Kellogg Company (K) [NYSE] | Industry: Consumer Packaged Goods

Close 74.05 | 52wk 61.13-78.10 | Vol 1,903,280 | Mkt Cap 26.10B | P/E(ttm) 47.22 | EPS(ttm) 1.57 | Div .50 | Moody’s Baa2

We currently have a price target of $81/sh. of Kellogg (K) stock.

This represents 10% upside to the stocks most recent close of $74.05

on May 17, 2016. The price target is based on 2017 EPS of $3.26 at

a 26 forward P/E multiple discounted 2 years at WACC (3.10%).

The dividend yield is currently 2.60%. We believe lower, stable

commodities pricing and an uptick in domestic demand provide the

catalyst necessary to ease the ongoing margin pressures Kellogg has

experienced over recent years.

Investment Summary As Kellogg’s continues to focus on cost control measures such as

zero-based budgeting and Project K, savings will provide a positive

impact on margins going forward. Combined with falling

commodities prices and increasing demand on both domestic and

foreign markets, Kellogg’s is set to outperform.

Zero Based Budgeting - Expected to deliver visibility to $100

million in annual savings in North America during 2016. ZBB will

expand into Kellogg’s international businesses during 2016 with

modest savings expected in certain locations in 2016. Kellogg’s

expects increased savings to be realized in their international

businesses in 2017 and beyond.

Projects K - Expected to generate between $425M and $475M

of annual cost-savings by 2018.

Commodity Pricing - Commodity Prices for items such as corn,

wheat and coarse grain have come down nearly 60% over the past

two years and are expected to remain stable, providing a 2% - 5%

decrease in COGS for Kellogg’s going forward.

Domestic Demand - Domestic demand seems to have bottomed

out and is expected to trend upwards at a moderate pace. Expected

compound annual growth of domestic demand for the period 2015 -

2019 is projected to be 0.8%.

Global Growth - The global market is expected to perform in a

similar pattern with CAGR of 2.7% for next five years and it will

reach a value of $36,498.8m in 2019. Also, CAGRs of the European

and Asian-Pacific market will be 2.6% and 5.7% with a value of

$10,351.9m and $4,382.7m in 2019 respectively.

We believe lower, stable commodities prices and an uptick in

domestic demand provide the catalyst necessary to ease the ongoing

margin pressures Kellogg has experienced over recent years. A price

target of $81/ sh. represents 10% upside to the stocks most recent

close of $74.05 on May 17, 2016.

Jinwoo Lee

Andrew S. Machado

Drilon Tershalla

Zachary T. Uher

Professor: Manoj Dalvi

FIN 4710

Advanced Investment Analysis

18 May 2016

Recommendation: Overweight

Target Price: $81/sh.

Dividend Yield: 2.59%

Shares Outstanding: 350.05M

Float: 278.29M

Held by Insiders: 0.25%

Held by Institutions 82.60%

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Kellogg (K)

Company Synopsis Business description The Kellogg Company was founded by Will and

John Kellogg in 1906. It was incorporated in

Delaware in 1922 and went public in 1952. Its

subsidiaries are engaged in the manufacturing and

marketing of ready-to-eat cereals and

convenience foods such as: cookies, crackers,

savory snacks, toaster pastries, cereal bars, fruit-

flavored snacks, frozen waffles and veggie foods.

Kellogg products are manufactured in 20

countries and marketed in more than 180

countries. Cereal products are generally marketed

under the Kellogg’s name and are sold to the

grocery stores through direct sales force for resale

to consumers.

Kellogg’s also markets cookies, crackers, crisps,

and other convenience foods under other brands

such as: Keebler, Cheez-It, Murray, Austin and

Famous Amos. These are then distributed to

grocers in the United States primarily through a

direct store-door (DSD) delivery system, although

other distribution methods are also used.

Management/ Governance John A. Bryant

Chairman and Chief Executive Officer

Mr. Bryant has been Chairman of the Board for

Kellogg Company since July 2014 and has served

as a Kellogg director since July 2010. In January

2011, he was appointed President and Chief

Executive Officer after having served as the

Executive Vice President and Chief Operating

Officer since August 2008. Mr. Bryant joined

Kellogg in March 1998, and over the next 8 years

was promoted to a number of key financial and

executive leadership roles. He was appointed

Executive Vice President and Chief Financial

Officer, Kellogg Company, President, Kellogg

International in December 2006. In July 2007, Mr.

