EUR 850.00 For Business Accounts Only

Morningstar | Inflation Eats at Kellogg's Profits, but Ongoing Strategic Shift Should Lead to Long-Term Gains

On the surface, Kellogg’s second-quarter results, 0.4% organic sales shortfall and 90 basis points of adjusted operating margin contraction to 14.2%, could be viewed as merely a reflection of the challenging competitive landscape. However, parsing through the noise, we posit that the merits of its strategic endeavor to move away from direct-store distribution in favor of warehouse delivery are starting to surface. In this vein, management repeatedly referenced qualitatively the broad-based sales and share stabilization it is realizing in U.S. snacks and even its core six U.S. cereal brands (including Special K, a laggard for the past several years), which we view positively. As we’ve been saying for some time, this shift affords the opportunity to increase brand spending as opposed to investing in distribution, which we believe is necessary if it is to withstand the intense competition--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 narrow economic moat.

Further, despite facing inflationary headwinds, Kellogg also attributed a portion of the profit erosion to outsize brand building (up double-digits) and investments behind new pack formats (growth in single serve packs exceeded management’s expectations, warranting added supply chain investments), but we perceive this as prudent spending for the long term. In light of its year-to-date performance, Kellogg bumped up its full-year sales (4%-5% growth, from 3%-4% prior) and earnings expectations (11%-13% growth, from 9%-11%). While we intend to review our assumptions, we don’t foresee a material change to our $74 fair value estimate or long-term outlook (nearly 3% annual organic sales gains and operating margin expansion to the high teens).

From a geographic perspective, Kellogg's sales on its home turf (around two thirds of its consolidated base) slipped 3.6% on an organic basis, but would have been up modestly if the stock-keeping unit rationalization and lower prices resulting from the direct-store distribution exit were excluded. However, the firm’s international markets (Europe, Latin America, and Asia Pacific), were the standouts, boasting mid- to high-single-digit organic sales growth in the quarter (driven entirely by increased volumes). In the past, varying tastes and preferences abroad had proved challenging for Kellogg, particularly as cold cereal has historically failed to resonate with global consumers. But we now believe recent results could be evidencing the advantages of its bent to acquire local firms or take part in joint ventures with native companies that understand the domestic market (in terms of consumers and distribution). In light of this, we wouldn't be surprised to see management opt to pursue similar agreements as it looks to further build out its operations around the world (particularly in markets where it is underpenetrated). While none of its recent deals have been material enough to move the needle on our valuation (on a stand-alone basis or in the aggregate) nor do we incorporate future tie-ups into our outlook, we forecast low-single-digit sales growth in the firm’s developed markets versus mid-single-digit gains in emerging regions.