Kellogg: Still Not the Tastiest Snack
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Kellogg (NYSE: K) announced the $2.7 billion purchase of Pringles yesterday, which follows the disaster at Diamond Foods. I agree with the consensus that this was a great purchase, especially when the company can issue debt at such low rates, and should yield incremental returns above the cost of capital. But let’s not get too far ahead of ourselves; the stock is still best left untouched by investors seeking market beating returns.
Kellogg is the leading producer of breakfast cereals with a domestic market share greater than 30%. The company generates annual sales in excess of $13 billion with top-selling brands such as Special K, Frosted Flakes, and Fruit Loops. The Pringles acquisition will allow the snack division to move toward 45% of sales and the Cereal division will drop to 55%.
Kelllogg is still a great business, but the operating trends are declining due to changing customer preferences, high promotional costs, high commodity costs, and private label competition. Free cash flow (operating cash flow less capex) has been exhibiting a declining trend in recent years. Operating margins are clearly declining and have been since 2002 when they topped 18%. Since then, it has been a steady decline and they finished 2011 at 15%. What about growth? You would clearly not expect gang-buster growth, but some nice stable growth would be nice. Instead, EBITDA growth has plummeted and only exceeded +5% once in the last seven years and was negative in three of those years. (2008, 2010, 2011)
The company has only been able to generate EPS growth of 6% per year over the last five years. According to JP Morgan, one-third of that growth was attributable to share buybacks. And what does the Pringles acquisition do? Management stated that it will cause the company to suspend share buybacks, a key fuel to EPS growth in recent years.
With weak operating trends, it might be ok to buy a cheap stock in anticipation of beating a low hurdle performance expectation. Unfortunately, Kellogg stock is not cheap. It isn’t horrible valued, but certainly not cheap. The stock trades at 15x trailing earnings-per-share versus 14x for the S&P 500 despite below-market growth. The enterprise value to EBITDA ratio is at 10x, in-line with the company’s ten-year average despite weakening operating trends. That ratio is in line with the company’s biggest competitor, General Mills (NYSE: GIS), at 10x. General Mills is the number two cereal producer in the U.S. and similar to Kellogg has a premium valuation despite below-market growth.
Other peers trade at a slight lower valuation, exhibit a similar dividend yield, and sport a below-average growth profile. JM Smucker (NYSE: SJM) is the owner of the Folger’s brand, Jif peanut butter, and other food spreads. Their EV/EBITDA is at 9x, the P/E is at 15x, and the dividend yield is at 2.46%. Dr. Pepper Snapple Group (NYSE: DPS) is a distant third-place in the non-alcoholic beverage category. Like many of the other names mentioned here, the sales growth is forecast in the 3-5% range with share buybacks helping boost that a couple more points. The valuation is a bit cheaper than Kellogg at 8x EV/EBITDA, 13x P/E, and 3.4% dividend yield. And lastly, Campbell Soup (NYSE: CPB), the largest producer of soups in the world. This is your prototypical defensive stock with EPS growth very stable, but very slow. The valuation is cheaper on this name and probably should be. The EV/EBITDA stands at 8x, the P/E at 13x, and the dividend yield at 3.6%.
Kellogg's stock was up on a favorable acquisition, but don’t expect the stock to continue its rise. In fact, it provides a good opportunity to dump a mediocre investment. The stock isn’t the worst thing out there, but there are much fatter pitches to swing at.
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