Kellogg's Quest for that Old Snap, Crackle, and Pop


By David Shook After several consecutive years of disappointing results due mainly to slumping breakfast-cereal sales, Kellogg (K), the maker of Rice Krispies and Frosted Flakes, has leveled with investors. For most, the truth hasn't been easy to swallow.

Kellogg is in for a rough-and-tumble 2001. As CEO Carlos Gutierrez said during a conference call last month: "The fourth quarter [of 2000] really represents the first of what should be three difficult quarters as we transition to this new phase of our strategy." Wall Street may have appreciated the honesty, but the yearend report and grim near-term prospects seem to have shocked analysts. True, the stock price has held steady since the conference call, but Kellogg is still trading at $27 a share, down from a high of $32 in 2000.

Most analysts who follow of the company's stock rate it a hold or neutral -- and they don't expect much, if any, market appreciation this year. "The company really lowered expectations substantially," says CS First Boston analyst David Nelson, who adds: "Kellogg finally fessed up to the magnitude of the problem. Recognizing it was a positive, but this company still doesn't provide a particularly exciting story."

SWALLOWING KEEBLER. Gutierrez told analysts that estimated earnings per share for 2001 will be $1.25, down sharply from $1.61 in 2000. This comes despite the promising acquisition of Keebler Foods (KBL), a deal that is expected to close by March. Keebler will add significant cash flow to the Battle Creek (Mich.) food concern and is at the heart of Kellogg's plans to reinvigorate the company. Keebler's top-notch management and profitable snacks, such as Cheez-Its and E.L. Fudge, have dueled impressively with Nabisco, now a division of Kraft Foods and the dominant player in cookie-and-cracker sales. But Keebler alone can't be expected to save Kellogg from a lackluster year.

"I think this will be yet another transitional year in which we'll see very limited top-line growth," says UBS Warburg's John O'Neil. "Part of the benefit of Keebler is that it diversifies Kellogg's portfolio away from cereal, but even Keebler is facing more competition now that Kraft owns Nabisco, which recently completed a successful turnaround." O'Neil doesn't expect Kellogg to make another big acquisition this year. But clearly, Keebler isn't likely to supply the magic elf dust that will make Kellogg's problems vanish.

The woes at Kellogg begin and end with the ready-to-eat cereal business. Sales across the industry are declining. Since 1994, Kellogg's U.S. cereal sales have gone nowhere. Worse, the company has lost market share to rivals General Mills, Post, and Quaker Oats. Just recently, General Mills, the maker of Cheerios, surpassed Kellogg in total-dollar market share, even as major cereal companies saw slight sales declines, according to Information Resources & Marketing, a research company based in Chicago. General Mills now controls nearly 33% of the cereal market, vs. Kellogg's 30%. This is stunning considering that Kellogg has reigned supreme in this business for decades.

TRICKY PROPOSITION. Give Kellogg credit for diversifying with the Keebler deal, but this is one company that still needs to squeeze more juice out of its core brands -- cereals such Froot Loops and Corn Flakes. Last year saw a telling example of the problem: Total sales and operating income didn't budge.

Getting the cereal business moving will be a tricky proposition, but Gutierrez insists it can be done. It's hard to say how much untapped value remains in these old brands. Gutierrez, who has spent his entire career at the company, certainly knows the products. But he has been CEO less than two years and deserves a bit more time to demonstrate whether or not he can turn this company around.

Don't expect any miracles. Marketing expenses will soar as the company moves to revitalize cereal sales. And new cereal launches have a tendency to cannibalize revenues from the older brands, which have higher profit margins and aren't burdened with the heavy initial marketing-and-development costs that new cereals require. The last thing Kellogg wants to do is mess with its profit margins on Corn Flakes.

ASIAN RETREAT. What's more, Kellogg has learned that sales outside the U.S. are especially difficult. In Asia, Gutierrez now admits the company was pushing ahead too quickly with plans to enter the convenience-food market, and doing so in smaller markets that offered little in the way of economies of scale. So Kellogg is backing off in Asia, where the company derives less than 10% of its sales and income, closing a plant in Malaysia, and reducing its spending across several markets.

Sales in Europe, which account for 22% of company revenue, also fell sharply, as did operating income due largely to a sagging euro. Combine that with what Gutierrez called a "suboptimal" domestic business model (apparently referring to the company's failure to jump-start sales of key cereal brands), it's hard to sugar-coat this year's expected results. The U.S. still accounts for 56% of sales despite nearly 11% sales growth in Latin America -- the only market in which Kellogg saw revenues increase last year.

Of course, nobody imagines a world without Corn Flakes and Tony the Tiger, or a cereal aisle bereft of Toucan Sam. All the same, people are eating less dry cereal and more bagels, fewer frozen Eggo waffles and more fresh croissants. If those trends continue, who knows? Maybe Kellogg will cease to be known as the dominant breakfast-cereal company.

NO MILK REQUIRED. More likely, slow-growth -- or no-growth -- cereal sales will continue, leaving it up to Gutierrez & Co. to find lots of creative ways to expand the stumbling food giant. Dry cereal still accounts for the overwhelming majority of Kellogg's $7 billion in annual revenue. But the company has been been reducing its exposure to cereal for the past several years, selling snacks, such as Nutri-Grain breakfast bars, that can be consumed in a car or on the train, unlike cereal with milk.

Dry cereal will become even less important once Kellogg integrates Keebler. The cookie-and-cracker company should account for at least 30% of the merged company's sales, and that figure could rise in coming years given Keebler's recent growth and respected management. Keebler has hit new sales and earnings records for each of the past five years. And while revenues increased only 3.3% in 2000 over the previous year, that's still a much better than Kellogg has been doing.

Until Kellogg shows Wall Street some evidence that the situation is turning around, it'll be no surprise if its stock continues to languish, like stale cereal, on the shelf. Shook covers financial markets for BW Online in New York


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