Murky Conditions for Kellogg But Has Solid Foundation

Heading into Kellogg’s K second-quarter earnings report, we think the market was keen to assess how its top line would stack up as the effects of the pandemic fade. And from our vantage point, the modest 0.4% draw-down in organic sales relative to 9% organic growth realized at the height of consumer stock-ups in the April through June quarter last year suggests Kellogg’s strategic playbook (focused on increasing investments in capabilities and brands) is hitting the mark.

However, cost headwinds are ravaging firms across industries, and Kellogg is no exception, with management calling attention (qualitatively) to the impact stemming from material, labor, and freight shortages. This resulted in margin degradation (not dissimilar from peers), with the adjusted gross margin contracting 160 basis points to 34.2% and the adjusted operating margin eroding 220 basis points to 14%. And while we don’t think these pressures will abate over the near term, we expect the hit to Kellogg could prove to be a bit more acute, stalling capacity additions from coming online in short order. But, unlike others, Kellogg didn’t just begin building out its manufacturing footprint following the rash of demand realized a year ago. And we think management will remain squarely focused on investing to support the long-term health of the business. As such, we aren’t wavering on our long-term outlook, calling for low-single-digit organic sales growth and high-teens operating margins through fiscal 2030.

When taken together, Kellogg edged up its fiscal 2021 organic sales outlook for growth of up to 1% (versus flat prior) but held the line on its 1%-2% adjusted EPS growth forecast (bang in line with our 1% estimate). As such, our $83 fair value estimate is unchanged. Despite a low-single-digit uptick in shares, we believe the wide-moat name (which trades nearly 30% below our intrinsic valuation and boasts a 4% dividend yield) offers a favorable risk/reward opportunity.

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