EUR 850.00 For Business Accounts Only

Morningstar | Despite Modest Gains, Broad-Based Sales Growth Eludes Kellogg in 1Q; Shares a Bargain

While change has been underway at Kellogg for quite some time (encompassing its move away from direct-store distribution, efforts to divest noncore offerings and SKUs, and bolster investments behind its manufacturing capabilities and brands), we posit the wide-moat packaged food manufacturer is still in the early innings, as evidenced by muted sales (at just 0.3%) and continued profit erosion in its first fiscal quarter. More specifically, adjusted gross margins contracted 340 basis points to 32.9% (the bulk of which stemmed from inflationary pressures, the costs associated with a product recall, and the added expense resulting from outsize growth in on-the-go product formats) and adjusted operating margins sank 150 basis points to 13.2%.

Despite the tepid performance of late, we continue to surmise Kellogg is pursuing a sound strategic course that is poised to aid its competitive position. For one, we think the dual mandate of reigniting sales (by extending the distribution of its mix and reinvesting in product innovation, including new pack formats, aligned with consumer trends both at home and abroad) and extracting $600 million-$700 million in costs through 2019--around 6% of its cost of goods sold and operating expenses excluding depreciation and amortization--is wise. We think this should support added brand investments (to the tune of 7% of sales or about $1 billion annually) and bolster profits over a longer horizon.

We don’t anticipate making any material changes to our $78 fair value estimate or long-term forecast (calling for of 2%-3% average annual sales growth and around 400 basis points of operating margin expansion relative to the average over the past three years to more than 18% by fiscal 2028) as results are generally tracking our expectations. After a low-single-digit pullback, shares trade at more than a 25% discount to our valuation; we think investors would be wise to stock up on this wide-moat name (which boasts a yield of more than 4%).

Dissecting its top-line results more granularly, the 4% organic sales growth chalked up in Europe (18% of consolidated sales), Latin America (7%), and AMEA (11%) strikes us as solid. We attribute these gains to the firm’s renewed focus on locally relevant product innovation and increased distribution. However, even on its home turf, we saw some bright spots in the quarter. For one, while North American snacking sales held flat with the year-ago period, consumption of some of its leading brands (Pop-Tarts, Cheez-It, and Rice Krispies Treats) edged up by a high-single-digit to low-double-digit clip, aided by efforts to build out its mix of the on-the-go format products. From our vantage point, Kellogg is poised to build off these gains as it rationalizes its fare and parts ways with noncore brands (including the previously announced sale of its cookie, fruit snack, cone, and pie crust businesses), which should enable it to focus its resources (both financial and personnel) on the highest return opportunities. This underpins our forecast over the next decade for Kellogg to realize low-single-digit organic sales growth each year in its developed market regions and mid-single-digit emerging market growth.

Beyond the first-quarter print, Kellogg also announced that CFO Fareed Khan would be leaving the organization this summer and would be replaced by current President of Asia, Middle East, and Africa Amit Banati, a seven-year veteran of the firm who had previously worked in the finance arms at Procter & Gamble and Cadbury. Given Banati’s industry and company experience, we believe he is well equipped to fill the CFO role, and this change does little to alter our standard stewardship rating. In this vein, we surmise the firm’s priorities for cash will likely remain to lower leverage levels and return excess cash to shareholders through the combination of dividends and share repurchases.