Bryant was appointed Executive Vice President

and Chief Financial Officer, Kellogg Company,

President, Kellogg North America and in August

2008, he was appointed Executive Vice President,

Chief Operating Officer and Chief Financial

Officer. Mr. Bryant served as Chief Financial

Officer through December 2009.

Ronald L. Dissinger

Senior Vice President and Chief Financial Officer

Mr. Dissinger was appointed Senior Vice

President and Chief Financial Officer effective

January 2010. Mr. Dissinger joined Kellogg in

1987 as an accounting supervisor. During the next

14 years he served in a number of key financial

leadership roles, both in the United States and

Australia. In 2001, he was promoted to Vice

President and Chief Financial Officer, U.S.

Morning Foods. In 2004, Mr. Dissinger became

Vice President, Corporate Financial Planning, and

CFO, Kellogg International. In 2005, he became

Vice President and CFO, Kellogg Europe and

CFO, Kellogg International. In 2007, Mr.

Dissinger was appointed Senior Vice President

and Chief Financial Officer, Kellogg North

America.

Alistair D. Hirst

Senior Vice President, Global Supply Chain

Mr. Hirst assumed his current position in April

2012. He joined the company in 1984 as a Food

Technologist at the Springs, South Africa plant.

While at the facility, he was promoted to Quality

Assurance Manager and Production Manager.

From 1993 to 2001, Mr. Hirst held numerous

positions in South Africa and Australia, including

Production Manager, Plant Manager, and

Director, Supply Chain. In 2001, Mr. Hirst was

promoted to Director, Procurement at the

Manchester, England facility and was later named

European Logistics Director. In 2005, he

transferred to the U.S. when promoted to Vice

President, Global Procurement. In 2008, he was

promoted to Senior Vice President, Snacks

Supply Chain and to Senior Vice President, North

America Supply Chain, in October 2011.

Industry at a Glance

Over the past five years, the breakfast cereal

industry has been volatile due to price fluctuations

of necessary commodities. A Russian export ban

in 2010 resulted in the drastic price increase of

wheat in 2011. Also, other major inputs such as

sugar, coarse grain and corn increased their prices

due to supply shocks. Although the prices of

commodities have declined, pressure for all-

natural products from consumers have resulted in

increasing development costs and are expected to

contract profit margins over the next five years.

The price hikes consequently caused many

operators to exit the industry or become acquired.

For example, Post Holdings acquired MOM

Brands in 2014 to expand and diversify within the

industry.

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North America The breakfast cereal industry in the US is the most

lucrative in the world. The UK market is in second

by a vast difference, being more than 5 times

smaller.

Changing domestic consumer trends and

economic recovery have translated to a

contraction in demand for cereal ever since 2011

(Figure 1). As low-carb diets have become

popular, there has been less demand for cereals.

In addition, industry revenue has declined due to

the rise of disposable income. Consumers tend to

spend more money on luxuries that they could not

previously afford due to the recession. For

instance, they will now choose to go to a café for

pastries rather than have cereal at home.

Figure 1

During the next five years, rising levels of per

capita disposable income will encourage

consumers to purchase more expensive premium

cereals, which are marketed as more nutritious.

However, growth will be limited by rising

competition from substitutes that may offer more

convenience such as fast-food breakfast

sandwiches.

The US breakfast cereal market sported total

revenues of $13,523.7M in 2014, representing a

compound annual growth rate (CAGR) of 0.7%

between 2010 and 2014. In comparison, the

European and Asia-Pacific markets grew with

CAGRs of 2.7% and 5.5% respectively. In terms

of dollars: in 2014, the European market reached

$9,086.5M in revenue, and Asia-Pacific reached

$3.321.0M.

The performance of the market is forecasted to

follow a similar pattern with an anticipated

CAGR of 0.8% from 2014-2019. Thus, expanding

the US market value to $14,054.0M by the end of

2019.

Global The global breakfast cereal market had total

revenues of $31,915.9M in 2014, representing a

CAGR of 2.7% from 2010 to 2014.

The global market is expected to perform in a

similar pattern with CAGR of 2.7% for next five

years and it will reach a value of $36,498.8m in

2019. Also, CAGRs of the European and Asian-

Pacific market will be 2.6% and 5.7% with a value

of $10,351.9m and $4,382.7m in 2019

respectively.

Competitive Analysis Kellogg Company is one of the leading

competitors in the breakfast cereal industry.

Kellogg’s market share in 2016 is 27.3% in the

U.S. (34% global leader), which is the second

largest following General Mills Inc.’s 28%

market share. Some other major competitors

include Post Holdings Inc. and PepsiCo Inc. they

have market shares of 20.9% and 6.1%

respectively.

