Motley Fool Money - 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

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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. Asset, thanks for joining me. Dylan, thank you for having me. We've got Dry Ink on two different spin-offs 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 Ego 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. So I think this is a response to some investor angst over investing in this space. Big multinationals are looking where they can unlock value, looking for where they can unlock

value. And this deal makes a lot of sense in that vein to me. Diving into the details a little bit, the serial brands are now going to be housed under the WK Kellogg name, which will trade under the ticker, K. 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. And, Asset, 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. And that's essentially what we're getting here

with WK Kellogg. This is so counterintuitive, Dylan. I mean, 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?

So, Kellenova might be interesting because it reminds me a bit of Mondalese. Mondalese being the spin-off from Kraft that happened in 2012. They spun out what they called their power brands and have done pretty well. Haven't beaten the S&P 500 on a total return basis since then. I think they've trailed by about 40 percentage points, but have done decently against the market. Those brands are more snacking oriented. and Kellenova is keeping that kind of 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, 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, uh-uh, I'll go with sliced bread for a couple of weeks. You know, it's interesting because looking at this deal, I kind of took a step back and looked at my own kitchen. And to your point, Osset, 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 for me. making Rice Krispy 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. And 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.

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 24, sales are projected to be flat. Fiscal year 2025 and 26, net sales are projected to be flat. Now, the company's projecting to really increase its EBITDA margins, its operating profits. But in terms of that topline growth, it's just not there. So 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 increase sales versus a base year of fiscal year 2023. With spin-offs and spin-outs, we see a company say, you know what, 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.

And 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 the other consumer snacks into three different businesses, that didn't wind up happening. And I'm curious if at some point we may see that, especially if some of the plant-based stuff comes back into vogue, because that would seem like a more traditional spin-off 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 is 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 Kellanova now, I think they show in their investor presentation that they're going just slightly ahead of the snacking market, maybe 7% organic growth.

versus 6%. And 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's 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. So, their argument is, look, yeah, it may seem like you're getting a little bit of a near-term dud in the Serals company, but us breaking these two apart, let's 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. All right. 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 Vestis. And if you're wondering, what the heck is Aramark? This is a company you've seen at stadiums, hospitals, and schools providing food services. Asset, the story with Kellogg was a bit of consumer

tastes driving the spin. What is happening here with Aramark and Vestis? 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 Unifers and Sintas, the two biggest

players in the uniform industry. So this is interesting. What Aramark is trying to do is unbundle some of its offering. So instead of going to an institution saying, we'll handle your food, we'll handle cleaning, will handle uniforms, they're letting that uniforms business compete in that fragmented industry. And 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 Vestis, the spinoff company, uniform company, with some debt, I think $1.5 billion or so worth of debt. So the financials could look a little cleaner when you start projecting forward, but there's

some opportunity here. And of the two, I'm sort of interested actually more investis than the slower growth error mark. 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. Vestis will now trade under VSTS. And I'm curious, why is Vestis 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 five-year contract. Oftentimes, they will bundle in things like construction services. So 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. And in turn, we're going to get this great contract for five or ten 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 Aremark. Spinning off a company like Festus allows it to operate at a smaller level. And even though 92% of Vestis' 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 Sintas and Unifers 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. Well, for the last 10 years, let's spin Vestis 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. And I think that's why I think Vestis is a more flexible company financially. I like Airmar. As you were pointing out, when we were prepping for the show, Dillon, Airmark is growing just fine.

It has 15% year-over-year revenue growth, and you're 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 like $6.5 billion company on just over half a billion dollars in trailing 12-month revenue, something like that. Yeah. So 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 Vestis. 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. So I think this one looks interesting, a little more interesting than the previous Kellanova Kellogg spinoff to me. I think the strategy is pretty clear with both of these.

