Barron's Streetwise - Kellogg’s Snacktivist Split

Episode Date: June 24, 2022

The cereal giant borrows a play from Mondelez, but investors aren’t biting. Plus, the outlook for earnings estimates. Learn more about your ad choices. Visit megaphone.fm/adchoices

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And I think that's one area where there's still some questions. Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe, and the voice you just heard is Brian Spillane. He's a food and beverage analyst at B of A Securities, and he's talking about Kellogg's announcement that it will split into three companies. That move is meant to unlock value, but investors didn't seem carried away with enthusiasm. We'll hear why. And Brian will tell us which food stocks he thinks are good defensive buys now. Plus, we'll talk with a top investment strategist about why a U.S. recession isn't a sure thing,

but why earnings estimates will have to come down. earnings estimates will have to come down. Listening in is our audio producer, Jackson. Hi, Jackson. Hi, Jack. Favorite breakfast cereal. Let's hear it. Mini wheats.

Is that the one with the frosting or are we just talking plain shredded wheat? I'm thinking frosting. So maybe the correct term is frosted mini whe frosted it's still appalling okay uh the correct answer we were looking for is something undeniably delicious like cinnamon toast crunch now there was big restructuring news in the cereal aisle this past week kellogg's announced on tuesday that it will divide the company in three separate independent companies. More than 100-year-old consumer giant. It's set to now become three public companies. So let me tell you how this is going to work. Kellogg announced that it'll split into three companies by the end of next year. And yes, I said Kellogg Singular.

That's the name of the company that trades under the ticker symbol K. The Kellogg Company. Kellogg's with an apostrophe S as a trade name, meaning a name that customers are familiar with, one that a company might use in its advertising. Now, the three new businesses will focus on snacks, cereal, and vegetarian foods. It's unclear whether any of them will be called Kellogg or Kellogg's. For now, the company is referring to them as Global Snacking Co., North American Cereal Co., and Plant Co. I believe this is exactly the kind of step that Mr. Kellogg himself would have taken to create tremendous opportunities for the business and our stakeholders.

That's Steve Cahillane, Kellogg's CEO, explaining the changes in a company video. And when he says Mr. Kellogg, he's referring to company founder Will Keith, or W.K. Kellogg, not his brother, Dr. John Harvey Kellogg, who was famously depicted by Anthony Hopkins in the 1994 movie The Road to Wellville. Dr. Kellogg was superintendent of a health resort called the Battle Creek Sanitarium, and he had a lifelong passion for clean living and vegetarianism, and judging by the movie, frank discussion of bodily functions. My own stools, sir, are perfect. They are gigantic and have no more odor than the hot biscuit.

You see, that's way too descriptive, and I'm pretty sure I'm off dinner biscuits for a while. Now, the movie depicts a taste test of a new food invention called cornflakes, conducted unceremoniously in a pigsty with less than appetizing results. I've got it. I've got it. We'll sell this batch as pig food. Don't think so, Charlie. Even the pigs won't eat it. I don't know how accurate that portrayal is, but what's clear is that the sanitarium eventually got the recipe right for toasted flakes of wheat and corn, and the flakes were a hit with

sanitarium visitors. Dr. Kellogg's brother, W.K., he was the bookkeeper at Battle Creek, he wanted to sell these flakes more broadly, but Dr. Kellogg disagreed, and the two had a falling out, and as a result, W.K. launched the Battle Creek Toasted Corn Flake Company, which would later be called the Kellogg Company. That was 1906. Today, Kellogg's cereal brands include Special K, Frosted Flakes, Rice Krispies, Fruit Loops, and Corn Pops. But cereal is a relatively small part of the business. Less than 20% of revenue comes from brands that will be part of the new Cereal Co. and Plant Co. combined. I suspect that's a big part of the company's motivation

for splitting up. Everyone still thinks of Kellogg as a cereal company. It wants to be known as a snack company because snacks are hot. There's apparently endless demand for cookies and chips. Just look at Pepsi. It's named for a soda, but its North American beverage sales this year are seen dipping by 1%. Its North American Frito-Lay sales, you know, Doritos, Cheetos, SunChips, and so on, those are expected to grow by 12%. If you add in the company's Quaker business, which is best known for oatmeal, but also has snack bars, chips, and cookies, then Pepsi in North America is about as big in food as it is in beverages. Investors like that stock so much that it trades at 25 times earnings. Or we can look at Mondelez. It was created a decade ago when the old Kraft Foods

said snacks are where the action is, so it split off its cheese slices and other products into a new company that it called Kraft Foods, and it held on to Oreo cookies and Ritz crackers and other snacks, and held a naming contest among its employees, and came up with Mondelēz, which sounds global because Mond is close to the word for world in some Latin languages, and just to be sure we got the point, the company made the name Mondelēz International. This past week, by the way, Mondelēz agreed to buy an energy snack company called Cliff Bar. Anyhow, Mondelēz is a solid grower, and true to the name, less than a third of sales today come from North America. And investors love that stock, too. It goes for 21 times this year's projected earnings. That leaves Kellogg sitting here at less than 17 times

