A Dividend Stock to Buy That’s 49% Undervalued and Yields 4%

WK Kellogg KLG is the domestic cereal arm of the former Kellogg. With its entire business tied to a competitively challenged industry and no exposure to the more growth-oriented global snacking business (which now belongs to Kellanova K), WK Kellogg is getting overlooked by the market. While we forecast tepid growth, we expect the company to prioritize its dividend. As such, the stock looks attractive for income investors at today’s price. WK Kellogg lands on our analysts’ list of their favorite 33 undervalued stocks for the quarter. It is also among Morningstar chief U.S. market strategist Dave Sekera’s five undervalued stocks to buy in the first quarter.

WK Kellogg’s top priority is upgrading its outdated supply chain. The company targets $450 million-$500 million in capital expenditures over the next three years to realign its manufacturing and facilities network and invest in technology and automation. We think upgrading its fixed assets will structurally enhance operational efficiencies and lift profitability. As WK Kellogg yields benefits from optimizing its fixed-asset base, we expect it will continue to direct a portion of its excess cash to shareholders through a dividend. We forecast free cash flow as a percentage of sales to be in the mid- to high single digits annually longer term, with a dividend payout ratio in the 40%-60% range. However, the cereal maker has also said it is looking to tap into other categories with higher growth prospects in the medium to long term.

Key Morningstar Metrics for WK Kellogg

• Fair Value Estimate: $27
• Star Rating: 5 Stars
• Economic Moat Rating: None
• Uncertainty Rating: Medium

Economic Moat Rating

We don’t believe WK Kellogg has a durable competitive edge in the mature and secularly challenged North American cereal market. Despite its strong foothold in the cereal aisle—the number-two position with 28% share in the United States, per Euromonitor—competitive pressures and a plethora of breakfast alternatives weaken our confidence that the company will continue extracting excess economic rents. We don’t think it has demonstrated a cost advantage, either. Despite comparable sales bases, WK Kellogg’s low- to high-single-digit operating margins lag the low to mid-20s of Post’s consumer brands segment, which houses its cereal business. We expect that WK Kellogg will generate returns on invested capital (including goodwill) of 15% on average over the next five years, in excess of our 7.6% estimate for its cost of capital. However, we believe this only reflects revenue growth management initiatives and operational efficiency gains from the pending supply chain modernization, as opposed to a competitive advantage.

Read more about WK Kellogg’s moat rating.

Fair Value Estimate for WK Kellogg Stock

Our $27 fair value estimate implies a fiscal 2024 enterprise value/adjusted EBITDA ratio of 10 times. Our discounted cash flow model assumes a 7.6% weighted average cost of capital. We model 2% sales growth in 2023 (which will be reported in mid-February), but longer term, we expect the top line to decline by nearly 1% on average over our explicit forecast period, largely in line with our expectations for the overall domestic cereal category. We expect WK Kellogg will spend around 11% of sales each year, or about $300 million, to support its brands. We forecast incremental margin improvement driven by supply chain modernization and increased operational efficiencies. Our midcycle adjusted EBITDA margin reaches 14%-15%, in line with management’s midteens target by fiscal 2026.

Read more about WK Kellogg’s fair value estimate.

Risk and Uncertainty

The biggest risk facing WK Kellogg’s business is the many nutritious and convenient breakfast alternatives jockeying for market share. We don’t think these competitive pressures are likely to subside. The company is also subject to fluctuating commodity costs, which could weigh on profit or volume, depending on whether it opts to raise prices to dull the margin hit. Moreover, we think WK Kellogg wields less bargaining power with its retail partners than General Mills and Post. Management has hinted at pursuing acquisitions, which brings the risk of overpaying or facing integration challenges.

Read more about WK Kellogg’s risk and uncertainty.

WK Kellogg Bulls Say

• With its singular focus on cereal, WK Kellogg can invest more in automating its supply chain and manufacturing footprint, which should drive enhanced efficiencies and lift margins.
• Roughly one fourth of cereal consumption occurs outside of breakfast time. This could partially offset the negatives of reduced dairy consumption and consumers’ penchant for more-convenient fare.
• Cereal appeals to cash-constrained consumers, with a cost of about $1 per serving.

WK Kellogg Bears Say

• We expect competition to intensify as other leading brands, small startups, and lower-priced private labels chase market share in the mature cereal aisle.
• Given its reduced scale following the spinoff, the company’s negotiating power with key retail partners and suppliers stands to deteriorate.
• Like its peers, WK Kellogg intends to enter adjacent categories in the medium to long term, which could prove value-destructive if it extends too far from its core competencies.

This article was compiled by Susan Dziubinski and Sylvia Hauser.