Kellogg Company (NYSE:K) reported quarterly results Tuesday morning (Nov 2), and met analyst estimates for earnings of $0.90/share (see earnings report here and earnings call transcript here). On a year over year basis, that is a decline of roughly 4.25% from EPS of $0.94 in Q3 2009. Cereal revenues in the U.S. also struggled, falling 6% on a YOY comparison. As noted by CEO David Mackay, “2010 has been extremely difficult, and our softer performance is reflected in our current 2010 outlook.” While weak cereal sales affected results, there is another factor that is affecting the segment: promotional sales.
As noted by Treehouse Foods (NYSE:THS) CFO Dennis Riordan at the Barclay’s Back to School Conference back in September, 40% of all branded sales dollars from 2008 to 2010 were sold on promotion. In the next several months, Kellogg’s says that will change; John Bryant, COO for Kellogg, talked about the shift to cutting back on promotional activity that would occur over the remainder of the year back in Q2, saying that, “Our overall share was flat as we decreased our promotion activity in the second quarter in order to return to more balanced levels.”
[General Mills] continue[s] to believe renewed, moderate levels of inflation for the industry will gradually result in improved sales trends in our categories as promotion levels will likely ease in response to renewed cost pressure.
True to his word, GIS announced price increases less than a month later, saying it would raise prices “by a low single digit” on about 25% of their cereals starting November 15 due to increased commodity costs (cost pressures). The problem, in my mind, is that General Mills and Kellogg’s have backed themselves into a corner.
When the economy turned south, promotional naturally took over. However, that dependence on promotional dollars to drive sales has left them in a tough spot. As noted by Morningstar author Eric Swenson in a recent analyst note,
increased promotional spending throughout the industry is conditioning consumers to expect lower prices, and in the absence of product innovation that resonates with consumers, weaning them from lower prices could prove challenging, particularly as unemployment levels remain elevated.
The conditioning described by Eric is already over; as noted by the 40% of all sales in the past two and a half years, many consumers are set on promotional pricing. When these price increases begin and the promotional activity ends, the big boys may be surprised to find that a portion of their customer base may trade down to private label brands. Research from McKinsey shows that 75% of consumers who traded down to private label in 2010 say they won’t be switching back, which is not what companies like Kellogg’s and General Mills want to hear.
The prolonged focus on promotional sales has left the cereal industry between a rock and a hard place. Without innovative new products to drive sales, consumers have grown accustomed to “buy one, get one” type pricing. I believe that both Kellogg’s and General Mills will find a similarly tough environment as they were met with at the start of this year when they look forward to 2011.
Disclosure: No position in the companies mentioned.