Kellogg (NYSE:K), one of the leading packaged food companies of the world, has struggled to grow its revenues consistently due to weak cereal category performance. The shift in the consumer preferences towards organic and natural food products has adversely affected the company's top line growth. To address the top line challenges, K has been focusing on altering its product portfolio consistent with consumer demands, but its product innovations have failed to fuel revenue growth. In the challenging industry conditions, the company's management corrected acted with a sense of urgency to create shareholders value by accelerating cost cut measures, which will result in profit margin expansion and fuel earnings growth. Also, margin expansion acceleration will allow it to combat foreign currency headwinds. The company's increased focus on cost savings will augur well for the stock valuation. The stock is trading at a forward P/E of 20.5x, versus its peers average forward P/E of 21x.
The company reported mixed performance for 2Q16. It posted EPS of $0.91, in line with the consensus estimates. The company's revenues were down by 2% YoY in 2Q16. Also, the company's North America sales were down by 3.5% due to weakness in Special K snacks and sales re-alignment. However, the cereal category growth in North America remained flat in 2Q16, as compared to down in 1Q16, and K maintained its market share. However, Cheez-It and Pringles performance in Europe remained healthy; Pringles sales increased by double-digits for the quarter. The company's operating margin improved by 100bps to 15.5%. A positive takeaway from the recent earnings call was the company's increased focus on cost cuts to fuel EPS growth in the challenging industry conditions.
As the company has been facing sales volume pressure, it acted with a higher sense of urgency to create shareholders wealth and fuel EPS growth, through improving its cost structure. K has expanded its Zero-Based Budgeting program to its international operations, which will not only allow it to support its growth investments targeted at strengthening its product portfolio, but also fuel EPS growth. The company's accelerating cost saving measures will allow it to expand its operating margin by 350bps by 2018. Under its Zero-Based Budgeting plan, K aims to achieve annualized cost savings of $450 million by 2018, mainly by price pack architecture, price realization and reducing growth investments behind some brands.
The company's Zero Based Budgeting and Project K are expected to result in total cost savings of $875 million to $930 million by 2018. Despite the fact that the company increased and accelerated its cost savings target, I think, it can further expand its operating margins to 20%, by reducing its overhead costs. The company has a relatively low operating profit margin of almost 15% in contrast to its peers average of 18%. Also, General Mills (NYSE:GIS), K's close competitor recently accelerated its margins expansion efforts and targets operating margin of 20% by 2020. Once K starts to implement its cost savings measures and achieve its targets in the coming quarters, the company is highly likely to increase its margin expansion target which will augur well for its stock price.
The company's margin expansion efforts will provide earnings growth visibility for the next 3-5 years, which will enhance investors' confidence. Also, along with cost cuts, the company should continue to strengthen its portfolio by focusing on innovation to address sales volume pressure; K currently has R&D as a percentage of sales of 1.5%, versus 1.25% for General Mills. Moreover, the company should look for strategic acquisitions, to strengthen its product portfolio and expand its international footprint. I think, the company should look to acquire snack companies, with strong brand portfolio and significant emerging market presence.
Valuation And Summation
As the company continues to face sales volume pressure, it has rightly increased its focus on margin expansion to fuel EPS growth and create shareholder value. The cost cut efforts will not only allow it to generate earnings growth but also support its brand building initiatives, which will augur well for its long-term sales growth. Moreover, I think the company can further increase its long-term margin expansion target. Also, a slight improvement in the company's sales volume trend will positively affect the stock price. As the company will implement its cost saving measures and achieves its targets, it stock valuations will expand. The stock is trading at a forward P/E of 20.5x, in comparison to its peers average of 21x.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.