Kellogg Earnings: Despite Resilience Amid Headwinds, Business Separation Takes the Limelight

We don’t expect a material change to our $84 sum-of-the-parts valuation for wide-moat Kellogg K after digesting solid second-quarter results. Despite sales growth (up 7.1% on an organic basis) and advancing margins (up 130 and 120 basis points, respectively, at the adjusted gross and operating margin lines to 33.7% and 14.9%), the market has yet to be placated, as it awaits further details on the impending split into its global snacking and North American cereal arms. The breakup remains on track to transpire during the fourth quarter, though specifics were deferred to the individual firm’s investor days on Aug. 9.

Against an intensifying competitive and weakening consumer backdrop, we surmise Kellogg’s future prognosis will hinge on the capital allocation priorities that each business sets. In our view, Kellogg must make investments in consumer-valued innovation and advertising to convince consumers to accept the higher prices at the shelf (a nearly 15% benefit to Kellogg’s top line in the quarter), while also entrenching its standing with leading retailers. In this context, we expect the consolidated operation will direct nearly 7% of sales ($1.2 billion) annually toward research, development, and marketing on average for the next 10 years.

We still view shares of the combined entity as undervalued, trading at a 20% discount to our valuation, buoyed by its 4% dividend yield. We’ve long thought the divergence has stemmed from a lack of appreciation by the market to Kellogg’s efforts to increase its exposure to the snacks category (which boasts faster growth prospects and lower levels of private-label penetration) and emerging markets (where favorable income and demographic trends should manifest in long-term opportunities). Even though we haven’t wavered in our belief that the rationale for the split is to unlock a higher multiple for its global snacks business (not more focus, as has been suggested), we still think shares offer a tasty treat.