Kellogg Co. (K, Financial) is undergoing a transtion to break its business up into multiple parts. While management may claim that it is making a good move to create value for shareholders, I find myself disagreeing with the entire proposition. Compared to similar companies, the stock might look undervalued as its price-earnings ratio is just 16.21, but I think the lower valuation is fair because Kellogg faces headwinds. The proposed reorganization plan seems like a sign of trouble in my view, as it implies the company is pulling out all the stops to increase its stock price. Why would it need to increase its stock price at the expense of brand cohesion if its prospects are good?
About Kellogg
Kellogg is a legacy American convenience food company. The company and its subsidiaries manufacture and market breakfast cereals, snacks, convenience foods, frozen foods and even plant-based vegan alternatives to meat. It sells its products in 180 countries.
Kellogg is a strong brand identity builder. Brand identity can affect consumer decision-making and behavior. Right Guard deodorant, for example, created an ad campaign that men needed to smell better before its deodorants could sell well. Kellogg built breakfast cereal into a staple while pork producers persuaded Americans to eat hearty breakfasts of bacon and eggs.
Kellogg’s best-selling Corn Flakes, Frosted Flakes and Rice Krispies have marketing appeal to children. Keebler, Cheez-It, Pringles and many more are among Kellogg's other best-selling brands. A 2021 national survey of consumers conducted by Statista reveals over 8 million Americans devour 10 portions or more of Frosted Flakes in a year. That amounts to one to four helpings per week.
Kellogg sells directly to retailers, brokers and distributors. The Battle Creek, Michigan company was founded in 1906. The current market cap is $24.17 billion. Its enterprise value tops $31 billion in the $1.77 trillion food industry. Kellogg placed seventh in brand finance of the top 50 most valuable food brands according to SyncForce.
Transition plans
Kellogg's plans to transition its business come in two parts. First, Kellogg opened two new high-technology cereal plants in China and Argentina. The breakfast cereal and snack foods market has stagnated for several years, and the U. S. market is expected to grow annually by just 2.33%, so Kellogg is looking internationally for growth. I expect the heftiest future sales in China among its growing middle class enjoying convenience foods. But the issues is that breakfast cereals are not a staple in either China or Argentina, so marketing will be the key to success.
Second, on June 21, Kellogg announced a plan to split into three publicly traded businesses. It will spin off the North American cereal business and its plant-based vegan mean alternative division by the end of 2023. Snacks, international cereal business, noodles and North American frozen breakfast brands will comprise the third segment. Kellogg’s stock will split. Management is proposing tax-free distributions of spin-off shares. Investors and financial media are trending positively on this plan, but I see it as a major negative.
Headwinds hinder valuation
Throughout the beginning of Covid-19, Kellogg's stock floundered in the $50 to $60 range. The shares stuck there until April 2022. The share price began climbing amidst rumors of the reorganization plan. By August, shares were ~$76. The share price is up 10% for the year.
However, I see four primary potential share price suppressants going forward: insider trading, hedge funds’ positions, unionization and supply chain issues.
Corporate insiders and hedge funds are not sowing confidence in Kellogg. Insiders sold $6.8 million of shares in the last three months. Hedge Fund managers cut about 177,000 shares last quarter. Between the second quarter of 2021 and the second quarter of 2022, the number of hedge funds holding Kellogg stock fell from 32 to 25. The fewest hedge funds own Kellogg stock in 2022 than any time in the past five years.
My third concern is that the stock looks overvalued. In addition to the boost that the split will provide, the company is also posting solid results that are making investors overly optimistic in my opinion. The company ended the fiscal year 2021 with net income of $1.49 billion, or $4.36 per share on the common stock; that was a 19% increase from $1.25 billion, or $3.65 per share, in 2020. Kellogg’s second quarter non-GAAP earnings per share were $1.18, or 13 cents more than forecast. Revenue was up 8.7% over the same quarter in 2021. The actual revenue beat forecasts by $220 million, hitting $3.86 billion.
Profitability is Kellogg’s strong suit. The gross and operating margins are strengthening. Its net margin is better than 80% of similar companies and rose closer to 12% from a historical low of about 5%. The return on equity is better than 90% of more than 1,700 other businesses in the industry. The most reassuring numbers in the second quarter report include 12% organic sales growth and a 10% rise in currency-neutral operating profit.
Nevertheless, management blames not being able to show better results partly on the increases in workers’ benefits from the strike. More business troubles are brewing as well. There are new demands and strike threats from the Bakery, Confectionary, Tobacco and Grain Millers International Unions. They are organizing at other Kellogg plants on the heels of their latest gains. Compounding the situation is the traction unions are garnering among low-wage employees due to labor shortages from Covid-19 deaths and the retiring Baby Boomer generation.
Another issue is that commodity prices are on the rise from their 2020 lows. Bad weather and war are driving sugar, wheat and cereal prices higher. By July, cereal and bakery product prices soared nearly 12% year over year. Kellogg’s selling prices in the second quarter rose 13.7%.
Price hikes might eventually slow cereal sales, but in all fairness, the second-quarter sales volume of breakfast cereals dropped less than 2%. More expensive cereal brands bolstered sales and margins. Breakfast cereals and snacks remain comparatively cheap and convenient.
Kellogg’s 3.32% dividend is attractive and safe, but that's about the only positive I see for the stock. The reorganization plan sounds potentially beneficial to investors in the short-term, but I'm not sure it's worth breaking up a company that relies so heavily on brand strength.
