Kellogg Co. (NYSE: K). While we remain concerned about the company’s post-COVID operating environment, we expect it to benefit from cost-savings initiatives, as well as recent acquisitions, including RxBar, which makes protein bars with a few simple ingredients. The company is also changing its geographic focus to emerging markets and planning to accelerate growth in its MorningStar Farms brand of plant-based meats. The company recently announced the Incogmeato brand of burgers, bratwurst and Italian sausage, that will compete with Beyond Meat in the fast-growing refrigerated category, rather than in the frozen-food aisle.
Management is well aware of the challenges it faces from changing perceptions about food, changing shopping habits, and a changing retailer environment. The company had reduced costs and it is now focusing on growth initiatives, including investments in on-the-go packages which had been strong sellers before the pandemic. Kellogg recently completed the divestiture of its cookie business and a few others, giving it the financial capacity to invest in faster-growing businesses. We think this is a good decision in a sector that is searching for growth.
The company’s CEO Steven Cahillane purchased $1.1 million of shares at an average price of $65.33 on February 10.
Kellogg shares are down 9% this year, underperforming a 1.5% return for S&P 500 and a 9% return for the Consumer Staples industry ETF (Ticker: IYK).
On October 29, Kellogg reported 3Q20 earnings that topped our estimate. Adjusted EPS was $0.91 per share compared with our estimate of $0.88.
Total sales were up 1.7% to $3.43 billion. Total sales grew less than organic sales because of last year’s divestiture of the cookie, pie crust and ice cream cone businesses, which cut 1.7 points of sales growth. Total were also hurt by currency pressure from the strong dollar, which cut 2.8 points. Management said that demand for packaged foods for at-home consumption remained elevated but moderated from the second quarter. The quarter ended on September 26. The company saw continuing declines in away-from-home locations including cafeterias, vending machines and convenience stores.
Adjusted operating income of $400 million missed our estimate of $423 million. Higher sales and gross profit were offset by higher SG&A, including higher advertising, higher performance-based compensation and currency pressure.
Within North America, organic sales were up 3% in the third quarter. They were up 3.6% in the Snack segment, 7.4% in frozen foods, and up 0.6% in the cereal business.
EARNINGS & GROWTH ANALYSIS
We expect the strong sales in developed markets to normalize and away-from-home channels to improve slowly. The company also plans double-digit brand investment in 4Q.
Based on the guidance provided in the 3Q20 earnings release, Kellogg expects 6% organic growth for the year, up from previous guidance for 5%. It expects adjusted operating profit to increase 2% on a currency-adjusted basis compared with an estimate of 20% previously. This includes about 6 percentage points of drag from divestitures. Adjusted earnings are expected to rise 2% on the same basis, compared with 1% previously. Earnings in 2020 will benefit from an extra week in the fiscal period, which happens about every six years.
We are keeping our 2021 EPS estimate at $4.10 per share.
Management has maintained a close eye on expenses, notably through a cost-reduction and efficiency-improvement program, called Project K. The plan was announced in November of 2013, and 2019 was its final year. Going forward the company’s initiatives are more likely to be focused on building brands and driving sales growth. Our five-year growth rate forecast is 6% based on our expectation for slightly positive organic sales, total sales growth of low-to-mid-single digits helped by acquisitions, and small increases in operating profit. We think gross margin will, and should, probably decline but we expect an offset from expense leverage and a more profitable product mix as a result of the divestitures.
One potential growth driver that deserves some discussion is Kellogg’s ownership of MorningStar Farms and Gardenburger in the plant-based protein business that includes competitors Beyond Meat and Impossible Foods. Morningstar has sales of approximately $300 million, or 2%-3% of the company’s total. The company is having success with veggie based ‘Chik’n’ nuggets, breakfast ‘meats’ and corn dogs. The biggest area of growth in the market is in the refrigerated veggie products that advertise that they have a taste and consistency that is more like real ground beef. Most of the Kellogg-owned products are currently in the frozen section but the company recently announced the Incogmeato brand of burgers, bratwurst and Italian sausage, that will compete with Beyond Meat in the faster-growing refrigerated category. We will continue to discuss this product category in coming notes. Some key questions are how many nonvegetarians can the new generation of burgers can win over, if these burgers are truly healthier to eat, and how pricing and competition will evolve.
FINANCIAL STRENGTH & DIVIDEND
Having ready access to short-term borrowing allows companies to carry less cash, which raises their return on capital, in normal times. Losing investment grade status would jeopardize the short-term ratings. The company has expressed a commitment to maintaining investment-grade ratings. The company ended 3Q with no borrowing on either a five-year credit agreement that matures in 2023 and has a capacity of up to $1.5 billion, or a 364-day facility initiated in January that has a capacity of $1 billion. The company had $116 million of bank borrowings at the end of 2Q, according to the quarterly filing.
Kellogg’s adjusted operating margin of 13% in 2019 is higher than the retailers in our coverage, but lower than Coke and P&G, at over 20%.
Management is using the proceeds of the business sales to reduce debt.
A small number of competing companies could be suitors for an attractive growth company. The ability to make a transformative acquisition could depend on being able to raise cash more easily than competitors.
