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About the Company
Kellogg (K) manufactures and markets cereals and other convenience foods (cookies, crackers, toaster pastries, cereal bars, frozen waffles, and meat alternatives) for distribution around the world.
Despite short term weakness, recent cereal recall and intense competitive pressures in the ready-to-eat cereal category, we believe Kellogg is one of the highest quality assets in this industry because it has:
- Attractive category exposure in the long-term;
- Historically superior innovation;
- Broad-based market share growth;
- Consistent and above advertising spending (improves business model sustainability);
- Most importantly, a commitment to returning cash to shareholders (i.e., $2.5 billion in repurchase authorization available through 2012).
We are aware that input cost inflation will continue to hamper Kellogg's profitability. In our view, rising commodity costs are unlikely to abate, given supply constraints as well as increased demand for commodities in emerging and developing markets. Furthermore, we believe Kellogg will increase its investments in R&D and marketing so it can accelerate sales growth, limiting margin expansion this year.
Even with all this, we believe efficiency improvements and investments in marketing and product innovation should ultimately benefit Kellogg in this difficult operating environment. In addition, we believe there is a reasonable upside to current market prices, making the firm one of the more attractive names in packaged food at this time.
Despite short term promotional dynamics, we continue to be attracted to cereal as it is a convenient and a less expensive alternative to out-of-home breakfasts, per serving costs are low, they can be branded as a healthy meal where brands matter, and private label penetration is lower than other supermarket items.
We are confident in management’s ability to drive the company forward, taking on General Mills (GIS) and Nestlé’s JV (OTCPK:NSRGY) in the emerging market. A clear example of management’s stewardship is the acquisition of Keebler in 2000, which was a game changer, providing Kellogg with a direct store delivery system, and thereby allowing the firm to leverage its well-known cereal brands into the snack food segment.
This, combined with a strong portfolio of brands, has allowed Kellogg to build a moat around its business and we expect healthy returns to follow.
Key Value Drivers
- Potential for leverage from acquisitions or further JVs
- Continued expansion in emerging markets
- More efficient advertising
- Unexpected rise in sales revenue guidance
- Margin expansion
- Input cost inflation
- Greater volatility of energy (Kellogg's 10k states that it uses natural gas as a primary source of energy, which suprisingly has not increased since the Middle East debacle.)
- Increased competitive and promotional spending
- A strengthening US Dollar
- Private label threat
- Leverage (Total Liablities/Equity): 4.5x - On the flip side, good returns if everything goes well.
The market is pricing in a slight turnaround for Kellogg. Analysts have raised their target EPS for the next year but lowered it for FY 2012. By 2012, at these prices, Kellogg will be trading below its 5-Yr P/E ratio low, which gives us margin of safety. We do believe that any upgrade in revenue guidance will increase the current P/E multiple.