Long-Term Investing Lessons From The Cereal Industry

In February, Business Insider published an article titled “Millennials Aren’t Eating Cereal Because It’s Too Much Work.” The tongue-in-cheek title had some data points to consider. American cereal sales are down over 30% in the past fifteen years, turning from an industry that sold almost $14 billion worth of cereal to a bit over $10 billion worth of cereal. Affluent customers have come to disfavor industrial processed grains, and the basis for the headline is a 2015 Mintel survey in which 40% of millennials said they didn’t eat cereal because it’s too much work.

The complaint about cereal being hard work fueled a lot of social commentary about the cultural decline propelled by the rise of the millennial generation. I’m mostly sympathetic to commentary that points out the flaws of my generation, but this one didn’t bother me. Cereal itself arose because it was convenient, and given that convenience is one of the three elements that naturally leads to business success, I see nothing out of the ordinary about favoring convenience over time. I also respect the work involved in making money, and as a consequence, it seems appropriate to withhold judgment about how people spend the money that they themselves earned (outside of conversations about whether the behavior should be emulated).

I’m more interested in the data point that the younger generation, as well as the pickier insistence on quality ingredients that often accompanies personal affluence, has quietly scarred the cereal industry.

The investing lesson is an important one. When well-branded products in industries known for stability encounter hardship trends, the rate of harm comes slowly. People don’t just stop eating Cheerios or Lucky Charm’s. It happens very gradually over time, meaning it would take about three decades for the market share to cut in half. This gives the large, diversified cereal companies time to move on to faster-growing product lines that can offset some of the declines in the traditional cold cereal markets.

In 2000, Kellogg earned $8.6 billion in revenues, mostly from cold cereals. In 2016, they’re on pace to earn $13.6 billion. During a sixteen-year period in which the cold cereal industry has declined by 2.16% annually, Kellogg has actually managed to grow revenues by 2.91% annually. Why? Because it bought Keebler in 2001. It bought Pringles chips in 2012. It built out a snack division with Cheez-It and Famous Amos cookies. The middling single digit revenue growth from snacks is able to compensate for the slow declines in cold cereal.

From 2000 through 2016, Kellogg managed to compound at 9.32%. Your nominal value quadrupled as $10,000 in K stock grew into over $40,000 of K stock. That is absolutely outstanding. The core industry shrunk, and continues to shrink, and yet the shareholders haven’t missed a beat.

If a magic genie visited you in the year 2000 and informed you that cereals would contract from nearly $14 billion to $10 billion during the forthcoming sixteen years, you’d probably stay away from the cereal sector. And yet, the pace of change has been so slow that diversification towards snacks has enabled the company-wide revenues to grow.

This is not a recommendation that you should buy Kellogg. There has been some serious financial engineering among the cereal sector firms, and Kellogg’s debt has more than doubled compared to profits since 2000 as part of efforts to acquire snack businesses and reduce the share count from 400 million to 350 million. The revenue growth is quite slow, with current profits of $1.2 billion being on pace with 2009 profits of $1.2 billion (the current figure is more like $1.4 billion if you adjust the currency for the strength of the dollar).

But the experience at Kellogg the past sixteen years explains why people seem to “settle” for entrenched companies with slow-growing brands that find it difficult to achieve mid single digit revenue growth and seem to foreclose the possibility of returns north of 12%. In fact, it seem like you’re settling for 8% or 9% returns.

The benefit of “settling” is that these types of stocks come with limited downside. The major cash cows of the cereal makers like General Mills and Kellogg have experienced ongoing decline these past sixteen years, and yet the enterprise remains intact because the growth is slow enough to right the ship (the General Mills story is similar to Kellogg although it also included a foray into the restaurant industry with Darden Restaurants).

With technology companies, you don’t get this slow decline that gives the management team literally decades to solve the issue. Ten years ago, everyone was using Research In Motion’s Blackberry. It went from $600 million profits to $3.4 billion in profits in under four years, hit a high of $148, and has been unprofitable every year since 2012 (with a whopping $700 million loss in 2013). The reason it’s still around is because management put no debt on the balance sheet until it had no other choice in 2013. The amount of time to diversify operations, and live off the profits of yesteryear, were nearly nonexistence.

Kellogg can still ride the nostalgia wave from marketing efforts and habits that were formed in the 1970s and 1980s. The decline of cold cereals has been substantial over the past two decades, but it has come slowly. The reason consumer staples end up becoming such a core component of most long-term investors’ portfolios is because even when things don’t work out as originally planned, you can still get over 9% returns during a time when the industry’s reach consolidates by a third.

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Originally posted 2016-04-04 04:00:26.

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