Kellogg (K) has been an intriguing investment. The company has been struggling for a while and despite poor sales growth, margins, high restructuring costs, and a leveraged balance sheet, shares continue to trade at very elevated levels.
A rush into defensive names, and an M&A premium left shares expensive as management tries to justify the current price by boosting margins in the years to come. While potential earnings improvements could justify the current share price and even higher levels, Kellogg is facing some secular headwinds, deals with leverage as management does not deserve the benefit of the doubt.
Despite these challenges, Kellogg announces a bolt-on deal, boosting its presence in Latin America in what appears to be a relatively attractive deal. Despite the nice bolt-on move, I am not attracted to the shares given the reasons mentioned above.
An Overview of The Business
Kellogg is a large diversified food business, generating sales of $13.5 billion per annum. Roughly, $8 billion of these sales are generated in North America through the sale of morning foods, snacks, specialty foods and other. Europe is responsible for $2.5 billion in sales while Latin American and Asia each generate roughly a billion in sales each year.
The company has been struggling for years as more consumers are skipping breakfast or have it out of home, while they favor fresh over packaged foods. A strong dollar is not helpful either, shaving off a billion in sales in 2015.
The earnings story is highly complicated. Kellogg reported adjusted operating profits of $2.07 billion in 2015. While this 14% margin number looks reasonable, the number itself is questionable.
The GAAP operating profit number is just half that, at $1.09 billion as Kellogg's earnings continue to be hit by many structural items in recent years. The strong dollar hurt profits by $132 million as the troubles in Venezuela cost the company another $120 million. The main charges to GAAP earnings encompass $323 million in project K costs as well as $446 million mark-to-market charges in relation to pension and retirement liabilities, as well as other derivative contracts.
Lack Of Growth, Project K Aids Adjusted Margins, Growth Is Still Non-Existent
Kellogg has grown its sales from $11 billion in 2006 to peak at nearly $15 billion in 2013. A strong dollar, lower soft commodity prices and poor demand reduced the revenue base towards $13.5 billion by 2015.
To combat the lack of growth, Kellogg has announced project K some three years ago. This extensive project has already resulted in large costs, as cumulative charges of the initiative run at $850 million for the period 2013-2015.
The real benefits are still to be seen as low commodity prices and soft demand are not helpful either. If we generously use the +$2 billion ¨very adjusted¨ operating profit number of 2015, margins would have come in at 14%. This shows that Kellogg is still facing big headwinds, as GAAP operating margins averaged at roughly 15% in the period 2006-2010.
The company has somewhat offset the lack of growth and decline in GAAP margins by consistently buying back stock, although share repurchases have come to a near standstill in recent years. Over the past decade, Kellogg has reduced the outstanding share base by a tenth.
Lack of recent share repurchases result from lower earnings and the fact that dividends cost the company roughly $700 million per annum, providing investors with a 2.7% dividend yield. As restructuring charges are high and pension costs continue to mount, reduced earnings are much needed to cover the dividend, leaving Kellogg with few funds to buy back stock.
The company held $531 million in cash at the end of the second quarter, indicating that net debt stands around $7.7 billion. If pension-related liabilities are included, this number increases by roughly a billion towards $8.7 billion. If we use 2015's "very adjusted" operating earnings, EBITDA comes in at $2.6 billion, for a 3.3 times adjusted leverage ratio, being quite high by all means.
What Can Earnings Look Like?
The situation at Kellogg is highly complicated as a result of continued charges, retirement costs and large currency fluctuations. If we look at comparable operating profits for 2015, which exclude the impact of currency changes, operating profits came in at $2.07 billion, equivalent to 14.3% of comparable net sales or $14.5 billion. While this metric shows improvements in the first half of this year, with margins improving by 2 percentage points, the issue is that this number excludes all the bad news, which often is quite structural.
For the year 2017-2018, Kellogg anticipates to grow these adjusted margins by some 350 basis points on the back of zero-based budgeting, a recovery in growth and contribution from Project K. If we assume that sales come in at $15 billion by 2018, margins of nearly 18% translate into potential operating profits of $2.7 billion. Note that these are non-GAAP metrics, not taking into account any potential charges.
With interest carrying debt totaling roughly $8 billion, and assuming a 4% cost of interest, interest expenses are seen at $300 million. That suggests that earnings before taxes are seen at $2.40 billion in the best scenario. With taxes ranging at 25-30%, that could result in after-tax earnings of $1.75 billion, equivalent to roughly $5.00 per share.
A softer dollar could do wonders to achieve this target, yet that does not seem very likely to happen at this point in time. Kellogg sees adjusted earnings at $4.11-$4.18 per share for this year, including a currency headwind of $0.53 per share, after headwinds were already very fierce in 2015. Adding those currency effects back, and factoring in some improvements, a +$5 earnings per share number looks realistic, certainly if some long-term headwinds start to alleviate.
Shares would certainly look appealing in that case at $75 per share, for a 15 times earnings multiple. At the same time, leverage multiples would fall below 3 times on the back of a much improved EBITDA number, alleviating any potential leverage concerns as well.
Adding To Latin America
Despite the current headwinds to GAAP earnings, high dividend payout ratio and leveraged balance sheet, Kellogg announced a sizable acquisition in Latin America. The timing is remarkable given the challenges of the continent, although now might be a cheap time to buy assets in a long-term growth market.
The company will acquire Ritmo Investimentos which is a controlling shareholder in Parati S/A, Afical Ltda and Padua Ltda. With the deal, Kellogg will add both snacking and emerging market exposure to its portfolio. Acquired brands include crackers, powdered beverages, instant noodles and pastas. The $429 million deal will contribute some $190 million in sales, for a 2.2 times sales multiple. While this deal will only add less than 1.5% to Kellogg's overall revenues, it will grow the business in Latin America by a fifth.
The sales tag looks relatively appealing, as Kellogg trades at 2.5 times sales if you factor in debt. To finance the deal, the company is cutting back on share repurchases in order to maintain leverage ratios. The transaction is expected to contribute to 2018's earnings and thereafter, as I like the relative sales multiples, having the potential to create real long-term value.
Final Thoughts, Too Leveraged, Too Risky
Investors in Kellogg face a delicate balancing act. Investors like the stability, a 2.7% dividend yield and potential for $5 earnings per share by 2018. If realized, the market would probably be happy to attach a $100 valuation in such a case, as demand for stable companies remains high in this uncertain environment.
On the other hand, Kellogg is facing growth issues, is highly leveraged as actual GAAP earnings are much lower on the back of large project K costs, a strong dollar as well as pension-related charges. The latter continues to be a concern amidst sluggish markets and low interest rates. If these charges are taken into account, earnings are seen at roughly $2.75-$3.00 per share. That translates into a very high multiple as dividends will eat up most of the earnings, giving the company little capacity to reduce leverage.
So shares trade anywhere between 15 and 25 times earnings based on current GAAP earnings, and a rosy 2018 outlook, as growth is sluggish and leverage is high. Uncertainty has pushed up the valuation for all ¨safe¨ investments as Kellogg has furthermore often been named as an acquisition target for 3G. While such a move can happen, and such a party might be able to slash costs, investors end up paying too much for an investment if such a party does not come by.
While I understand the potential and like the bolt-on deal, the valuation is too steep and leverage is too high for me to get involved at this point in time.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.