One of the biggest concerns currently about the overall consumer staples sector is how staid and established food product companies adapt to changing consumer tastes and preferences when their tried and true brands no longer resonate with many customers. Brand loyalty is on the wane for many of these companies. Kraft Heinz’s (KHC, Financial) $15.4 billion goodwill write-down for the declining value of its trademark Oscar Meyer brand, as well as others, illustrates the challenges the sector faces.
Kellogg (K, Financial) has been a laggard among the companies within the consumer staples sector; its stock has been stuck in the doldrums. The stock has fallen more than 20% from 2017 to 2018. Though Kellogg shares are up approximately 12%, including dividends, this year, it trails the Consumer Staples Select Sector Exchange-Traded Fund (XLP, Financial) by 22%.
Fortunately, all is not lost. The stock has shown some promise in recent months. Its August earnings report was solid; the company raised its dividend.
There are a number of factors that will help propel the company’s organic sales growth and improve its somewhat lackluster and declining operating margins. The company has made a strategic shift to snacks, versus giving its old-line cereals top billing. Kellogg has restructured its food product mix, reducing its reliance on its principal traditional source of revenue from its cereal brands. In 2019, 36% of the company’s sales have come from Kellogg’s cereal products, compared with 50% in 2010.
The snack component is now 50%, up from 38%. This is a substantial revision to its product offerings and is a prudent move as a younger generation eats less cereal and consumes more snacks. The company is counting heavily on the potential organic sales growth from its snack products.
Additionally, snacks offer better growth prospects than cereal in the developed markets. In the second quarter, Kellogg’s total net sales for cereal had a small overall decline; most analysts expect cereal sales to grow at a tepid 1% annual rate. Indeed, in 2018, organic net sales of $12.8 billion was the same as the previous year’s result. In short, the company’s foray into emerging markets and its strategic shift to snacks was opportune.
The company has initiated cost-cutting measures and innovations, such as rolling out its existing food product in smaller packages. Kellogg is hoping these changes will help accelerate organic sales growth. Operating margins, which declined 4% in the second quarter, have been impacted by expenses for new products as well as its recent acquisitions, but should stabilize this year as production ramps up for the smaller packaging products.
In an interesting note, Kellogg has found consumer loyalty for its snack brands among a rather unusual customer demographic: teenagers. A recent Piper Jaffray report found that the company’s products were chosen by teens as one of their “favorite snack brands.” Cheez-It, Pringles and Rice Krispies were among the most preferred brands. In an era where established staples companies are losing market share to smaller companies with healthier organic products, the teen loyalty survey is good news.
The company has benefited both from a smart acquisition and a margin-improving divestment. In order to help replace flatline domestic cereal sales, in 2016, Kellogg acquired Parati Group, a Brazilian food group, to help raise its profile in emerging markets. Cereal sales in the U.S. have remained flat for a number of years. Kellogg’s $1.3 billion sale of Keebler cookies and its other associated products will free up cash for reducing debt and should help increase growth now that the underperforming division, which contributed to stagnant sales growth, is off the books.
Some of the changes are bearing fruit. Kellogg’s second-quarter report showed organic sales increased 2.3%, the most since 2016—led by snacks and with an assist by frozen food products. In August, the company offered 2019 guidance for net sales growth of 1% to 2%.
Another positive sign: Kellogg has revamped its distribution model, changing from a direct-to-stores model in favor of one where retailers are responsible for moving product from warehouses to their stores. The older model was capital-intensive, so eliminating that operational distribution system will free up capital that can be reallocated to areas such as marketing and smaller packaging tied to its existing brands, which is an important market in distribution channels such as convenience stores.
There are a number of factors that indicate Kellogg is undervalued relative to the overall staples sector.
The stock is currently selling at $69.78, below its 52-week high of $72.98 and above its 52 week low of $51.34. Its price-earnings ratio is 16.2 and its forward earnings are $3.85 per share, a discount from its five-year average of 17.5, as reported by FactSet. By comparison, The Consumer Staples Select ETF, fetches about 20.5 times profit estimates — above its five-year average of 20 times.
With a current yield of 3.7%, Kellogg has an attractive valuation relative to many of its peers in the staples sector, whose prices have risen over the past six months to relatively high levels.
With most other stocks in the consumer packaged goods industry currently selling at a premium, Kellogg, at $69.78 a share, is worthy of consideration.
Disclosure: I have no positions in any of the securities referenced in this article.
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