EUR 850.00 For Business Accounts Only

Morningstar | Kellogg Opts to Up the Ante on Brand Spend to Drive Sustainable Top-Line Gains; Shares Attractive

After just completing his first year at the helm, Kellogg’s CEO Steve Cahillane has provided further perspective surrounding the state of the business and the course it's poised to embark upon now that it has closed the chapter on its move away from direct-store distribution. We’ve long viewed this shift (toward warehouse distribution, which was initially disclosed in February 2017) as a prudent means to extract complexity from its operations while freeing up funds to reinvest in brand-building (as opposed to its distribution network prior), which equates to around 7% of sales, or about $1 billion annually. In our view, these investments should ensure Kellogg is able to 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 fare.

And while the crux of management’s strategic agenda now seems to center on growing the top line 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 surmise further investments in its manufacturing platform will also be slated for 2019. For one, on-the-go pack sizes have been boasting outsize demand at Kellogg of late, but given the firm presently lacks the supply chain capabilities to meet this heightened demand, this growth has weighed on profits. However, we believe these investments stand to support the intangible assets that underlie its wide moat over a longer horizon.

In this vein, we don’t intend to alter our long-term forecast (2%-3% average annual sales growth through fiscal 2027 and 400 basis points of operating margin expansion to around 19% by the end of the decade) and see little change to our $81 fair value estimate. With the shares trading at a 20% discount to our valuation and when combined with its 3%-plus annual dividend yield, we think investors should look to stock up.

From our vantage point, an inability to bring products to market in a timely fashion (with product innovation taking anywhere from 18 to 24 months to move from concept to shelf) has stifled top-line gains for firms throughout the consumer products industry. And as such, we think the onus is on Kellogg to ensure its products consistently win with consumers. Beyond investments in its existing operations, we believe that one means to overcoming this challenge could reside in acquiring local firms or taking part in joint ventures with native companies that understand the market (by providing insights into local tastes and preferences as well as routes to market, with the firm’s recent focus on expanding its footprint in Africa and Brazil). Further, Peter Rahal, president of RX (a U.S.-based snack bar company that was acquired in October 2017 for $600 million, or $400 net of tax benefits, equating to 12-14 times forward EBITDA) emphasized that his business is benefiting from the resources (specifically as it pertains to R&D, data, and analytics) and scale (especially as it relates to procurement and media), which are further enabling increased distribution given the relationships Kellogg already maintains with leading retail partners. However, from Kellogg’s vantage point, we posit the benefits from adding niche businesses to its mix extend beyond the increased exposure to faster-growing categories or markets. Rather, we believe smaller niche operators have demonstrated an ability to be more agile in adapting their mix to changing preferences. As such, we perceive tie-ups with these operators as potentially affording Kellogg the opportunity to extract insights into how to respond to evolving consumer trends in a timelier fashion.

Both at home and abroad, we continue to believe that Kellogg’s bent toward acquisitions will generally center on smaller, bolt-on deals that are unlikely to move the needle on its financial performance (similar to the recent tie-ups). We think the inability to do so has plagued firms throughout the grocery store and view efforts to grease the wheels of its innovation cycle positively, supporting our Standard stewardship rating. On the whole, we expect the pace of emerging-market growth (which presently accounts for around one fifth of the firm’s total sales base, up from less than 15% in 2012) to exceed more developed markets longer term given favorable demographic and disposable income trends, and forecast mid-single-digit annual top-line gains in the firm’s Latin America and Asia-Pacific regions, above the low-single-digit we anticipate for the firm’s North American and European operations.

However, we don’t think the firm is anchored on growing for the sake of it. In this vein, management disclosed that it is exploring the sale of its cookies, fruit snacks, cones, 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. Management stressed that this decision wasn’t the result of poor performance, and instead stemmed from an inability to appropriately invest to support the growth of these offerings (as other brands have been a higher priority as it pertains to research, development, and marketing dollars). We think this stance is supported by the fact that Keebler Fudge Shoppe and Famous Amos are boasting nearly 3% and 6% growth year-to-date in retail sales on its home turf. At 2 times sales (just less than the 3 times sales expended for recent transactions in the space based on data from PitchBook and company filings), we think these funds could be used to finance additional organic and inorganic investments in the business, which we view as prudent.

Further, Kellogg announced its intent to reorganize its North America operations to hone in on its category exposure and leverage its scale, as a means to facilitate more efficient decision-making (in line with the shift at other leading consumer product manufacturers) and more effectively allocate resources (both financial and personnel on the highest returning opportunities). But stressed that this decision fell within the construct of its previously announced Project K restructuring initiative (which began in 2013, targeting $475 million in annual savings) that is now slated to wrap next year (as opposed to encompassing another effort in driving efficiencies). As a result, we aren’t wavering on our expectations for Kellogg's operating margins to expand to around 19% by the end of the next decade, about 400 basis points north of its average profitability over the past five years, which is generally in line with the high-teens to low-20s we expect for other leading branded operators.