EUR 850.00 For Business Accounts Only

Morningstar | With Entrenched Retail Relationships and a Cost Edge, We Now Posit Kellogg Boasts a Wide Moat. See Updated Analyst Note from 10 Aug 2018

We’re raising our moat rating for Kellogg to wide from narrow to reflect our greater confidence that its intangible assets and cost edge should afford it the ability to generate returns above its cost of capital over the next two decades. We surmise its position as a leading packaged food manufacturer and its arsenal of resources have enabled Kellogg to maintain valuable shelf space for its offerings, even in the challenged cereal aisle, where category dynamics have languished from the onslaught of competition. Further, we have viewed Kellogg's decision to pivot away from direct-store distribution (which had accounted for about 25% of its U.S. business, including around 60% of its U.S. Snack sales) and transition completely to a warehouse model as a prudent means to free up resources to invest further behind its brands (in terms of innovation, marketing, and new packaging). From our vantage point, more effective brand spending should enable Kellogg to better weather competitive pressures, and as a result of its brand spend, we posit Kellogg’s products will uphold strong positions in the respective categories (including cereal) long term. In line with our contention surrounding its competitive position, Kellogg has generated returns on invested capital (including goodwill) of 14% on average, double our 7% cost of capital estimate, over the past 10 years, and we project a similar level of returns each year on average over the next five years.

As a result, we’ve bumped up our fair value estimate for Kellogg to $81 per share from $74 to account for the longer duration over which we project excess returns (now at 20 years, from 15 prior). Despite this, we haven’t wavered on our long-term assumptions, calling for around 3% annual sales growth and operating margins ticking up to 19% by fiscal 2027. With the shares trading at a more than 10% discount to our valuation (which also boasts a 3% dividend yield), we’d suggest investors keep this wide-moat name on their radar.

However, we recognize that Kellogg plays in challenged categories (particularly cereal, which accounts for more than 40% of the firm's consolidated sales base) that could impede the extent to which it stands to sustainably price in excess of inflation, supporting our negative moat trend rating (unchanged) as well as justifying Kellogg's decision to fuel further investments in its brand mix as a means to weather the current competitive onslaught. And although we see retailer relationships as firm, e-commerce (and the resulting disintermediation of brick-and-mortar retailers) has lowered the barriers to entrants at a time when consumers are increasingly willing to experiment with unfamiliar brands, which in some categories (like snacks and organics) have gained share (at the expense of large, branded operators). In this vein, we believe Kellogg’s vast resources (spending 8% of sales on research, development, and marketing annually or $1.2 billion) should serve to bolster the stickiness of its retail relationships, ultimately supporting its competitive prowess.