Motley Fool Hidden Gems Investing - A Pure Play Cereal Company?

Episode Date: October 4, 2023

(00:21) Asit Sharma and Dylan Lewis discuss: - How Kelloggs became Kellanova and what to make of its cereal spin-off WK Kellogg.  - Food service company Aramark spinning out its uniform business Vestis and why one might be more interesting than the other for investors. - The traps to avoid when looking at spin-outs.   (15:51) Ricky Mulvey and Bill Mann check in on Costco – the business, its potential, and its new food court offerings.  (27:05) The Motley Fool Money team goes out into the field to taste test Costco’s new roast beef sandwich, mango smoothie, and strawberry ice cream.  If you're looking for investing ideas, we’re offering Motley Fool Money listeners a discount on our flagship service, Stock Advisor. To learn more head to fool.com/mfmdiscount Companies discussed: K, KLG, ARMK, VSTS, COST Host: Dylan Lewis Guests: Asit Sharma, Bill Mann, Ricky Mulvey, Sierra Baldwin, Mary Long Engineers: Dan Boyd  Learn more about your ad choices. Visit megaphone.fm/adchoices

You gotta try breakfast at A&W. You gotta try breakfast at A&W. And what better way than with a delicious Pret Organic Coffee, starting at just $1 all day, every day, now until December 31st. You gotta try breakfast at A&W. At participating A&W locations in Ontario. Dylan Lewis. We're heading into the spin cycle. Motley Fool Money starts now. I'm Dylan Lewis, and I'm joined over the airwaves by Motley Fool analyst Asit Sharma. Asit,

thanks for joining me. Asit Sharma. Dylan, thank you for having me. We've got dry ink on two different spinoffs this week. We're going to be zooming in on both to see what they say about their businesses and what investors should make of them. Asit, let's start with a household name. Pantry staple Kellogg spun out its cereal business, separating it from the rest of the company's food brands, including Cheez-It, Pop-Tarts, and frozen foods like Eggo and

Morningstar Farms. This was announced back in the summer of 2022. What do you think it says about the state of food and consumers right now? Dylan, one thing I think this says is that it's really hard to make money in consumer goods for investors right now, because we've got this inflation which seems to be persistent. We've got huge multinational conglomerates that have trouble in the best of times finding revenue traction. I think this is a response to some investor angst over investing in this space, big multinationals are looking for where they can unlock value. This deal makes

a lot of sense in that vein to me. Diving into the details a little bit, the cereal brands are now going to be housed under the WK Kellogg name, which will trade under the ticker KLG. The remaining food brands will stay with Kellogg, which is rebranding as Kellanova, and will continue to trade under Kellogg's legacy ticker, K. Diving into this a little bit, I had to stop and think because I was like, you know what? I don't know if I've ever heard of a pure-play cereal stock before. That's essentially what we're getting here with W. K. Kellogg. This is so counterintuitive, Dylan. You're looking at the opportunity to invest in cereal.

It's been a long time since you could do that, more than 100 years in the public markets. What does this mean? Should we go out and invest in brands that are just so prominent in the consumer space, you get a chance to buy directly into Frosted Flakes? I say, maybe not. Yeah, let's dive into that a little bit. We have two very different offerings here, with the cereal pure play and then all these legacy consumer brands. Are either of these more interesting to you? Are either of them interesting at all to you? Kelenova might be interesting, because it reminds me a bit of Mondelez. Mondelez being the spinoff from Kraft that happened in 2012. They spun out what they call their

power brands and done pretty well. They haven't beaten the S&P 500 on a total return basis since then. I think they've trailed by about 40% points, but have done decently against the market. Those brands are more snacking-oriented, and Kelanova is keeping that indulgent snack powerhouse brand lineup within its own stable. What's it spinning off? Our cereals, which we find don't have much pricing power in a high inflation environment. General Mills was talking about this earlier this year. They raised prices last year, all of these consumer goods companies have, but we'll keep paying a bit more for soft drinks, potato chips, indulgent snacks. When it comes to our breakfast cereal, there's a point where we're like, I'll go with sliced

