I recently discussed how, contextually, the performance of Kellogg stock these past sixteen years has been nothing short of remarkable considering that the cold cereal market shrunk to about two-thirds of its size over this time frame. Receiving positive returns, let alone the 9.32% annual returns that Kellogg provided, speaks to the value of becoming a part owner in publicly traded businesses with revenue streams that decline slowly if they decline at all, as this provides much advanced notice to use the cash from declining operations to diversify into related yet different businesses with better growth prospects.
But once you, as an investor, have this notice about demonstrable industry difficulties, the question becomes: How should this information affect your contemplation of purchasing a stock like Kellogg?
The short answer: You need to apply the discipline that is necessary to be a successful utility stock investor, pouncing when the stock is trading at a discount or fair value, but refusing to purchase it even when it’s a little bit overpriced because you admire the stability of the cash flows.
The reason people appreciate companies like Kellogg is because the profits grew from $2.99 per share in 2008 to $3.16 per share in 2009, and the dividend payout from each share grew from $1.30 to $1.43. That’s fantastic. The majority, if not a supermajority, of your common stock investments should be geared towards companies that maintain stable profits during economic recessions. It’s the best form of insurance in the world because it enables you to maintain your rationality when otherwise sound holdings like Wells Fargo, General Electric, U.S. Bancorp, and American Express are experiencing dramatic but ultimately temporary declines in earnings, dividends, and stock prices.
The best thing you can do before troubled times arrive is actually put yourself in a position so that you can maximize objectivity and rationality when it comes time to evaluate assets in distress (either that you own or contemplate owning). You do that by minimizing the amount of debt on your household’s balance sheet and also owning cash-generating assets that have an overwhelming probability of maintaining cash payouts during recessions.
That’s where Kellogg comes in. It is the best form of insurance that can exist–it grows in value over time and regularly gives you money. The point isn’t necessarily for Kellogg to beat the S&P 500 individually, but rather, to act as an appreciating asset that gives you cash so that you can strike from a position of power and rationality when analyzing the cyclical, beaten-down stocks during market downticks. Someone with 1,500 shares of Kellogg that gives him $1,950 in 2008 and then $2,145 in 2009 has a portfolio construction advantage over someone lacking an asset that reliably pumps out cash regardless of overall economic conditions. Owning Kellogg during troubled times is great for orienting yourself towards thinking rationally, and then acting rationally.
But in the past two decades, a few demerits have started to pile up in addition to the clear benefits of owning a national (almost global) cereal and snack provider. The slow ticking declines of the cereal cash cow have strained revenue growth, as the moderate single digit growth from the snack divisions have offset the cereal declines but don’t create enough of a gap for Kellogg’s revenue growth to be impressive compared to some other high caliber consumer staple stocks.
In 2010, Kellogg had $4.9 billion in debt, earned $1.2 billion in profits, and earned revenues of $12.3 billion. Here are the 2016 estimates: Kellogg has $7.9 billion in debt, will earn $1.2 billion in net profits, and will earn $13.8 billion in revenues. The debt has shot up, the profits are stagnant, and the mediocre growth hasn’t even boosted overall profits because Kellogg’s profit margins have declined by 10%. That’s 1.94% annual revenue growth, 0.00% annual profit growth.
Even adjusting for the strong dollar, you would then get figures of $1.4 billion in net 2016 profits and $14.2 billion in revenues. This alternative construction still only gives you 2.94% annual revenue growth and 2.60% annual profit growth. Earnings per share will have increased from $3.30 to $3.65 due to stock buybacks exclusively, and even if you use the $3.97 figure adjusting for currency translations, you are still only talking 3.13% annual earnings per share growth during the 2010-2016 stretch.
And here’s where things have gotten really wild. The P/E ratio of Kellogg has increased every year coming out of the recession. The current $78 price tag is going to make it very difficult for you to build wealth from this price point because the growth isn’t there. The P/E ratio is 21. That’s the highest P/E ratio Kellogg has seen since the late 1990s-2001 period when the growth characteristics of Kellogg were higher than they are today.
I can’t even think of an example to hedge my conclusions–this is literally worst time in the 21st century to make a large purchase of Kellogg stock. My view is that Kellogg stock may grow earnings in the 4-8% annual range over the coming ten years, and the P/E ratio will revert towards the 15-17x earnings range to eventually reflect the lower growth reality (and perhaps Kellogg stock may become especially disfavored if interest rates run high).
Picture this generally optimistic view–Kellogg earns $3.65 per share this year, grows earnings at 7% for ten years, and then trades at 17x earnings ten years from now. That assumption gives you $7.34 in earnings for a $124 fair stock market value at a P/E ratio of 17. In that case, you are only looking at capital appreciation of 58%. A $10,000 investment grows into Kellogg stock worth $15,800, plus around 2.5 additional percentage points from the dividend.
Now, consider the low-end estimate–say you get 4% annual growth and an ending P/E ratio of 15. Kellogg would be earning $5.44 in 2026, and then trading at $81.60 per share. You’d get less than 1% annualized capital appreciation per year. In this much less rosy scenario, you basically spend the next ten years collecting the Kellogg dividend and don’t collect much more than that.
This range of outcomes doesn’t suggest any wisdom in rushing into shares of Kellogg right now. I would rather focus on Diageo, Tiffany, Royal Dutch Shell, and Bank of America/Wells Fargo depending on your risk profile. The bands of potential outcomes for those stocks are just much more favorable right now.
Even if Kellogg is the missing piece in your portfolio, I would still wait for a better entry price because this is the worst valuation the stock has seen this generation. Keep track of Kellogg’s earnings, and refuse to pay a price above 17x earnings. Based on Kellogg’s current earnings, that would suggest not paying above $61 for the stock. It needs a solid 20% haircut before you should consider it.
With companies like Brown Forman, Colgate-Palmolive, Disney, Becton Dickinson, and Nike, you can overpay a little bit and it’s not the end of the world. Even if you overpaid by 20%, you would eventually do well because the earnings growth is so strong it would eventually burn the overvaluation off. It might take 5-10 years, but you’d get there. The earnings quality of Kellogg is exceptional, but the growth component is not. Therefore, you don’t get that “burn off overvaluation” benefit and have to be more disciplined.
If I had to take a fifty year nap, and choose thirty companies to own during that time period, Kellogg would be one of the 30 spots. But it would be one of the last spots on that list because the only way you would ever get annual returns north of 11% would be through purchasing the stock during a substantial decline like 2008-2009. The dividend will grow annually, and will weather many economic storms in the decades to come. That’s the reason why I give it this full due diligence treatment. But if you are trying to build wealth, and are looking for decisions to make in 2016 that will do their part to advance your net worth by 8-12% annually over the next decade, you can do better than Kellogg stock at a price of $78 per share.
Originally posted 2016-04-05 00:53:17.