Dividends and Deals in the Cereal Aisle

Erin Lash: While sales and consumption growth in the cereal aisle has languished over the past few years, we think investors would be well-served to indulge on the shares of the leading manufacturers in the space, namely wide-moat General Mills and Kellogg, both of which we view as undervalued.

For one, we think the market's confidence in General Mills' ability to restore top-line growth has faltered, considering continued softness in volume across the industry as well as skepticism around the acquisition of natural pet food company Blue Buffalo earlier this year. While the deal carries some inherent risk as General Mills enters a category in which it has limited experience, we remain confident in the firm's ability to efficiently integrate Blue Buffalo and extract cost synergies from combining these operations, as we expect it will lean on the experience gained when it added Annie's and others to its mix--leveraging its supply chain and distribution capabilities while largely leaving the acquired firm's operating model intact.

Further, we don't surmise its hunger for deals will compromise its ability to return cash to shareholders. We model a dividend payout ratio averaging 65% over our 10-year explicit forecast (which is in line with its five-year historical average), and implies mid-single-digit dividend growth. Given its discounted price, trading about 25% below our $58 fair value estimate, and with a 4%-plus dividend yield, we think the stock provides a sufficient margin of safety for long-term investors.

Further, we suggest investors with an appetite for income should give Kellogg a look, as it boasts a dividend yield of more than 3%. Kellogg's position as a leader in the U.S. cereal aisle (holding more than one third share of the domestic ready-to-eat cereal space), combined with its efforts to bolster its position in the on-trend snacking category (which now accounts for more than half of its total sales base, up from just one quarter at the start of the century) makes it a valued partner for retailers.

From our vantage point, Kellogg's decision to pivot away from direct-store distribution (which had accounted for about a quarter of its U.S. business) and transition completely to a warehouse model has been a prudent means to free up resources to invest further behind its brands in terms of innovation, marketing, and new packaging, and ultimately support its entrenched relationships with retailers, which we believe is a pillar of its intangible asset-based wide moat.

As such, with shares trading around a nearly a 15% discount to our valuation, combined with our expectations for mid-single-digit annual growth in its dividend over our explicit forecast horizon, we think investors would also be wise to keep this wide-moat name on their radar screens.