In past years, Kellogg has remained a global

leader in the breakfast cereal industry. In 2012,

the company announced a joint venture for

manufacturing, sales and distribution with

Wilmar International Limited, one of the largest

food businesses in Asia. Thus, expressing

Kellogg’s interest in expanding their business to

Asia, especially China.

Compared to the other competitors, one of

Kellogg’s strengths is their strong and

recognizable brand names such as Special K,

Froot Loops, and Corn Flakes. In addition, due to

the company’s geographic diversity, products of

Kellogg’s are manufactured in 20 countries and

marketed in more than 180 countries.

A major weakness is that consumers have

preconceived notions that Kellogg’s products

contain a lot of sugar. However, the company has

developed various healthy cereals and now are

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also known for healthy cereals and snacks such as

Special K, and Fiber Plus.

The price changes of raw materials and rising

competitors are threats to Kellogg. However,

Kellogg has minimized pressures from

commodity price changes by using long-term

contracts to hedge their positions. Furthermore,

Kellogg has expanded their market globally so

they can generate more revenue and diversify.

Recent Performance

Total shares outstanding are about 350M, and

their current market cap is $26.1 billion. The 2015

five-year average net income growth was -

13.21%, and the 2015 five-year average EPS

change was -12.22%. Kellogg’s revenue, gross

margin, net income, EPS, return on assets, and

operating cash flow have been decreasing since

2013. Their debt equity ratio is 2.49 and financial

leverage is 7.17. In 2015, Kellogg Co. reported a

dividend of $1.98, which represents a 4.21%

increase over last year. The stock price was

$74.05 at market close on May 17, 2016.

Kellogg’s generated sales of more than $13

billion in 2015 and at the time the global breakfast

cereals market was worth $32.8 billion. In Q1

2016, Kellogg’s gained 0.2% of the market share

putting their current market position at 34.1%

globally. The high value of the breakfast cereals

market can be attributed to its international spread

and steadily increasing demand. North America

and Europe presently account for the majority of

the global breakfast cereals market, which may be

attributed to the early adoption of breakfast

cereals as the standard breakfast fare. In contrast,

the Asia Pacific market has been a “late bloomer”

and has shown impressive growth rates in the past

few decades. Over the forecast period, the Asia

Pacific breakfast cereals market is expected to

exhibit the highest growth rate, leading to a

respectable 13% share in the global market by

2019.

Financial Trends Figure 2 illustrates Kellogg’s revenue trend and

margins from 2011 to 2015. The company’s

revenue has increased from 2011-2013 with

respectively 6.6%, 6.8% and 12.2%, followed

with a decrease in revenue of -1.4 % in 2014 and

-7.62% in 2015. Kellogg has had higher gross

profit margins compared to its major competitor

General Mills, however the end results show

lower net income rate as percentage of sales.

Figure 2

There may be several reasons behind it however,

looking closely at Kellogg’s income statement we

notice greater than average S&GA expense.

Kellogg has had higher S&GA expense for 2011-

2015 than top competitor General Mills; being a

smaller company in size and incurring much

higher fixed costs than General Mills has alerted

Kellogg’s management to initiate major projects

such Project K and Zero-Base Budgeting.

Word on the Street Analysts have had mixed thoughts about

Kellogg’s market performance. Goldman Sachs

has recently updated its position from sell to

neutral with a target price of $80-$90. Analyst

Jason English stated that Kellogg has margin

potential which are too large to ignore. Goldman

Sachs updated Kellogg’s future earnings for 2016,

2017 and 2018 with an increase of respectively

0.5%, 2.7%, and 4.1%. Citigroup on the other

hand suggests a buy with a target price of $90.

Figure 3

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Recent Developments

Farewell CFO Kellogg has announced, Ron Designer will retire

as Chief Financial Officer at the end of 2017. He

promised to remain with Kellogg during 2017 to

assist his successor make an effective transition to

the company, thus management has already began

looking for a replacement. Mr. Designer has been

working for Kellogg for almost three decades, and

was promoted to CFO about six years ago. He

contributed a great share of work as a member of

the Global Leadership Team, and played crucial

roles in projects the company implemented

throughout the years such as the acquisition of

Pringles as well as Integrated Margin

Management, Project K, Zero based budgeting

and the development of Kellogg’s future growth

plan for 2020.

