Kellogg: A Perfect Play Or Played Out?

 |  About: Kellogg Company (K)
by: Markos Kaminis

In trying times like the ones currently giving stockholders indigestion, sector strategists typically direct investors to increase their weighting of consumer staples shares like those of Kellogg Company (NYSE:K). The logic behind the recommendation is clear. As economic risk shakes loose hands from cyclical and otherwise risky shares, the operations of suppliers of basic needs often offer safety.

On the surface of things, Kellogg fits the bill. After all, people have to eat! Let’s take a closer look to make sure.

Kellogg is the world’s leading cereal producer and a significant provider of snack foods. Some of the company’s most recognizable brands include Kellogg’s, Pop-Tarts, Keebler, Eggo, Nutri-Grain, Rice Krispies, Special K, Mini Wheats, Famous Amos and Kashi. When you think cereal, you recall plenty of great Kellogg’s brands like Frosted Flakes, Corn Pops, Frosted Mini-Wheats and others.
While cereal is a mature market in the U.S., the company has found renewed opportunity through product innovation, for instance through health-focused brands like Smart Start. At the same time, the international market offers Kellogg plenty of growth opportunity for its traditional product lines.

The company recently reported second quarter earnings, and exhibited an ability to move products through established and expanding distribution channels. As a result, K improved both sales and margins despite rising food cost pressures. Overall sales rose 9%, but after taking out the beneficial impact of currency, as the Michigan-based company sells into Europe, Latin America and Asia, “internal sales” rose a still healthy 6%.

Cereal sales in the mature North American market edged up 3%, as the company benefited from price increases and new product penetration. Total North American internal sales rose 6% as we believe the company leveraged economies of scope to move higher margin products through its channels. North American retail snack internal sales grew 9%, while frozen and specialty channels increased 8%.

Kellogg International drove sales of 13%, 6% when accounting for currency translation impact. Cereal sales in the U.K., and double-digit growth from snack products, contributed significantly. During its conference call, management cited solid performance in the U.K., France, Spain and Italy. While total European internal sales grew 7%, Latin America rose 8% and Asia declined 1%.

Gross margin expanded 120 basis points, on operating leverage, cost-savings, and a favorable impact from pricing actions. However, operating margin expanded less, 60 basis points, due greatly to up-front investments and greater advertising expenditures.

Moving forward, Kellogg anticipates increased pressure on food costs in the second half of the year, and also foresees some $0.26 to $0.30 a share full-year impact from cost inflation. This is $0.08 more than it previously expected. During the call, management expressed anticipation for some margin pressure as a result of these factors. Still, they maintained their $2.71-$2.74 EPS forecast for 2007.

In terms of valuation, it looks like plenty of investors have the same “safety” idea, as Kellogg and its peers seem fully valued. Kellogg is clearly no secret, with P/E and P/B ratios atop the small group of close peers we selected to look at below. Its dividend does not offer anything special compared to peers either.

Company ----------- Ticker -- Div ---- P/E ttm --- P/B
Industry Average ------------ 2.6% --- 20.9 ------ NA
Kellogg --------------- K ------ 2.3% --- 20.2 ------ 9.0
General Mills ------- (NYSE:GIS) ---- 2.7% --- 18.1 ------ 3.7
Unilever NV -------- (NYSE:UN) ----- 3.5% --- 13.3 ------ 5.2
Pepsico -------------- (NYSE:PEP) ---- 2.2% --- 19.4 ------ 7.0
ConAgra Foods ---- (NYSE:CAG) ---- 2.7% --- 17.5 ------ 2.8

So, now we must ask, do we have a great company whose shares are perhaps fully valued or overvalued and may lack superior appreciation potential, or is there good reason for the valuation premium and is it sustainable? Also, we must decide whether the industry could see valuation expansion if the macroeconomic picture weakens further and capital seeks safety.

We believe a good deal of the value premium K enjoys is due to its management’s focus on improving the efficiency of free cash flow generation, and its success in doing so in the past. However, even management agrees that opportunity may be limited to improve further. For instance, working capital as a percentage of revenues may be tapped out of opportunity, but in saying so during a recent presentation, management was also clear to point out its belief that K holds a leading industry position in its efficiency in that area.

In light of likely capital flow into staple names, we would recommend holding on to K, despite its valuation. It may in fact be deserved, due to the company's strong cash flow generation. And we definitely like management’s style, and the global growth opportunity before Kellogg. Still, we think a closer look at smaller peers might avail an individual story offering more value creation opportunity and a new buy idea with more pep for your portfolio.

K vs. PEP vs. CAG vs. UN vs. GIS 1-yr chart:
food stocks