bread for a couple of weeks. It's interesting, because looking at this deal, I took a step back and looked at my own kitchen. To your point, Asit, I see a lot of snacks in there that would fit or be competitors to what's sticking with the legacy Kellogg brand, Kelanova. I don't see a lot of cereal in my pantry. I have some Rice Krispies in there, but that's from making Rice Krispies treats recently. I'm not actually having cereal as a breakfast food anymore, and I feel like I'm not alone in that. it's being consumed less as alternatives just proliferate on the grocery store shelves, alternatives to the cereals we grew up with. I think this shows up in the investing materials,

so the preliminary prospectus filings for W. K. Kellogg, the new cereal company. Throughout that presentation, they're talking about the objective of having stable sales, stable sales, and they're going to improve the bottom line through supply chain optimization, making operations more efficient. When you get down to their financial outlook, fiscal year 2024, sales are projected to be flat. Fiscal year 2025 and 2026, net sales are projected to be flat. Now, the company is projecting to really increase its EBITDA margins, its operating profits. But in terms of that topline growth, it's just not there. You're looking at a company that's going to try to show investors it can generate more cash, it could be this nice earnings proposition,

but it's not going to be the whole deal for some time to come. We're looking out three years until the company sees any kind of innovation and revenue management that'll lead to increased sales versus a base year, a fiscal year 2023. Sometimes with spin-offs and spin-outs, we see a company say, we want to take this small operation and hive it off so that we can really appreciate the value and the growth here. This seems to be a little bit of the opposite, where we have this struggling portfolio that maybe is weighing down some of the other ambitions that this company has. I have to remind myself, this was originally proposed, when it was proposed, as a three-way

split, with Kellogg splitting out cereal snacks, its plant-based brands, and the other consumer snacks into three different businesses, that didn't wind up happening. I'm curious if at some point we may see that, especially if some of the plant-based stuff comes back into vogue. That would seem like a more traditional spinoff to me. Yeah, that's absolutely what would have to happen. It's going to be a long time before all of the plant-based innovation settles in the marketplace. The initial hype and fervor, we've seen the struggles, we've seen that ease off. And rightly so, the company decided, now's not the time for a plant-based spinoff. But the argument isn't bad. The company is giving

a pretty traditional argument. You, shareholder, are going to get a tax-free distribution. You'll have this pure play cereals company. It will be a nice earner, maybe a great cash flow generator. In the meantime, we're going to speed up. We're going to innovate faster than our category. I think they show in, and I'm talking about Kelenov now, I think they show in their investor presentation that they're going just slightly ahead of the snacking market, maybe seven percent organic growth versus six percent. I noticed that they also are talking about some bottom-line optimization. They stole a little page from Pepsi's playbook. They have a part of their presentation called More Better Faster, which is a direct lift from Ramon Laguerta,

CEO of PepsiCo's idea of better, faster, stronger. All these companies are in the same boat trying to show higher revenue growth, but at the same time, this focus on making the supply chain more efficient, finding margin in places that'll benefit shareholders. Their argument is, look, it may seem like you're getting a little bit of a near-term dud in the cereals company, but us breaking these two apart lets both sides focus on what they do best and allocate their resources accordingly. At the end of the day, you'll make more money holding both of these shares than you would if you just held on to the legacy company. Over from a household name to a company you've probably encountered without even

realizing it, Aramark spun out its uniform and workplace supply business under the name Vestas. If you're wondering what the heck is Aramark, this is a company you've seen at stadiums, hospitals, and schools providing food services. Asit, the story with Kellogg was a bit of consumer tastes driving the spin. What is happening here with Aramark and Vestas? So, Aramark has this very interesting side business in uniforms, uniform rentals, also cleaning supplies, etc. And this market is really fragmented because you've got small businesses that try to do everything in-house, you've got slightly larger businesses that will rent uniforms, and you've got mega-businesses which want long-term contracts. There's been

