EUR 850.00 For Business Accounts Only

Morningstar | Although Shares Have Soured, Brand Investments Support Kellogg's Competitive Edge

Kellogg's shares slumped at a high-single-digit rate following third-quarter results that included 0.4% organic sales growth (a 1.9% increase in volume was offset by a 1.5% hit from lower price and unfavorable mix) and a 150-basis-point retreat in adjusted operating margins to 13.6%. Not only is Kellogg battling the same commodity and logistics inflation as its peers throughout the industry, but it also had a high-single-digit uptick in brand-building investments in the quarter, which we view as supporting its entrenched retail relationships despite the near-term erosion in profits. Management attributed further cost pressures to the uptick in sales of single-serve packs, which ultimately necessitated the use of third-party copackers (as it failed to maintain sufficient capacity to meet demand) and is likely to linger over the next couple of quarters. While this isn’t favorable as it pertains to the firm’s margin profile, we view the outsize demand trajectory as indicative of Kellogg's efforts to more effectively align its mix with consumer trends and thus a modest positive.

In light of its performance through the first nine months of the year, Kellogg now expects full-year sales at the high end of its prior guidance (4%-5% growth). However, it believes heightened costs will persist and lowered its earnings growth expectation to 7%-8%, from 11%-13% growth most recently and 9%-11% initially. Even after accounting for year-to-date results, we don’t intend to materially alter our $81 fair value estimate, which calls for around 3% annual sales growth and operating margins ticking up to 19% by fiscal 2027. We recommend giving this wide-moat name a look as it trades around a 20% discount to our fair value estimate and offers a 3% annual dividend yield.

From a geographic perspective, Kellogg's sales in North America (around two thirds of its consolidated base) remained a tad sluggish, down 1.8% on an organic basis. However, this quarter still included a bit of noise following the transition to direct distribution (reflecting stock-keeping unit rationalization and lower list prices), as well as the recall of Honey Smacks this past summer and lapping increased shipments during last year’s active hurricane season. We still believe that Kellogg's decision to pivot away from direct store distribution and transition completely to a warehouse model has been a prudent means to free up resources to invest further behind its brands, in terms of innovation, marketing, and new packaging. Unlike others in the packaged food realm, management’s rhetoric suggests to us that Kellogg is attempting to reignite sales even at the risk of constraining near-term profits, with the ultimate goal of chalking up sustainable, profitable top- and bottom-line improvement long term, which we view as prudent. As such, we don’t believe Kellogg will ratchet back its spending on its brands; we forecast it to direct 8% of sales to research, development, and marketing annually, or $1.2 billion. We think more effective brand spending should enable Kellogg to better weather competitive pressures--resulting from other branded operators, small niche peers (which have proved more agile in responding to evolving consumer trends), and lower-price private-label offerings--and ultimately support the brand intangible asset that underlies its competitive edge.