Despite Stout Changes to Its Mix, Kellogg's Shares Still Strike Us as a Bargain | K Message Board Posts


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Msg  24 of 25  at  7/22/2021 7:45:37 PM  by

jerrykrause


Despite Stout Changes to Its Mix, Kellogg's Shares Still Strike Us as a Bargain

 Morningstar Investment Research Center
 
 Despite Stout Changes to Its Mix, Kellogg's Shares Still Strike Us as a Bargain
 
 
Erin Lash
Sector Director
 
 
Analyst Note | by Erin Lash Updated Jul 22, 2021

Although consumers have warmed to center-store fare since the pandemic took hold in March 2020, investors’ fervor for Kellogg shares has yet to heat up, with the stock essentially flat, versus the nearly 37% increase in the Morningstar U.S. Consumer Defensive Index. Years before COVID-19 came on the scene, Kellogg started taking steps to alter its mix toward more attractive alcoves (both from a category and geographic perspective), which we believe the market fails to appreciate. More specifically, over the past decade, Kellogg has shifted its product mix away from the mature cereal aisle toward on-trend snacking (which now represents nearly half of its sales, up from around one third in fiscal 2011). This compares with the less than 40% of sales derived from its global cereal arm. And although cold cereal’s lack of international appeal had limited its global ambitions, Kellogg has pursued inorganic means to build an industry-leading presence in faster-growing emerging and developing markets (currently more than 20% of its total sales base), which should provide another vector for growth.

Going forward, we expect the firm will simultaneously invest in supporting the brand intangible assets within its core mix (one leg of its wide moat), while also keeping an eye out for attractive, bolt-on tie ups. When taken together, our consolidated forecast calls for Kellogg to post 2%-3% organic sales growth on average over the next 10 years with operating margins approaching 18% by fiscal 2030, which outpaces the 0.8% and 16% respective marks that we believe are implied by its current $63 share price. As such, we posit investors would be wise to add shares of this wide-moat name to their shopping carts, trading 30% below our $83 fair value estimate and consistently offering an annual dividend, which currently yields nearly 4%.

Business Strategy and Outlook | by Erin Lash Updated Jul 22, 2021

We’ve long held that Kellogg is working to steady the business for the long term. In that vein, management began laying the groundwork to reignite its sales trajectory by moving away from direct store distribution in favor of warehouse delivery, divesting noncore fare and stock-keeping units, and increasing investments in manufacturing capabilities and brands years before the onset of COVID-19. And once the pandemic took hold, we believe Kellogg wisely prioritized investments to support its labor force and retail relationships while also focusing its manufacturing endeavors on its fastest-turning stock-keeping units. As an extension, it opted to delay some previously slated launches (including its lineup of plant-based meat alternatives) to maintain service levels to its retail partners in light of high demand, which we view as prudent.

While we recognize Kellogg has benefited from consumer stock up of essential fare recently (as 90% of its sales result from the retail, including 85% in the United States), we think these multi-year efforts are beginning to manifest in improved category performance around the world, with snacks (46% of sales), cereal (less than 40%), and frozen (15%) boasting mid-single-digit organic top-line growth marks in the March-ending quarter of 2021 relative to the same period in fiscal 2019 (with particular strength in its Pringles, Cheez-Its, Eggo, and Morningstar Farms lineups). We think this showcases the multiple vectors Kellogg maintains to support its growth even as concerns surrounding the pandemic fade.

Although we anticipate the pace of top-line gains will ultimately slow (as demand moderates once consumers eventually navigate beyond their homes as vaccines are more broadly distributed), it appears management understands the importance of leaning into brand spend (research, development, and marketing), even against a more challenging economic backdrop so its brands stay top of mind. We forecast the firm will spend more than 7% of sales, or around $1 billion annually in aggregate, on research, development, and marketing over the next 10 years to ensure it withstands unrelenting competitive and macro pressures.