earnings saying, hey, what about our snacks? We've got Pringles and Cheez-Its and RX bars and Pop-Tarts and townhouse crackers. And don't forget Rice Krispies treats, those marshmallowy snack bars that are made from the cereal. Kellogg also has noodles and more that are big sellers overseas. So this new split into three companies looks a lot like it's trying to pull a Mondelez, which sounds like a good thing for investors. So why didn't the stock rise more than a couple of percent on the announcement? To learn more about that and food stocks in general, I reached out to Brian Spillane, who covers the group for B of A Securities. If he sounds a little nasally, it's because he was home

bouncing back from the flu. Kellogg went through a period of integrating their businesses in a more fulsome way starting back in 2018 as a means to drive efficiency and shore up margins. So now you've got a fully integrated business in North America, the cereal business, which now has to be pulled back out and separated. So there's going to be some costs, certainly, of trying to stand that company up alone. That's one question about the new Kellogg move. How does it help? Want to add to costs? Another question has to do with growth.

The whole point of creating a separate snack company is to impress investors with growth. But lately, with interest rates rising, growth stocks have been underperforming, and value stocks have been outperforming. What investors seem more interested in than revenue growth at the moment are strong cash flows. It's still kind of unclear whether or not there's a real value creation, if there's an incremental cost, and whether the growthy company will also have substantial cash flows. As for the individual companies, Brian says breakfast cereal has made a comeback because consumers are using it

for, you guessed it, a snack. Over 30% of breakfast cereal now is consumed outside of the morning. It's funny that you say that because I wouldn't dream of having a sugary cereal for breakfast. That's like giving up before I've even started the day. But I will have a bowl of sugary cereal for dessert at the end of the day. So is that the kind of thing people are doing? Absolutely. And you think about it, you know, you wind it up next to eating a bowl of ice cream, right? It's got fiber.

It's got vitamins. You know, you're adding milk to it. It's actually a healthier option when you compare it to other dessert options. But that's totally it. That leaves PlantCo, which Brian says is different from companies like Beyond Meat in that it doesn't target meat eaters with very realistic meat substitutes. Its core customers tend not to eat meat. It's an older company that's relatively small and slow growing, although results picked up a little during the

pandemic. Okay, so that's Kellogg. Food stocks in general tend to be defensive. And with investors worried about the economy, shares of these companies are in demand. Brian says the things to look for in food stocks are strong cash flows and pricing power, which allows companies to pass higher costs on to customers. Also, stick with companies whose goods tend to continue selling well when the economy slows. One of Brian's favorites now is Kraft Heinz. There was a 2015 merger between Kraft and Heinz that brought together ketchup and cheese and Oscar Mayer hot dogs and Planner's peanuts and more. And Warren Buffett and a well-known Brazilian investment firm were involved. And the deal was a colossal flop. Sales, profits,

and the share price slumped. Some critics said the new company focused too much on cost-cutting rather than creating innovative products. But the company has sold its cheese and nuts businesses to reduce commodity exposure, and it has brought in new management, and things are looking up. Here's Brian. You're seeing very consistent results. And importantly, you know, they've cleaned up their balance sheet. So, you know, we think that's a business that's really well positioned, particularly if we're heading into a recession. But even with that, you know, the valuation, I think, is still compelling enough that it's still not getting full credit for that turnaround.

I think, is still compelling enough that it's still not getting full credit for that turnaround. Brian also likes Mondelez, which we've talked about, and another snack player, Hershey. He says they've had success with Reese's, Kisses, and Twizzlers, and that every time they add more capacity, they use it up quickly, and that the company does a big holiday business, which tends to be less vulnerable to economic weakness. Another one Brian likes is called Lamb Weston, and it's a big player in French fries. Last year was the worst potato crop in 25 years, which really negatively impacted not just their profitability, but their sales because they just didn't have enough potatoes. And, you know, conditions look very good this year for a more normal crop. And this is a business that also has a lot of pricing power.

Okay, so those are some of Brian's top picks. How about a couple of stocks he's not bullish on at the moment? One of those is Campbell Soup. Can you guess the problem there? Yeah, it's the soup. Their soup business and their canned meals business has clearly been a COVID winner. And not only with people staying at home, but also to the extent that soup consumption is tied to when people are sick, this has been like the most

extended, what are flu, cold and flu season, right, that we've seen. So, you know, to the extent that world begins to normalize, is there a little bit of give back there? They also tend to be a little bit more skewed to low-income consumers, people on fixed incomes. And so maybe a revenue risk if we get into a recessionary environment. Brian is also cautious about McCormick, the spice maker, because the shares look expensive and there's risk of trading down to private label spices. And there's a third problem that's less obvious. With protein prices being as high as they are, is there a risk for McCormick that consumers buy less meat in the grocery stores? And if they do,

that may have some impact on the related seasonings. Thank you, Brian. Jackson, Kellogg is going to need some help naming those three new companies. I'm thinking for the snack business, because Mondelez wanted to sound so worldwide, I'm thinking Munchiverse for snacks. You get the whole universe there. It's not just the world. In case, interplanetary potential. But I'm stuck on cereal and plants. What do you have for those?