a latent opportunity in this space, but Aramark hasn't been able to take advantage of this fragmented market. Why? Because there are two really worthy competitors that are already, I would say, comparatively on fire for this industry for so many years. Those, of course, are UniFirst and Cintas, the two biggest players in the uniform industry. This is interesting. What Aramark is trying to do is unbundle some of its offerings. Instead of going to an institution saying, we'll handle your food, we'll handle cleaning, we'll handle uniforms, they're letting that uniforms business compete in that fragmented industry. I think there's a large market opportunity here and this may be an interesting play. I will say there's not a clear-cut value proposition

here if you're an existing Aramark shareholder because the company has burdened Vestas, the spin-off company, uniform company, with some debt, I think $1.5 billion or so worth of debt. The financials could look a little cleaner when you start projecting forward. But there's some opportunity here. Of the two, I'm interested more in Vestas than the slower growth Aramark. Let's dive into that a little bit. This one is more straightforward than Kellogg because we don't have so many names changing. Aramark continues to trade under ARMK. Vestas will now trade under VSTS. I'm curious, why is Vestas and Aramark a little bit more interesting for you?

Aramark is a company that does well by signing long-term contracts with institutions. If it works with a university, it will sign a five-year contract. Oftentimes, they will bundle in things like construction services. They have these deals that are very tied together. We'll help you actually build a building on campus. We'll help you, university, build this new dining hall. We're going to actually pay for some of those construction costs. In turn, we're going to get this great contract for five or 10 years where we'll get really premium prices on the food we provide. That's the real-world mechanism here that's going on with Aramark. Spinning off a company like Vestas allows it to operate at a smaller level.

Even though 92% of Vestas' projected revenue is recurring, those contracts are going to be shorter term, they can go out and roll up smaller independent companies. This is the way that Cintas and Unifirst have grown. They bought so many small mom and pops and rolled them up into their businesses. Aramark is looking over its shoulder and saying, man, we could have been doing this as well for the last 10 years. Let's spin Vestas off. Let's cut this puppy loose and let it start wheeling and dealing in a much more free type of environment as far as contractual work goes. I think that's why I think Vestas is a more flexible company financially. I like Aramark. As you were pointing out when we were prepping for the show, Dylan, Aramark is growing

just fine. It has 15% year-over-year revenue growth. You were pointing out that it's not really an expensive company. You had a multiple of, what, 12 times trailing 12-month earnings? Yeah, I think that's about right. I think they're a $6.5 billion company on just over half a billion dollars in trailing 12-month revenue, something like that. Yeah. Here you get perhaps a situation where a fairly trading company spins out a unit with the ability to grow faster. Again, strategically, both sides can focus on what they do best. Capital is somewhat freed up. In the case of Vestas, it does have that debt burden, but that doesn't prevent them from raising more cash and working capital maybe from the

public markets or just through their own free cash flow generation in the future. I think This one looks a little more interesting than the previous Kelanova-Kellogg spinoff to me. I think the strategy is pretty clear with both of these. One of the things I'm curious on, Asit, is taking a step back and thinking broadly about spinoffs. When we talk about IPOs, and spinoffs are IPOs in a way, they're as close as you can get to an IPO without IPOing for a company that's already public, we say that often IPOs happen when a company wants them to, often to their benefit or to stakeholders' benefits. Do you think it's worth applying similar logic here as we look at the timing of these deals

and what these companies are trying to do? You have to be careful as a shareholder. I've seen academic studies that show that both the parent of a spinoff and the spinoff itself outperform the market in general over a 24-month period. Now, that is pushed a little bit by the averages of the outperformers, so 40% of these companies actually underperform. You can get lost in the details, Dylan, of the prospectus type information that these companies put out. As you put out, it's like an IPO. You get to look at the spin-off, see its financials, understand what the business strategy is. But so much of the time, these companies are presenting their information in relation to the parent company. We're different

the parent company because of X. We can grow faster or we can optimize our bottom line because we'll be separated from them. You have to be careful and take that spin-off and plunk it down amongst its competitors. If you're going to compete out in the real world, who are you competing against? How fast are they growing? What are their opportunities? That's why your questions at the beginning of this show were so relevant, like, okay, a pure play cereal company, we haven't seen that in a while. Why? Because no one wants to be in that business just selling cereal. If you look at Kellogg's investment prospectus, they do show that in the future, they also want to branch out beyond cereal. I think in general, there's some nuance here.

