Kellogg's Sales Remain Soggy, but Margin Gains Persist

We don’t foresee a change to our $70 fair value for narrow-moat

In contrast to its languishing top line, Kellogg chalked up improving profitability, as adjusted operating margins edged up 80 basis points to nearly 15%. A portion of these gains reflect efforts to rein in its cost structure, as the firm targets incremental cost savings of $450 million-$500 million by 2018 (more than 4% of cost of goods sold and operating expenses, in line with the 4%-7% its peers aim to extract), which we view as prudent. However, we don’t anticipate that the entirety of these savings will fall to the bottom line. Because Kellogg operates in an intensely competitive environment where category dynamics remain muted, we suspect the firm will continue to spend to more effectively tailor its brand mix to align with consumers' desire for healthier fare made with simpler, more natural ingredients, while also touting its offerings in front of consumers. As a result, we expect Kellogg will continue to invest more than 8% of sales--or around $1.1 billion annually--behind its labels to support its brand intangible assets and ultimately prop up its top line.

In combination, these factors drive our long-term forecast, which calls for 3% annual sales growth (slightly more than half from expanding volumes and the remainder from higher prices and improved mix) and operating margins approaching 19% by fiscal 2025--about 500 basis points above the average of the last three years. However, shares trade a touch north of our valuation, and as such, we’d suggest investors refrain from building a position at current levels.

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