Sunday, July 29, 2012

Kellogg Faces Many Headwinds

Kellogg  $K is one of the classic ‘mom and pop’ stocks that has been bid up as a kind of replacement for seemingly overvalued US treasuries. For dividend hunters the recent pullback may well be an opportunity to catch some yield. For anyone else, I think there have been more questions than answers in Kellogg’s recent performance.

Aside from some supply chain logistics and execution problems that need ironing out, the company’s core cereal market appears to be challenged by rising input costs and by some possible structural issues with end demand. Moreover, competition in the snacks market is heating up with the likes of Kraft $KFT refocusing in the sector. The Pringles acquisition also creates some integration risk. Many challenges ahead.

What Went Wrong?

In the recent results, Kellogg downgraded full year revenue growth expectations to 2-3% and significantly reduced full year EPS guidance to $3.18-3.30. A quick summary here.

There are two main problems here. Firstly, the core cereal market seems to be in continued decline. At the back end of last year a private label food company, Treehouse $THS, had warned of weakening conditions in the US. Notably, the company talked of customers trading down to buy groceries from so called dollar stores.

In addition, rival General Mills $GIS also gave disappointing numbers this year. Listening to Kellogg’s explanation, it is clear that cereal volumes are under pressure and Kellogg is fighting hard to retain share in a falling marketplace. Things aren't getting much better for this marketplace.

USA Cereal Market

No doubt, rising commodity costs have played their part and hard stretched consumers are demonstrating more price elasticity than management had hoped they would. There is little that Kellogg can do here, as hedging out these costs is always problematic and, to say the least, expensive.
Kellogg hedge out input costs for no longer than a year, so even with costs falling now, the company is not seeing the benefit dropping into the bottom line because last year's hedges were profitable. The good news is that, on current trends for corn, I would expect some upside next year from the prices they have been hedging at this year.

That said, I think there maybe a structural problem here. I’m intrigued by General Mills’ acquisition of interest in Yoplait and the continued encroachment of Danone’s (NASDAQOTH: DANOY.PK) yogurts in the US. As they both extol the virtues of a healthier dairy based breakfast, it will help to create a market buzz around the product in general. Indeed, both are expanding sales in the US and I can’t help feeling that the high price of corn is helping tip the balance of many consumers away from breakfast cereal.

I think that with issues of obesity and healthy eating being high in the public eye, it is natural that the US should increase its per capita consumption of yogurt vs. high carb breakfast cereal. It gets worse. Within breakfast foods, Kraft’s Belvita and General Mills’ Nature Valley were cited on the conference call as new entrants. I think there is a good case to be made for a structural decline in breakfast cereals.

With regards to snacks, the Pringles acquisition is a clear attempt to expand sales in that direction. It is a bold move, but will not come without execution risk. And execution, by Kellogg’s own admission, is not something being done well right now. Kellogg is planning some supply chain investment and that too will contain risk. Moreover, Kraft is refocusing toward snacks and Kellogg can expect to feel the heat of competition. In summary, things are hard in Kellogg’s core market.

European Difficulties

I’m not sure where to start here. Management talked of significant weakness in cereal in Europe with price elasticity causing part of the sales drop off. I write ‘part’ because Kellogg was keen to point out that a lot of the European issues were ‘company specific.’ In other words, they can be turned around.
And there is a lot to turnaround. European brand building exercises were curtailed due to lack of success and there have been senior management changes at the European operations. Kellogg is planning to respond further by reducing overhead in order to deal with falling sales. All of which smacks of a tough market place.

Frankly, even though the European economy is going through a very difficult patch, I think there is more to the story here. There does appear to be a structural decline in demand for breakfast cereal and, as a way to boost sales, I would question the long term reliance on this product.

What does Kellogg need to do?

For the stock to become attractive - at least to me - the company needs to integrate Pringles well and come up with an acquisition or two in order to find or create a brand that it can grow sales with. Simply relying on some piecemeal restructuring efforts may well not be enough to turn things around.

Lower commodity costs will help in future and the management restructuring will surely have its effect. So clearly, there is some upside here. A decent dividend will attract some investors. However, it is not enough and until Kellogg executes and/or makes some strategic decisions about how to deal with conditions in its core product market, I’m merely inclined to monitor the stock.

If you like the sector then General Mills is worth a look. Danone is attractive but has heavy exposure to both France and Spain. Kraft appears to be positioning itself better than Kellogg. Nevertheless, none of this group is immune from headwinds this year.

Perhaps food stocks are not as defensive as everyone thought they might be.

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