To me, it comes down to looking at what's going to happen in that new industry amongst the competitors you're suddenly going to be competing against. Asit, no plans on spinning you off from Motley Fool Money anytime soon. Appreciate you coming on today and talking through these deals with me. Thanks so much, Dylan! This was a lot of fun! At Motley Fool Money, we love talking stocks and looking for the next big thing. That's why we bring analysts like Asit on the show. By day, Asit is also a member of the team, picking stocks and providing coverage for

The Motley Fool's suite of premium investing services. If you're looking for investing ideas, we're offering Motley Fool money listeners a discount on our flagship service, Stock Advisor. With Stock Advisor, you get two stock recommendations per month, access to analysts like Asit on our members-only live stream, Motley Fool Live, and Stock Advisor's full scorecard of stocks generating market-beating returns. To learn more, head to fool.com slash MFMDiscount. We'll put that link in the show description as well.

Coming up, you may know that Costco has unleashed some new food items on the food court this year. A roast beef sandwich, mango smoothie, and strawberry ice cream. We'll have our official reviews after the disclaimer on today's show. But first, Motley Fool Money's Ricky Mulvey caught up with Bill Mann to talk about the business, how Costco creates its own magic, and why it could still be a compounder for years to come. You just found out that your sales team is at risk of missing quota. Don't panic. Just ask Rippling AI. Since it's built on your real-time people and business data, Rippling AI can pull metrics from Rippling and Salesforce into a meeting-ready dashboard showing quota attainment, headcount plan, and monthly revenue to quota by region.

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Sign up for exclusive access today, rippling.ai slash fool. Bill, before we get started on the business of Costco, I think the very important question is if you have any food court reviews you'd like to share. I mean, of course, the hot dog and drink combo for $1.50 is iconic. For me, the best option at Costco's food court is the pizza. Yeah. It's an 18-inch pizza. It's very simple. You can get it two ways. Would you like cheese or would you like pepperoni? They're not putting a whole lot of thought into it, but the type of pepperoni that they use is exactly the kind of pepperoni that you would want a discount pizza to have on it. Fair enough. I think with the new stuff, they're getting outside of their

circle of competence, I'll say kindly, a little bit. But if you get a chance, the strawberry ice cream soft serve is a welcome addition. I don't know who decided the roast beef sandwich was a good idea, but that's one I'd be happy to see them walk back. It's so funny, because it's like $10 for that also. Which is not to say that a roast beef sandwich for $10 is not a 2023 experience. But that has to look a little bit funny on that board. When you've got an ice cream cup for $2, you've got a chicken salad for $7. Seems a little bit of a low and outside baseball pitch. There you go. Or an unforced error. How about that?

But now, getting to the business, I think it's good to maybe talk about your experience with Costco as a shopper and as an investor. I've been going to Costco, and this will date me just a little bit. going back to when it was Price Club. A lot of people don't know this at this point, but Price Club wasn't called Price Club because of the prices, it's because it was founded by a guy named Sol Price. Going back a ways, back before the merge when they became Costco. I outfitted my dorm room, I ate as a college student using Costco, sometimes ending up with five gallons of mayonnaise that you have to figure out what to do with. Really, as soon as I had income that was free and floating, I became a Costco investor.

The mayonnaise thing makes it sound like someone else did that to you. That's right. Mistakes were made. It is one of my favorite things to hear people do to blame bad food choices on others and on circumstances. And let's be fair, for a lot of people, that may be the case. For college-age Bill Mann, it was bad choices. There you go. A lot of companies have great stores, great products. We were talking about a couple of them before this recording, in fact. But they haven't bridged the gap to being a great stock. Costco has historically been a market beater. It's also in the very difficult business of retailing. How do you think Costco has bridged that gap?

