By Renee O'Farrell
Kellogg (NYSE:K) is buying the Pringles brand from Procter & Gamble (NYSE:PG) in a $2.7 billion acquisition that is expected to be finalized this summer. The deal comes after a previous, mostly stock deal for $2.4 billion with Diamond Foods (NASDAQ:DMND) fell apart. Diamond had already bought the Pop Secret and Kettle brands, but the deal fell through after Diamond had to deal with the accounting scandal that caused the company to have to restate its financial statements and resulted in its share price plummeting.
Kellogg offered more and will pay cash for the acquisition, taking on another $2 billion in debt to its existing long-term debt of $5 billion. Pringles boasts roughly $1.5 billion in annual sales. According to The New York Times, "Kellogg expects Pringles to add 8 cents to 10 cents to its per-share earnings this year, excluding costs related to the deal. It also hopes to achieve at least $10 million in cost savings this year, a number that it expects to grow." Pringles also brings a strong international position. By acquiring the unit, Kellogg will take on the No. 2 position in the worldwide savory snacks category. It will also allow Kellogg to put some products in its portfolio that are not easy for rivals to imitate the way products such as Corn Flakes and Rice Krispies are. Generic knock-offs are a major issue for the cereal maker, as are changes in consumer preferences.
Snacks are a primary driver for this company. Cereal and other breakfast options are just not used as often today, having lost ground to frozen foods, cereal bars and yogurt. Right now, one of Kellogg's major success drivers and the focus of its strategy is in creating new, snack-oriented products that are not as easy to replicate while providing a strong mix of nutrition and flavor. The company, as reported by The New York Times, "aspires to earn 15% of its annual revenue from products introduced in the last three years."
But, Kellogg will have to address some serious supply chain issues, like in June 2010 when 28 million boxes of cereal had to recalled after reports they emitted a "stale odor." According to Reuters, "Last November, Kellogg said it was spending an additional $70 million in the second half of 2011 to improve its manufacturing after it suffered several blows, including food safety problems."
The question is whether its efforts will be successful, or whether the issues will carry over to the Pringles operation. Make no mistake about it, there is a risk here. Hedge funds like Israel Englander's Millennium Management and Douglas Case's Advanced Investment Partners significantly cut their stakes in the company during the fourth quarter of 2011, and Phill Gross and Robert Atchinson's Adage Capital Management sold out completely.
Right now, Kellogg is trading at roughly $51 a share. Last year, the company managed to beat analyst estimates by 1 cent, coming in at $3.38 over $3.37. Analysts expect Kellogg to earn $3.48 a share this year, rising to $3.78 a share next year. This puts the company's forward P/E ratio at 13.49, vs. its industry's average of 16.29. Kellogg pays a $1.72 dividend (3.20% yield) on a 49% payout ratio and has increased its dividend regularly since 1985. But is Kellogg worth the risk right now? I don't think so. I think the company's share price may increase after the deal with Pringles is finalized, but the boost won't hold until the market can see whether Kellogg is up to challenge. I advocate waiting.
Rival General Mills (NYSE:GIS) competes with Kellogg on several fronts, from sugared cereals to savory snacks. It also carries the distinction of being the country's most reputable company, according to Forbes -- a big difference from being known for a "stale odor" recall. General Mills has also been pushing into organic foods, with brands like Cascadian Farms, Muir Glen and Food Should Taste Good. General Mills is also responsible for the refrigerated and frozen Pillsbury products that are becoming so popular for breakfast.
Today, the company is trading at almost $39 a share. It met analyst earnings expectations of $2.48 a share last year. Analysts predict General Mills will earn $2.54 a share this year and $2.76 next year, making its forward P/E ratio 14.13. The company's dividend is $1.22 (3.10% yield). It has a payout ratio of 51% and has raised its dividend regularly since 1983. General Mills isn't a bad choice by any means, but there are better choices out there.
Kraft Foods (KFT) is responsible for brands like Jell-O, Oreo and Philadelphia. Its snacks business makes up half of its portfolio. While its products may not compete directly with Kellogg -- there are very few Kraft foods in the cereal aisle -- it does compete with the latter in the sense that consumers are choosing some of Kraft's products over cereal in the morning. Plus, as Kellogg gets into the snack business, it will surely compete with Kraft more often, especially as the latter splits to separate its snacks business from its grocery business.
Kraft is currently trading at $38 a share. After beating analyst earnings estimates by just one penny last year ($2.29 vs. $2.28), analysts say the company should earn $2.52 a share this year and $2.80 a share next year, making its forward P/E 13.57. Kraft pays a $1.16 dividend (3.00% yield) on a 58% payout ratio. The company has increased its dividend regularly since 2001. I think the split is a great move given the respective strength of Kraft's grocery business and its snacks business, and recommend the company as a buy as a result.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.