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Kellogg (NYSE:K) has spent the last 100 years building its brand presence. From Tony the Tiger to the Keebler Elves to Snap, Crackle and Pop, Kellogg makes some of the most enduring names ever with international sales accounting for about one-third of revenue.

Profitability

Trending consistently higher, earnings per share have averaged growth of 6.1% annually for the last three years. While gross margins have been pressured by rising input costs, net margins have remained steady. Margins are above average for the industry.

Kellogg’s Earnings per Share

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

1.16

1.75

1.92

2.14

2.36

2.51

2.76

2.99

3.16

3.30

Debt

Great businesses typically generate strong cash flows and require little debt financing. I like to see long-term debt less than three times current net earnings. With long-term debt of $5.5 billion and trailing 12-month net income of $1.2 billion, Kellogg’s debt gives me reason for pause. While I understand the appeal of financing growth with low cost debt, especially for companies with high-profile brands and stable business models, all else being equal I would go with a less leveraged competitor over Kellogg.

Return on Equity

Companies that consistently deliver high returns on equity create true wealth for shareholders. Average businesses typically offer a 12% return on equity while great businesses return over 15%. In Kellogg’s case I’ve gone with the return on invested capital metric instead since it includes the use of debt.

Kellogg’s Return on Invested Capital (rounded)

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

9%

11%

12%

13%

14%

14%

15%

16%

17%

16%

Kellogg’s 10-year average ROIC is 14%.

The Dividend

Kellogg currently offers a 3.4% yield supported by a 53% payout ratio. It has increased its dividend annually for seven straight years at an average 8% clip over the last five years.

Retained Earnings

I want to own companies that are free to reinvest retained earnings at high rates of return. What I don’t want to see is high research and development costs or capital expenditures in the form of plant and equipment replacement. Kellogg can occasionally spend as much as 50% of net income on investment in property, plant and equipment in any given year. This is twice as much as its competitors. I’d like to know the reasons for the company’s higher capex costs before considering an investment in Kellogg.

Valuation

At $50.89, Kellogg sells for a price-to-earnings ratio of 15.7, which makes it slightly undervalued based on its five-year average P/E of 15.7. Based on a three-year average of past earnings growth, it's selling for a very high PEG ratio of 2.6. Forward PEG based on 9% projected earnings growth is 1.8. I don’t believe Kellogg’s growth profile supports its current valuation and while it's not grossly overvalued, there are better options in the packaged food industry. As much as I love my Frosted Flakes, Round 1 goes to General Mills.

General Mills (NYSE:GIS)

Hormel (NYSE:HRL)

General Mills

Winner

Kellogg (K)

Campbells Soup (NYSE:CPB)

Champion

Heinz (NYSE:HNZ)

Kraft (KFT)

Winner

Winner

JM Smucker (NYSE:SJM)

Nestle (OTCPK:NSRGY)

Source: Is Kellogg 'Great,' Or Just OK?