Economic Moat | by Erin Lash Updated Jul 22, 2021

Our wide moat rating reflects our confidence surrounding Kellogg's ability to generate returns above its cost of capital (even under a more bearish set of assumptions) over the next two decades, stemming from its intangible assets and cost edge. We think its position as a leading packaged food manufacturer and its arsenal of resources have afforded Kellogg the ability to maintain valuable shelf space for its offerings, even in the cereal aisle, where category dynamics have languished from the onslaught of competition resulting from lower-priced private-label fare, other branded operators, and the encroachment of smaller foes from within the category and other breakfast alternatives. We see little to suggest this competition will subside, but we think the strength of Kellogg’s relationships with its retail partners should ultimately ensure its edge persists longer term. We believe Kellogg also maintains a cost edge resulting from the economies of scale in production and distribution across its global network, which has afforded it the ability to invest significant resources behind R&D and advertising. We expect this competitive advantage should result in excess economic profits, with returns on invested capital (including goodwill) averaging around 14% over the length of our explicit forecast, exceeding our 7% weighted average cost of capital for at least the next 20 years.

Kellogg’s position as a leader in the U.S. cereal aisle (holding more than one third share of the domestic ready-to-eat cereal space), combined with its efforts to bolster its position in the on-trend snacking category (which now accounts for around half of its total sales base, up from just one fourth at the start of the century), makes it a valued partner for retailers, in our opinion. The firm boasts four brands that generate $1 billion or more in annual sales (Pringles, Cheez-It, Frosted Flakes, and Special K) and another five that generate sales of $500 million-$1 billion each year (Eggo, Pop-Tarts, Corn Flakes, Rice Krispies, and Nutri-Grain) that help drive traffic into retail outlets. In our view, this position is enhanced by the resources Kellogg maintains to invest in new product launches (spending around 1% of sales, or about $150 million, on R&D annually over the past three years) and tout those offerings in front of consumers (spending 5%-6% of sales, or more than $700 million, each year) to drive customer traffic into stores--bolstering the stickiness of its retailer relationships (a pillar of its brand intangible asset moat source). We've 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 (which it embarked on in 2017) as a prudent means to free up resources to invest further behind its brands in terms of innovation, marketing, and new packaging. More effective brand spending should enable Kellogg to better weather competitive pressures, and as a result of its brand spending, we think its products will uphold strong positions in their respective categories over the long term.

We also believe Kellogg possesses a cost edge resulting from its expansive global distribution network. Becoming an entrenched part of retailers' supply chain creates a virtuous cycle, in our view. Scale affords manufacturers a mutually beneficial relationship with retailers in which the vendor is an important retail partner, developing sales strategies to maximize volume and retailers’ margins while also prioritizing its own brands. With a broad domestic manufacturing and distribution network, Kellogg operates with lower unit and distribution costs as well as greater supply chain efficiency and an enhanced ability to leverage brand spending than smaller peers, in our opinion. Further, we think that as a result of these cost advantages, Kellogg maintains the ability to replicate competitive products and ultimately offer this fare to retailers at a lower cost. This stands to limit the potential shelf space (and scale) new entrants can amass. We believe it is this self-reinforcing combination of sources of its competitive edge that has created high barriers to entry, shielding vendors like Kellogg that are entrenched in retailers' supply chains.

In line with our contention regarding its competitive positioning, Kellogg has generated returns on invested capital (including goodwill) of 11% on average, compared with our 7% cost of capital estimate, over the past 10 years. We expect this performance to continue, projecting a similar level of returns (just shy of 13%) each year on average over the next five years.

Fair Value and Profit Drivers | by Erin Lash Updated Jul 22, 2021

We're holding the line on our $83 per share fair value estimate for Kellogg, which still incorporates our expectations for a higher U.S. corporate tax rate beginning in 2022. In addition, we aren't altering our long-term prognosis for the business, which continues to call for low-single-digit annual sales growth and high-teens operating margins over the next decade. Our revised valuation implies a fiscal 2022 enterprise value/EBITDA of 15.

While Kellogg's domestic arm has benefited from consumers filling their pantries with essential fare due to the coronavirus outbreak, we don't think these marks (which have amounted to a mid- to high-single-digit clip in aggregate) will prove sustainable longer term. Although Kellogg’s recent sales momentum has been buoyed by its hefty exposure to the retail channel (about 90% of its total sales), competitive pressures abound, and we think the onus is on Kellogg to ensure its products consistently win with consumers. But, after a handful of tie-ups over the past decade, Kellogg now possesses one of the most robust emerging market networks (at more than 20% of sales) of its domestic packaged food peers, which should aid its growth. When taken together, we think Kellogg could sustain low-single-digit top-line growth by focusing on extending the distribution of its mix and reinvesting in product innovation (including on-the-go pack formats) aligned with consumer trends at home and abroad.