It contributed about $28 million in 2019. The company made discretionary contributions of $250 million in 2018. Kellogg also contributes to multi-employer pension plans as part of collective bargaining agreements for employees who are members of unions. Kellogg made contributions of $10.5 million to these plans in 2018 and made 2019 contributions that included $132 million to withdraw from two plans.
Total debt was 4-times EBITDA in 2018 and 4.6-times EBITDA in 2017. After the recent business divestitures and the use of proceeds to repay debt, management expects to be at about 4-times. We would estimate that debt was about 3.5-times. We would probably need to see this ratio move below 3-times for the company to have Medium-High financial strength.
The 2020 dividend is 53% of our adjusted earnings estimate, which is reasonable, but slightly above management’s 50% objective. Our FY21 estimate is also about 55% of our earnings estimate. Over the last 20 years, the company’s dividend payout has averaged 65%.
The company repurchased $320 million of its shares in 2018, $526 million in 2017 and $426 million in 2016. In December 2017, the board authorized a $1.5 billion share repurchase to replace its prior authorization, which expired on December 31, 2017. That authorization ran through December 31, 2019. In February of 2020 the company approved a new authorization to repurchase $1.5 billion. The full capacity was available on September 26.
MANAGEMENT & RISKS
On October 2, 2017, Steven A. Cahillane became Kellogg’s CEO, succeeding John A. Bryant, who had served as CEO for seven years. Mr. Cahillane also became chairman of the company in March 2018. The annual report describes his previous position as CEO of Alphabet Holding Company, Inc., and its subsidiary Nature’s Bounty Co., while this is indeed true we should clarify that this is a different company from Alphabet Inc., which is a holding company that owns Google and YouTube. In addition to running Nature’s Bounty, which had a very successful online and direct-to-customer business. Mr. Cahillane was previously president of Coca-Cola Americas which is Coke’s largest division. He was also Chief Commercial Officer at AB InBev, the world’s largest brewing company. This experience should give him deep knowledge in the production, marketing and distribution of consumer products. Unfortunately, we learned from Kraft Heinz last year that a consumer products company can’t be revitalized with cost and efficiency improvements alone.
Kellogg must demonstrate that it is relevant and in synch with where consumers’ tastes are going. Cereal is a mature category in the U.S. and it may not always be the healthiest or most convenient food option. Cereal can contain a lot of sugar, it is not a particularly inexpensive way to fill up in the morning, and cereal with milk is tough to eat on the go. While Kellogg is clearly adjusting and adapting, the company has to contend with changing dietary preferences that may, at times, shun carb-heavy or gluten-containing meals and snacks. Recent consumer preferences seem to be Greek Yogurt, egg-white omelets, hard-boiled eggs, fruit smoothies, or kale. Even the health benefits of the milk which contributes to the snap, crackle, pop of Rice Krispies is being questioned. Oat milk and almond milk are growing in popularity, but they probably raise the cost of breakfast.
An issue we have discussed in other notes is that there is a ‘Foodie’ movement. One long-time food executive half-joked that a foodie is someone who posts pictures of his or her meals on Instagram. It is a pretty good definition and one that executives of consumer companies should take seriously. One of the busiest shops in a local college town (when the students were still there) sells fruit bowls with Acai, oatmeal, fresh berries, granola and peanut butter with dairy-free, gluten-free and soy-free options available. They look beautiful and they appear to be very healthy. This is a challenge for the packaged food companies. Of course not all consumers have $10 to spend on a morning meal, there are health-conscious foodies who will spend $10 on a ‘bowl’ before class, take a picture for Instagram, and then scrimp on lunch. To be sure, Trader Joe’s sells a very good Organic Acai Bowl for $3.99.
Margins are another issue. The well-known consumer products generally have outstanding margins. While margins are important to driving a higher return on capital and higher earnings and potentially valuation, companies need to be aware of growing competition from private label products at Target, Kroger and from the 365 brand at Whole Foods.
In 2013, the company announced ‘Project K’ its global efficiency and effectiveness program. While we are in favor of efficiency and effectiveness, we think investors are aware that costs related to this program, which was announced in 2013, are excluded from adjusted earnings. The pretax costs totaled $54 million in 2019, $143 million in 2018, $263 million in 2017, $325 million in 2016 and $323 million in 2015. While many of these expenses may be considered as separate from the so-called core of the business, they do deserve attention when they are large and ongoing.
As a producer of food products, Kellogg is exposed to significant commodity price volatility and cost inflation. The company may also be hurt by negative currency effects and by price hikes as consumers trade down to lower-priced private-label products. Major recalls and other food safety issues could also have a severe impact on Kellogg’s sales and earnings.
Walmart is the company’s biggest customer representing 19% of 2019 sales. The company’s top five customers accounted for 33% of total sales and 50% of U.S. sales.
Kellogg, based in Battle Creek, Michigan, is the world’s leading breakfast cereal manufacturer and a major producer of snacks and convenience foods, with 2018 sales of $13.6 billion. Thirty-eight percent of 2018 sales came from outside the U.S.
We believe that K shares are favorably valued at recent prices in the $60s.
We are then assuming that the company will grow at approximately 3% after that and that it will be able to pay out approximately 75% of earnings as dividends. This is a reflection of the company’s profitability.