Regulatory Scrutiny The FDA is looking to scrutinize foods labeled as

“Healthy,” according to The Wall Journal. The

action intends to re-evaluate all ingredients of

nutrition clams of this food category. FDA has

demanded the public and food experts’ opinion

regarding what type of food should be labeled

“Healthy.” According to sources, foods would

only be marketed as healthy if they meet five

criteria: fat, saturated fat, sodium, cholesterol and

beneficial nutrients, such as vitamin C or

Calcium, e.g. the level of these ingredients differ

among foods but snacks cannot exceed 3mg fat.

With the new guidelines Kellogg should be able

to label “healthy” its Frosted Flakes and low-fat

Pop-Tarts. The new regulations would take a

several years to become in effect.

Investment Thesis

Revenue Disparity In recent years, volatile commodities pricing,

lower domestic demand and other economic

trends have put downward pressure on revenues.

As a whole this has caused the industry to struggle

and is the catalyst for the revenue growth disparity

between global and domestic revenues. Global

market value has grown by 2.3% to $31.92b in

2014 or 2.7% CAGR since 2010 compared to

domestic growth contracting by 2.6% to $9.75b in

2015, the industry’s largest market.

Figure 4

Contributing Factors As the industry is capital intensive, margins are

heavily dependent on commodities pricing.

Margins have been squeezed with costs of

commodities such as wheat jumping 100% from

2010 to 2011, coarse grains up 60% within the

same time period and corn up 150% from 2010 to

2012. Additionally, exchange rate volatility has

also put downward pressure on revenues. As the

dollar strengthens, overseas revenues are

adversely affected and limits the gains produced

by an expanding global market.

Figure 5

Industry revenues peaks during times of recession

and drop during times of expansion. This can be

seen domestically as per capita income rises,

demand dwindles. Alternatively, as the global

market begins to cool with countries like China

slowing down, exports are increasing. This

happens as a result of consumers opting for

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costlier alternatives from indirect competitors

such as restaurants.

Figure 6

A Light at The End of the Tunnel Domestic demand seems to have bottomed out

and is expected to trend upwards at a moderate

pace. Expected compound annual growth of

domestic demand for the period 2015 - 2019 is

projected to be 0.8%. As demand trends upwards,

domestic industry growth is expected to follow at

an equally moderate pace. Commodities prices

have been falling from highs and are expected to

stabilize, providing margin support. Easing cost

pressures provide the greatest bottom-line impact

for industry firms.

Figure 7

Zero-Based Budgeting In 2015 Kellogg’s initiated the implementation of

a zero-based budgeting (ZBB) program in the

North America business. This ZBB program is

expected to deliver visibility to $100 million in

annual savings in North America during 2016.

ZBB will expand into Kellogg’s international

businesses during 2016 with modest savings

expected in certain locations in 2016. Kellogg’s

expects increased savings to be realized in their

international businesses in 2017 and beyond.

In support of the ZBB initiative, Kellogg’s

incurred pre-tax charges of approximately $12

million in 2015. The company anticipates that

ZBB will result in cumulative pre-tax charges of

approximately $25 to $50 million through 2016

which will consist primarily of the design and

implementation of business capabilities.

Project K Project K is a four-year efficiency and

effectiveness program. It is driving the creation

of new and improved capabilities in various parts

of the company. In addition, it is also creating

the supply chain of the future and a global

business services structure; the latter is

streamlining some functional areas within the

company. Project K is a significantly-sized

project, which is expected to generate between

$425 and $475 million of annual cost-savings by

2018. These savings, in addition to those

generated by Kellogg’s zero-based budgeting

efforts, will provide the company the opportunity

to make significant investments in the business

while improving margins.

Valuation

Assumptions Considering GOGS has been below 55% of sales

during the past five years with the exception of

‘14, ’15 (due to volatile commodities pricing), we

assume a conservative COGS of 57% projected

from 2017-2018 and 55% from 2019-2020 as

Project K and ZBB begin to payoff. SG&A, which

has historically hovered around 26% over the past

five years, is also expected to remain constant.

Conservative revenue growth of .4% is projected

as we have evidence of domestic demand turning

upwards as well as continued success overseas.

Income taxes will remain at a high of 30% held

constant YoY.

P/E Multiple 2016 earnings are projected to be the lowest for

Kellogg’s in recent history, which we believe

provides a unique buying opportunity. At $2.34

2016 EPS and a forward P/E multiple of 26,

Kellogg stock is 20% overvalued. However, it

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seems a handful of savvy shareholders want to

keep the stock in their portfolio considering a

current stock price above $74. 2017 EPS is

conservatively projected to be $3.26 or $84.76/sh.