Costco has, in a lot of ways, created its own magic. It's one of the few companies that has focused on it. This is not 100% the case. In some cases, they just can't do it. But for the most part, Costco buys the land upon which it's putting its warehouses. Right out of the gate, if you have a retailing strategy that you believe in, you are in some ways creating your own feedback loop, buying land cheap, putting up some metal and some corrugated roof and a giant parking lot and then allowing other companies to lease the edge of that land. In some ways, the magic of Costco and where Costco has really been able to generate value almost has nothing to do with the fact that it is a great retailer or a great seller of products than it is that

it is a concept that brings in traffic and improves the value of the land that it's sitting on. Yeah. I think there's this idea where people of middle class across the world, across the country, spend in drastically different ways. But if you look at rich people, it's pretty flat with what they do. It seems like a lot of rich people are Costco members, and that would be a good idea for other retailers to want to be around that. Yeah. It's a little bit different from Walmart, which I do think is one of the world's great retailers. But Costco never did go and try and site its stores based on, hey, there's not competition here. They would specifically go into areas that were somewhat

central to middle-class and upper-middle-class areas. They did it in the U.S., and they've expanded and they've done it in the other markets that they are in to great success. In June of this year, earlier this summer, Costco really started cracking down on membership sharing. These fees are just 2% of Costco's revenue. They find it important enough to break it out in the revenue statement on their earnings. Why are these fees so important to the business? What should investors know about them? They're important because when you see a company with a super thin margin, which Costco has, they could have raised their prices across the board on a lot of things, a lot more than they have, nearly 100% of their bottom line comes

in the form of those membership fees. So, even though it's only 2% of the throughput at Costco, it's hugely important for the bottom line, because unlike anything else at Costco, these things have a margin of nearly 100%. So, the fact that people were sharing was in some ways, taking away from the part of Costco where there is a little bit of a social contract. We're not going to charge you very much for these products, but you are going to pay us for the right to come in and shop at our shop. That's why it's fantastically important for Costco that they get that right. Speaking of these fees, they have not increased the membership price of the Gold Star membership. It rose from $55 to $60 back in 2017. Every single earnings call,

it seems that analysts would like to know when Costco would raise these fees, and it absolutely could. It would probably have no pushback if they raised the price of a membership by $5 a year. But what do you think it says about the business that it hasn't, even though Wall Street analysts would very much like it to? One of my favorite companies or companies that onboard the capacity to suffer, has made the decision to not raise the prices of the Gold Star membership in the same way that they've made the decision to essentially, and this is not true, but it's roughly true, which is maybe the best statement to make, to have all of the products that go through

their store be essentially at zero margin. They could have raised its prices just a teeny bit. And they've been asked by Wall Street analysts quarter after quarter after quarter, like they've come up with a new invention. You know, if you just raise this 1%, you'd make a lot of money. And that's just not Costco's ethos. Costco's ethos is to be the place where you come in and they have a certain type of experience for you. And part of that experience is you get a treasure hunt, and you're not going to pay a lot for what you're discovering. Yeah. And it is a more mature, stable company. This would not fit it under the fast grower category. And at this point, it seems like Costco could be competitive for my investment dollars

with a regular old S&P 500 index fund. It's a defensive kind of thing that I don't want to think much about. Do you think that's a fair matchup for a business like Costco? Yeah, I think you would see a little bit more volatility if you were just to replace an S&P 500 index fund with any single company, but I think Costco is on the list. Costco, in some ways, we tend to think of investments as ones where there's growth. For Costco, what you're looking at is a company that if you were to have taken their business case to an MBA program 30 years ago and said, this company is going to grow at X per year, you would have failed. There's no way that they would have passed you, because when you do a discounted cash flow, basically, you say,

