Kellogg (NYSE:K) stock is not the defensive play it once was. Customers are avoiding the sugary cereals for which the company is best-known, pressuring sales. Kellogg earnings are set to decline this year, but that doesn’t mean Kellogg stock should be sold.
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Back in July I called K stock one of the best dividend stocks to buy. That wasn’t because the company was a defensive stock. Rather, it has become a turnaround play. The case for Kellogg is based on its pivot into snacks, and the potential value in its MorningStar Farms unit.
The valuations assigned Beyond Meat (NASDAQ:BYND) (even after a steep sell-off) and still-private Impossible Foods suggest that vegetarian-focused MorningStar isn’t priced into K stock yet. And an impressive Q2 earnings report in July, despite weakness in cereals, led Kellogg stock to gain nearly 10%, its best day in almost two decades.
Admittedly, Kellogg stock has gained over 20% from May lows, which might suggest investors have realized those positives. But valuation still is reasonable, and earnings growth should resume in 2020. There’s still a path to more gains here — if Kellogg can again deliver a solid earnings report next Tuesday.
What to Expect From Kellogg Earnings
Expectations for Kellogg earnings seem relatively soft. Analysts on average are looking for adjusted earnings per share of 91 cents, a steep decline from $1.06 the year before. Consensus revenue estimates suggest a 3%-plus decline year-over-year, though some of the pressure is coming from currency effects and the divestitures of smaller businesses.
That said, those soft earnings expectations don’t necessarily suggest that Kellogg has a low bar to clear. The well-received Q2 report showed similar weakness. Reported sales did grow 3% year-over-year despite a 1.9-point headwind from the stronger dollar. But adjusted EPS fell 13% year-over-year, due to lower operating profit and higher interest expense on the company’s debt.
Meanwhile, full-year guidance still is for 1-2% growth on a currency-neutral basis. After 6% growth in the first half, that suggests reasonably significant declines in both Q3 and Q4. The company projects full-year adjusted EPS to decline 10-11% excluding currency, which had a roughly two-point negative impact in the first half.
The broad point here is that, at the moment, this remains a declining business. Investors shouldn’t expect that to suddenly change. Nor should they believe that soft consensus implies a post-earnings gain is guaranteed.
In fact, expectations for Q3 may be somewhat high. Kellogg earnings in Q2 beat consensus by 7 cents, and revenue grew roughly 1.5 points faster than expected. It’s likely that the market is expecting a guidance raise after the quarter — and may be disappointed if it doesn’t come.
How K Stock Continues Its Rally
From a headline perspective, then, the full-year outlook may be more important than the Q3 numbers. But consolidated results also won’t make up the entire story here.
For one, I’d expect more commentary from management about MorningStar Farms. The business merited only a single mention on the Q2 conference call. CEO Steve Cahillane cited higher consumption in “measured” channels (i.e., larger customers) and called out the company’s recently-launched vegan cheeseburger.
But Kellogg has been busy with MorningStar of late. The company just launched a meatless sausage in a single-restaurant pilot with Yum! Brands (NYSE:YUM) unit Pizza Hut. New plant-based meat products will be released early next year. More detail on that front could add to the idea that MorningStar Farms can materially impact the valuation of Kellogg stock. After all, as Barron’s noted this summer, MorningStar Farms still has higher revenue than Beyond Meat, whose $6.3 billion market cap is roughly 30% of Kellogg’s.
Second, I’d expect investors to focus on the company’s areas of strength. Weakness in cereal likely will continue. Investors can and likely will shrug that off. But Kellogg needs to win in snacks. And it needs to continue momentum in emerging markets. The AMEA (Asia, Middle East, and Africa) was a noted bright spot in Q2, thanks to strong sales of Pringles potato chips.
Kellogg doesn’t need to show a sudden acceleration in company-wide growth in Q3. What it does to need to do is show again that it can win outside of cereal, which will further drive confidence in the company’s turnaround.
Kellogg Stock Is Cheap Enough
If Kellogg can do that, Kellogg stock can bounce next week. Yes, the stock has gained from May levels near $51. But those levels were roughly 30% below September 2018 highs — and off almost 40% from all-time highs reached in mid-2016.
Meanwhile, K stock trades at 16.2x 2019 consensus EPS, and currently yields 3.71%. That earnings multiple can expand if investors believe growth will return in 2020, and that dividend will look more attractive if the market sees sustainable increases ahead.
That said, this seems like a big quarter for Kellogg. The risks to the consumer packaged goods space are significant. The old idea of packaged food stocks, in particular, being safe income investments has been erased by competition from private-label brands and shifting consumer tastes. Rival General Mills (NYSE:GIS) also sits well below 2016 highs, and Kraft Heinz (NASDAQ:KHC) shows what happens when industry pressures are amplified by balance sheet worries.
A disappointing quarter thus hurts the case here. It undercuts the optimism created by the Kellogg earnings beat in July. Investors perhaps focus on near-term earnings pressures, 2020 expectations come down, and there’s a path for K stock to give back at least some of the recent gains.
The options market actually is pricing in a nearly 6% move in Kellogg stock between now and Nov. 15 — which is a big move for the typically low-volatility name. But that pricing makes some sense: this is a big quarter. Kellogg earnings can either confirm the bull case for K stock, or make the recent optimism look misplaced.
As of this writing, Vince Martin has no positions in any securities mentioned.
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