(26 P/E), a 15% gain from the stock’s current

price. After discounting the projected price/ sh. to

its present value we arrive at a projected target

price of $81/ sh. (26 forward P/E multiple

discounted 2 years at WACC 3.10%). Coupled

with a 2.60% dividend yield, Kellogg seems to be

the stock to own within any well-diversified

portfolio.

Considering a five-year holding period, 2020 EPS

is projected to be $4.17. At a forward P/E of 26

which is the industry average, the present value of

a common share discounted at WACC of 3.10%

provides a current stock price of $93.10/sh. 22%

upside from the stock’s current market price. It

may be considered that given Kellogg is the clear

market leader, a premium P/E multiple may be

applied which would drive share prices even

higher. DCF We have projected EBITDA to increase from

$2.03b to $2.61b and EPS to increase from $1.74

to $4.17 during the period 2015 to 2020.

Moreover, we expect future free cash flows to rise

from $1.13b to $1.25b, including capital spending

in the range of 4 to 5 percent of net sales during

the period. Gross profits are also projected to

increase from $5.53b to $6.18b for years 2016-

2020.

Based on projected free cash flows through 2020

discounted by WACC of 3.10%, enterprise value

is expected to reach $44.98b. Adjusted by current

shares outstanding we determine a current EV per

share value of $127.07 or 67% upside to K’s

current share price.

Risks

Commodities Pricing Agricultural commodities, including corn, wheat,

soybean oil, sugar and cocoa, are the principal raw

materials used in Kellogg products. Cartonboard,

corrugated, and plastic are the principal

packaging materials used by Kellogg’s. The costs

of the aforementioned commodities may fluctuate

widely due to government policy and regulation,

drought and other weather conditions (including

the potential effects of climate change) or other

unforeseen circumstances.

To the extent that any of the foregoing factors

affect the prices of such commodities and Kellogg

is unable to increase prices or adequately hedge

against such changes in prices in a manner that

offsets such changes, the results of operations

could be materially and adversely affected. In

addition, Kellogg uses derivatives to hedge price

risk associated with forecasted purchases of raw

materials. Hedged prices could exceed the spot

price on the date of purchase, resulting in an

unfavorable impact on both gross margin and net

earnings.

Competitive Landscape Kellogg faces competition across its product

lines, including ready-to-eat cereals and

convenience foods, from other companies that

have varying abilities to withstand changes in

market conditions. Most of the competitors have

substantial financial, marketing and other

resources. Competition with them in various

markets and product lines could require Kellogg

to reduce prices, increase capital, marketing or

other expenditures, or lose category share. Any of

which could have a material adverse effect on the

business and financial results. Category share and

growth could also be adversely impacted if

Kellogg is not successful in introducing new

products or in effectively assessing, changing and

setting proper pricing.

Large Accounts Kellogg’s largest customer, Wal-Mart Stores, Inc.

and its affiliates accounted for approximately

21% of consolidated net sales during 2015,

comprised principally of sales within the United

States. As of January 2, 2016, approximately 18%

of the consolidated receivables balance and 27%

of the U.S. receivables balance were comprised of

amounts owed by Wal-Mart Stores, Inc. and its

affiliates. No other customer accounted for

greater than 10% of net sales in 2015. During

2015, Kellogg’s top five customers, collectively,

including Wal-Mart, accounted for approximately

34% of consolidated net sales and approximately

47% of U.S. net sales. As the retail grocery trade

continues to consolidate and retailers become

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larger, Kellogg’s large retail customers may seek

to use their position to improve their profitability

through improved efficiency, lower pricing,

increased promotional programs funded by their

suppliers and more favorable terms. If Kellogg is

unable to use its scale, marketing expertise,

product innovation and category leadership

positions to respond, profitability or volume

growth could be negatively affected. The loss of

any large customer for an extended length of time

could negatively impact sales and profits. Foreign Currency Kellogg’s holds assets and incurs liabilities, earns

revenue and pays expenses in a variety of

currencies other than the U.S. dollar, including the

euro, British pound, Australian dollar, Canadian

dollar, Mexican peso, Venezuelan bolivar fuerte

and Russian ruble. Because consolidated financial

statements are presented in U.S. dollars, Kellogg

must translate its assets, liabilities, revenue and

expenses into U.S. dollars at then-applicable

exchange rates. Consequently, changes in the

value of the U.S. dollar may unpredictably and

negatively affect the value of these items in the

consolidated financial statements, even if their

value has not changed in their original currency.