this company is going to stop growing at a supernormal rate after a while. I don't actually see that point for Costco, which is not to say that it's a growth stock, because I think we think of growth stocks as being front-ended. But at the back end, I think Costco is going to grow profitably as a compounder for a long, long time. Fair enough. As we're wrapping up here, big story right now is that Costco is selling gold bars. I think that was my millionaire comment earlier, Bill, where the CEO, Craig Jelinek, is on the call saying, look, I'm getting calls about us selling gold bars. Yes, we're doing it. We have a limit. There's only two per member. They're setting a limit on how many gold bars their

members can buy. What is the deal with Costco selling gold bars? Was this retailer getting into the precious metal investment game something that you expected? What's your take on it? I mean, it goes back to Costco selling some other pretty weird things. They sold coffins a couple of years ago. You can get your vacations done by Costco. Again, and even looking at the pricing. There is a Swiss bar of gold, and then there is a South African rand-denominated bar of gold. Again, it's a bit of a pass-through for them. I get the feeling, and I used the word treasure hunt earlier, that Costco loves having those things that people talk about. Obviously, this will round to zero in terms of their revenue or in terms of, obviously, the profitability of

the company. But it does get you thinking, what else is in Costco that I'm missing? And why is it that I'm not there right now? Just seeing what's available. As always, people on the program may own stocks mentioned, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. We take ourselves seriously here at Motley Fool Money, and that's why we have our disclosure. It's also why we occasionally head out into the field to make sure we're not being misled by company filings or headlines. To prepare for today's second segment, Ricky Mulvey, Mary Long, and Kirkland superfan Sierra Baldwin went to the Costco food court for an official taste test on the new menu items.

Here's what they found. I took too big of a bite. I was going to say, you're contemplating. well first impressions were it looked juicy and you squeezed the sandwich a little bit i don't think this is an 11 roast beef sandwich 9.99 or okay ten dollars it's okay the ratios feel a little off i don't know if i would get it again i'm reading in a six out of ten she's deep in thought okay for background i would never say anything bad about costco however i think i would have to be starving at costco which you kind of are in order to get

this sandwich i don't think it's very good i'm gonna give it i'm gonna give it a six out of ten as well um yeah i hate to just be the same but six out of ten it seems pretty accurate to me I will say the sandwich is fresher than I expected it to be compared to some of the other menu items. Mango smoothie. Mango smoothie actually slaps. This is at least an 8 or a 9 out of 10. I'm going to go 9 out of 10 for a Costco menu item. It's not too sweet. I think it's good. I would definitely order this again. I think this is a product of Australia, and I'm happy to see it in the Costco food court. I'll say I was a big fan of the berry smoothie back in the day.

this doesn't disappoint. I'm not quite as enthusiastic as Ricky. I'm going to say 7.5. I'm feeling the same way. I'm actually going to give it a six out of 10. Wait, you think that is equivalent to the roast beef sandwich? Yeah. It's kind of slimy. That's a smoothie. And we also waited a little bit because we were doing like photos. So you didn't get it fresh off the press. My understanding is that there's no sugar added however it still to me tastes like a sugar bomb i don't think i could finish this entire thing there's something just a little bit off like maybe the mango wasn't quite ripe or something i've had better mango smoothies while sierra was talking i had about three

more bites so i clearly liked it okay i'll go first on this one oh my god this is delicious i love it it's the rating it's giving i'm gonna go home and crave this for the rest of my life i'm gonna give this a 9.5 out of 10 and i think i'll be back tomorrow to get it again okay i'm kind of hate on strawberry ice cream i don't love it this be good this be good i'm still gonna go like eight a steady progression through our through our taste test yeah i'm at eight out of ten yeah this is really good this is better than the mango smoothie i'm going back to my eight rating of the mango smoothie this like this is like theme park joy and i will happily give

this a nine out of ten incredible i don't know if i could finish this whole thing but balanced good texture. I love strawberry soft serve. I'm very happy about this. When I took a bite of the roast beef sandwich, I did not feel proud to be wearing Kirkland crew neck, Kirkland sweats, and Kirkland slides. However, I felt that way. I felt very proud when I took a bite of the strawberry smoothie, for sure.