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Kellogg (K) reported poor third-quarter results Thursday that showed significant operating-profit declines. We were disappointed by the quarter and even more with the firm’s outlook, but we think our fair value estimate adequately captures the downward revision. We are staying pat at a $48 per share fair value estimate.

The firm’s revenue advanced 5%, with internal growth at 3% in the quarter. Sales in North America jumped 4%, led by its frozen foods business (its cereal business was flat in the quarter). Kellogg’s international business also did quite well, expanding roughly 7% from the same quarter last year. The firm noted that Latin America is building momentum, with internal net sales growth in the region coming it at 9% during the period. Overall, sales progressed as expected.

However, operating profit fell a whopping 14% due to supply-chain initiatives to improve quality controls, which increased cost of goods sold in the period. This stands in stark contrast to the profit performance out of Kraft (KFT), which has been able to raise prices, almost at will, to offset rising costs. Unfortunately, this supply chain initiative has continued into the current period and will do so over the next couple years, proving to be a meaningful headwind to Kellogg’s future earnings.

We think Kellogg may have put off non-discretionary expenses related to its supply chain, and such a decision is coming home to roost. On the international front, operating profit declined 9%, as Europe’s internal operating profit was down 21% due to weakness in the UK and higher input costs. All in, third-quarter earnings fell to $0.80 per share, an 11% decline (and well below consensus estimates).

Looking ahead, Kellogg reaffirmed its internal net sales growth in the range of 4% to 5% for the full year, but lowered its internal operating profit guidance due to the weak third-quarter performance and continued investments to shore up its supply chain. Including an estimated $0.08 boost due to currency, Kellogg now expects 2011 earnings per share to come in at $3.41 at the high end.

As it relates to 2012, the firm expects similar internal net sales growth (4% to 5%), but operating-profit and earnings-per-share expansion to be below long-term targets. We maintain that Kellogg is fairly valued at these levels, and we remain on the sidelines until management reestablishes credibility with its operations and the company’s valuation becomes compelling.

Click here for our full 16-page report on Kellogg.

Source: Kellogg Cutbacks Surface In Disappointing Earnings