Morningstar | Kellogg Continues to Lay Groundwork for Profitable Sales Gains Long Term; Shares Undervalued
Kellogg's share price fell by midsingle digits following uninspiring fourth-quarter results, including a 0.6% pullback in organic sales, a 280-basis-point decline in adjusted gross margins to 34.6%, and a 90-basis-point erosion in adjusted operating margins to 13.1%. Despite this, we view the firm’s strategic agenda as sound, with a renewed focus on bolstering top-line growth 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.We believe Kellogg's current course was facilitated by the decision two years ago to abandon the direct-store distribution model in favor of warehouse distribution. In our view, this positions Kellogg to remove complexity from its business while freeing up funds to reinvest in brand-building instead of its distribution network. We forecast the firm will direct around 7% of sales, or about $1 billion annually, toward research, development, and marketing over the next 10 years. We believe these investments should ensure Kellogg withstands competitive pressures from other branded operators, small niche peers (which have proved more agile in responding to evolving consumer trends), and private-label fare.
We intend to assess the assumptions underlying our discounted cash flow model in light of full-year results. While we will probably trim our $81 fair value estimate by a low-single-digit percentage to account for a slightly more pronounced deterioration in near-term profits due to outsize brand and manufacturing investments in 2019, we don’t intend to alter our long-term forecast of 2%-3% average annual sales growth through fiscal 2027 and 400 basis points of operating margin expansion to nearly 19% by the end of the decade. As such, we continue to view the stock as undervalued, trading more than 25% below our valuation.
Despite its focus on expanding its sales base, we don't think Kellogg will do so at any cost. The firm is still pursuing a sale of its cookie, fruit snack, cone, and pie crust businesses (including brands such as Keebler, Mother’s, Famous Amos, and Stretch Island), which make up around $900 million in annual sales, or about 7% of Kellogg’s consolidated base. In the past, management indicated that this decision wasn’t prompted by poor performance but rather an inability to sufficiently invest to support the growth of these offerings (as other brands have been a higher priority for research, development, and marketing dollars). We think this stance is supported by the fact that Keebler Fudge Shoppe, Mother’s, and Famous Amos chalked up 2%, 2%, and 5% growth in 2018 in retail sales on its home turf. We think Kellogg could garner a valuation of around 2 times sales for these brands (just less than the 3 times sales expended for recent transactions in the space based on data from PitchBook and company filings), and we think the proceeds could be used to finance additional organic and inorganic investments in the business, which we view as prudent.
We will attend the Consumer Analyst Group of New York conference Feb. 18-22 and hope to hear Kellogg management provide added context around the opportunities and challenges to reigniting the top line. Further, we expect CEO Steven Cahillane will take the opportunity to divulge his perspective regarding capital allocation, including the firm’s appetite to act as an acquirer in the space.
Kellogg is engaged in the manufacture and marketing of ready-to-eat cereal and convenience foods. The company's principal products are snacks, such as crackers, savory snacks, toaster pastries, cereal bars, granola bars and bites; and convenience foods, such as, ready-to-eat cereals, frozen waffles, veggie foods and noodles. The company's snacks brands are marketed under brands such as Kellogg's, Cheez-It, Pringles, Austin, Parati, and RXBAR. The company's cereals and cereal bars are generally marketed under the Kellogg's name, with some under the Kashi and Bear Naked brands. The company's frozen foods are marketed under the Eggo and Morningstar Farms brands.
Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.
Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.
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