Well, plants, you're saying, you mentioned Beyond Meat. I think Beyond Beyond Meat for there. And cereal, my mind goes to the podcast cereal. So maybe cereal colon the food kind. Cereal the food kind incorporated. I feel like you nailed that one. Now, coming up, we've been talking about recession. Let's hear from a strategist who thinks we might be able to avoid one.

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TD, ready for you. Welcome back. Why did the stock market go up this past week? I don't know. Inflation has been running so high that the Federal Reserve is expected to raise interest rates to levels that could bring economic growth to a halt. But there are signs that the economy is already slowing, like something called the Purchasing Managers Index, which shows activity in manufacturing and services, and which this past week fell to a five-month low. So maybe investors are thinking, the thing we were worried about is already happening, but at least it might help cool inflation. And if that's in the cards, maybe the Fed won't have to be so aggressive, which means maybe we shouldn't be so worried.

Does that make sense? No, it does not. And that's why it was time for me to check in with Mike Mullaney to help me figure it out. Mike's the director of global markets research at Boston Partners, which manages close to $100 billion. He says, if you look at the Fed's goal for bringing down inflation, we can point to two prior occasions when inflation fell that quickly, and they both ended in recession. One was back in 1974, 75, in the midst of the Arab oil embargo and the recession that that caused. Post that, we did get a drop in inflation by that magnitude in the core PCE. a drop in inflation by that magnitude in the core PCE. And the second one was Volcker squashing inflation during 1980, when he just killed everything in another recession. So the takeaway

is this. If the Fed sticks to their inflation targets, as they have projected right now, history will tell us there's no way we can avoid a recession. No way we can avoid a recession. No way we can avoid a recession if the Fed sticks to the plan, which Mike takes to mean it might not stick to the plan. My gut feel is that they may balk on their targets a little bit and they may go to something like we've made substantial progress and there are now still structural issues that we don't have control over, but we're fine for the time being. So I think that's where you potentially can skirt a recession if the Fed backs off somewhat of what their inflation targets are.

Okay. So the good news is that we might avoid a recession. And the bad news is that to do that, the Fed might have to leave inflation a bit elevated. We'll have to see what that means for investors. But Mike says that they should lower their return expectations and that current estimates for company earnings look unrealistic. Why haven't earnings expectations come down yet? They're still, you know, basically they've come down by 90 basis points for 2022 and they haven't come down at all for 2023. Implicit in that is that analysts think that obviously those price increases and cost pressures that companies have can be passed through to their clients and their customers. I'm going to take the other side of that. I just think we're delayed because there was such a surprise in the first

quarter where expectations for the S&P 500 earnings were roughly 5.5%. And they came in 11 because they were able to pass through all these price increases. I don't see that happening. I think you're going to get first substitution from customers. And secondly, you're going to get customers barking if inflation stays at these levels, most particularly if gasoline stays where it is right now. I asked Mike what investors should do differently now. He said one of the clearest buying opportunities isn't in stocks. We've been maxed stocks relative to bonds for the better part of probably three years because we foresaw that you had negative real rates of return. So as I say, I'm a reformed bond manager. And as a reformed bond manager, I couldn't fathom buying bonds knowing that I was going

to lose real purchasing power. So I said, this is crazy. So I've had the call to go max. Now we're getting into, obviously, positive real rates. I'm starting to warm up to adding some bonds back into these balanced accounts right now just because their valuations have changed. I mean, now we actually have some positive real rates return in aspects of the market, not necessarily across the entire bond market, but it's getting there. And I do believe that you'll start to see the more traditional correlation between stocks and bonds where bonds actually do provide a volatility buffer to stocks. Boston Partners takes a value approach to stocks, but it also looks for signs of operational momentum. That's

to help separate companies that are cheap and improving from ones that are likely to stay cheap. For years, investors were able to just add money to S&P 500 index funds without thinking about valuations because the higher price growth stocks that dominated the index, like Amazon and Netflix and Tesla, kept doing so well. Those stocks have fallen, in some cases dramatically. Netflix is down so much that it was just added to the Russell 1000 value index. Mike isn't permitted to talk about his firm's recent stock purchases, but he says they include some former high flyers that suddenly sell at reasonable prices. He points out that higher interest rates

are a disadvantage for long duration stocks or shares of companies that have to wait for many years for their cash flows to ramp up. In his view, that means indexing for now might not perform quite as well. Going forward, I don't see it being a beta market, meaning just have market exposure and you do fine. I think it's going to be an alpha market, which means you're going to have stock picking skills to outperform going forward. Thank you, Mike and Brian, and thank all of you for listening. Jackson Cantrell is our producer. He puts the fun in shredded wheat with no frosting. I don't think there's a fun in there.

No, there is not. Subscribe to the podcast, rate it, review it, and speaking of making things awkward with self-promotion, you can follow me on Twitter. That's at Jack Howe, H-O-U-G-H. See you next week.