One of the things I'm curious on, Asset, is taking a step back and thinking broadly about spinoffs, when we talk about IPOs, and spin-offs are IPOs in a way, right? They're kind of 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 like a 24-month

period. Now, that is pushed a little bit by the averages of the outperformers. So, 40% of these companies actually underperform. And you can get lost in the details, Dylan, of the prospectus type information that these companies put out. As you put out, sort of like an IPO. So you get to look at the spinoff, 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 We're different than 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, okay, who are you competing against? How fast are they growing? What are their opportunities? And that's why your questions at the beginning of this show were so relevant, like, okay, Play cereal company. We haven't seen that in a while. Why? Because no one wants to be in that business just selling cereal. And if you look at Kellogg's investment prospectus, they do show that in the future, they also want to branch out beyond cereal. So, yeah, 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. Asset, no plans on spending you off from Motleyful 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 Asset on the show. By day, Asset is also a member of the team picking stocks and providing coverage for the

Motley Fool suite of the premium investing services. If you're looking for investing ideas, we're offering Motleyful money listeners a discount on our flagship service, Stock Advisor. For Stock Advisor, you get two stock recommendations. per month, access to analysts like Osset 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 MFM discount. 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 Full Money's Ricky Mulvey caught up with Bill man to talk about the business, how Costco creates its own magic, and why it could still be a compounder for years to come. These days, I'm all about quality over quantity, especially in my closet. If it's not well-made and versatile, it's just not worth it. That's honestly why I love Quince. The fabrics feel elevated, the cuts are thoughtful, and the pricing actually makes sense. Quince makes high-quality wardrobe staples using premium fabrics like 100% European linen, silk and organic cotton poplin. They work directly with safe ethical factories and cut out the middlemen so you aren't paying for brand markups

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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? So 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. And 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 edition. I don't know who decided the roast beef sandwich was a good idea, but that's one I'd be happy to see him walk back. It's so funny because it's like 10 bucks for that also. And it's not, which is not to say that a roast beef sandwich for 10 bucks is not a 2023 experience. But that has.

has to look a little bit funny on that board. When you've got an ice cream cup for two bucks, you've got a chicken salad for seven bucks, seems a little bit of a low and outside baseball pitch. There you go. Or an unforced air. How about that? But now, getting to get into the business, I think it's good to maybe talk about your experience with Costco as a shopper and as an investor. So, I've been going to Costco, and this will date me just a little bit, going back to when it was Price Club. And 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 Saul Price. So going back away is back before the merge when they became Costco. So 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. But 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. 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

whole business of retailing. How do you think Costco has bridged that gap? Costco is in a lot of ways create its own magic. It's one of the few companies that has focused on, and 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. So 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 big, you know, a giant parking lot, and then allowing other companies to lease the edge of that land. And so 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, because 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, and 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. 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. So that's why it's fantastically important for Costco that they get that right. And speaking of these fees, they have not increased the membership price of the Gold Star membership. It rose from $55 to $60 bucks 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 five bucks 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 kinds of companies or companies that onboard the capacity to suffer, Costco has made the decision to not raise the prices of Gold Star membership in the same way that they have made the decision to essentially, and this is not true, but it's roughly true, which is maybe the best kind of statement to make, to have all of the products that go through their store be essentially at zero margin. They could have rate 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 discovered. And it is a more mature, stable company. This is not, 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 of 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. I mean, 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

gross stock, because I think we think of gross 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. And I mean, as we're wrapping up here, big story right now is that Costco is selling gold bars. I think that was sort of 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. And 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. I mean, 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 to 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. Well, first impressions where it looked juicy, can you squeeze the sandwich a little bit? I don't think this is an $11 roast beef sandwich. It's $9.99, right? Okay, $10. 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. 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 going to give it a six out of 10 as well. Yeah. I hate to just be the same, but six out of 10, it seems pretty accurate to me. I will say the sandwich is fresher than I expected it to be. Yeah, compared to some of the other menu items. Mango smoothie.

Mango smoothie actually slaps. This is at least an eight or a nine out of ten. I'm going to go nine out of ten 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 two. 10. See?

So, wait, you think that is equivalent to the roast beef sandwich? Yeah. It's kind of slimy. I mean... 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. Well, 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. What's the rating? It's giving, I'm going to go home and crave this for the rest of my life. I'm going to give this a 9.5 out of 10. And I think I'll be back tomorrow to get it again. Okay, I kind of hate on strawberry ice cream. I don't love it. This be good.

This be good. I'm still going to go like eight, a steady progression through our taste test. Yeah, I'm at eight out of ten. This is really good. This is better than the mango smoothie. I'm going back to my eight rating of the mango smoothie. 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, Kirkland crewneck, 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.