And although hedging has limited the hit to Kellogg's bottom line from inflation thus far, we expect higher commodity costs will ultimately pressure its cost structure. We’re encouraged, though, that the firm seems to be employing a multipronged approach (anchored in pursuing productivity savings, altering price-pack architecture, and selectively raising prices where justified by innovation) to ensure profits don’t sour. As important, we don’t expect Kellogg will pull back on its brand spend--illustrating it's more concerned with supporting the business' long-term health than meeting short-term profit aims. We continue to believe gross margins will approximate the mid-30s over the course of our 10-year explicit forecast, while operating margins will bounce to the mid- to high-teens. Underpinning this is our expectation that the firm will expend more than 7% of sales, or around $1 billion annually, on research, development, and marketing over the next 10 years.

Risk and Uncertainty | by Erin Lash Updated Jul 22, 2021

Erratic changes in input costs can weigh on profits, as is happening at present. If Kellogg opts to raise prices to offset these pressures, volume may contract if consumers balk. However, we’re encouraged management’s rhetoric suggests it’s employing a multipronged approach (anchored in pursuing productivity savings, altering price-pack architecture, and selectively raising prices where justified by innovation) to ensure profits don’t sour. Further, Kellogg has struggled in the past at the hand of self-inflicted supply chain issues and lackluster innovation, which has weighed on its domestic morning foods and snacks segments (each have chalked up low- to mid-single-digit declines on average the four years prior to the pandemic). Management has been forthright in acknowledging past missteps and direct in its plans to right its ship, but we never expected the tide to turn overnight.

Further, with around 40% of sales generated outside the U.S., Kellogg is exposed to foreign exchange fluctuations, which may eat into sales and profits from time to time. In our view, varying tastes and preferences have proved quite challenging for Kellogg as it has looked to expand abroad, particularly as cold cereal has historically failed to resonate with global consumers. As such, we think the firm could continue pursuing select acquisitions as a means to gain a greater understanding of local consumers and routes to market. However, deals may prove less beneficial if the firm is forced to pay an excessive premium and/or stumbles in the integration.

From an environmental, social, and governance perspective, we surmise that the most tangible risks hinge on product quality and the extent to which heightened regulatory oversight could ensue as a means to combat the global obesity epidemic. Although we anticipate these factors could manifest at various points in time, we don't believe either will handicap its operations or competitive standing longer term.

Capital Allocation | by Erin Lash Updated Jul 22, 2021

We rate Kellogg's capital allocation as Standard, based on its sound balance sheet, combined with investments that have struck us as fair and shareholder distributions that we believe have been appropriate.

While leverage ticked up following a string of deals over the past few years, management has prudently prioritized reducing its debt load (with debt/EBITDA at 3.3 times at the end of fiscal 2020), and we anticipate that its debt balance will continue to fall to around 3 times on average over the next five years. In addition, with just around $700 million in debt coming due on average through fiscal 2025 (combined with the low cyclicality of its sales trajectory), we don't posit its debt levels will inhibit its ability to invest in its operations and return cash to shareholders.

From an investment perspective, CEO Steven Cahillane, continues to favor investments to support the long-term health of the business (behind innovation, capabilities, and capacity), which strikes us as prudent. We still believe the move away from direct-store delivery (which Kellogg closed the book on at year-end 2017) is affording the company the opportunity to remove complexity and free up resources to reinvest behind brands. In addition, similar to other consumer product manufacturers, Kellogg reorganized its North America operations over the past few years to hone in on its category exposure and leverage its scale, as a means to facilitate more efficient decision-making and more effectively allocate resources (both financial and personnel) toward the highest-returning opportunities. We view this plan as shrewd.

And although we think Kellogg will continue to look for opportunities to expand its product and geographic reach inorganically, the firm has done so judiciously in the past. We see little to suggest it will veer from this course in the future.

But we don't think this spend stands to jeopardize its ability to return excess cash to shareholders through its dividend and share repurchases. In this context, we anticipate that Kellogg will grow its dividend at a mid-single-digit pace annually (with the payout remaining between 50%-60%). Further, we surmise that management will opt to repurchase shares (to the tune of 2%-3% outstanding each year), which we view as a sound use of cash when shares are trading at a discount to our assessment of intrinsic value.

 
 
 


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