Kellogg this week reported an impressive turnaround in organic growth for the year through December but then spooked markets with a less inspiring outlook. Simon Harvey reviews the performance and what might be in-store.

On face value, Kellogg’s new strategy to return the US food major to organic growth is paying dividends as the Rice Krispies cereal maker posted its best performance in seven years but investors yesterday (6 February) reacted unfavourably to a less-than-optimistic outlook.

The share price closed in the red on Thursday after Kellogg reported its annual results, with a stellar rebound in organic growth to 1.9% from zero in the corresponding period. However, the stock got off to a poor start as chief executive Steve Cahillane proffered guidance for the new year of just 1-2%, which at best is conservative and suggests an element of caution. 

Cahillane sought to quell concerns among the investment community by describing his expectations for the next 12 months as “prudent” in a follow-up call with analysts, and understandably so, considering his Deploy for Growth strategy just rounded out its first full-year of existence having being introduced in February 2018, a matter of months after the CEO joined the business. 

And a 1.9% print is commendable when seen in context, albeit replete with a meagre 0.2% increase in the reported sales top line for the year ended in December, down from 5.4% in 2018. Only a few years ago, Kellogg posted a more than 2% decline in its organic metric before Cahillane employed Deploy for Growth, with the primary objective of returning the business to positive territory.

Robert Moskow, a senior analyst at Credit Suisse, offered his interpretation of the outlook.

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“We spoke to many investors who considered the pullback tempting but were curious why the sales forecast assumes growth decelerates from the 1.9% pace in 2019,” he writes. “Our view is that management has provided a very conservative outlook for sales growth and is now operating with a substantial amount of flexibility to reinvest and drop savings to the bottom line.” 

Last year saw Cahillane make his first major endeavour in executing the new strategy by disposing of a clutch of snacks and cookies assets in North America to Italy’s Ferrero, a move that consequentially widely impacted the 2019 results. His next challenge is reviving the cereal category, one he described on Thursday as still being a key pillar to complement new ambitions for its remaining snacks and frozen foods, along with, like many of Kellogg’s peers, a focus on capturing opportunities in developing markets.

“The primary goal of 2019 was to return to organic net sales growth and we did that”

“The primary goal of 2019 was to return to organic net sales growth, and we did that,” Cahillane says in his address to analysts. “I recognise we talk a lot about our snacks, frozen foods and emerging-markets businesses, and for good reason, but we never lose sight of the fact that cereal is incredibly important to us, and it is our legacy. 

“For the quarter and for the full year, this was our best organic net sales growth in several years, and this return to organic net sales growth is the strongest evidence that our Deploy for Growth strategy is working. We grew in all four quarters with full-year growth in all four regions.”

Flexibility to make faster decisions

Cahillane says the recent divestitures would enable Kellogg to improve its underlying, or organic growth rate going forward, and also its margins as the company drums down on its core businesses, with more flexibility now to make faster decisions. And a benefit coming from the disposals, was a US$1bn cut in debt, the CEO adds.

Alexia Howard, a senior analyst at Sanford Bernstein, suggests Kellogg will need to reinvest in cereals if it’s still serious about the category, especially given the declines of last year.

“Overall, it feels as though the company’s reversal of its cereal strategy is leading 2020 to be yet another year of reinvestment,” she writes. “This time last year, the company noted it did not need US cereal to grow to achieve the company’s overall long-term earnings growth algorithm.” 

While Kellogg still has work to do in reinvigorating cereals, with some progress already made, the owner of the Special K and Corn Flakes brands is making further inroads in emerging markets, a key cash generator as those countries mature and consumer spending improves.

Cahillane says Kellogg has “rapidly built up distribution” of its new branded noodles in Africa, and for the first time has kicked off production of Pringles snacks on the same continent and also in Brazil, while developing the noodles market in Egypt and South Africa. 

Kellogg also witnessed “good results” for Pringles in the Middle East.

In Russia, an emerging market but one that falls within Kellogg’s European remit, the CEO notes how cereal posted “strong” double-digit growth, gaining ground behind its Krave brand, and also expanded Pringles, which also grew at a similar rate.

“We continue to expand into central Europe. So we have good reasons to be confident in top-line growth again in Europe in 2020,” he says. “And with enhanced revenue growth management and a reorganisation that we executed in 2019, we have room to increase investment in 2020 and still deliver margin expansion.” 

Growth in Latin America was primarily driven by Mexico, where Kellogg increased market share across all three categories, he says, with “strong commercial plans” for the current financial year.

Nevertheless, the company met with obstacles in Puerto Rico, namely “softness” across all categories due to an economic slowdown, with a similar scenario playing out in Brazil.

“While the economic challenges may persist into 2020, we like how we are positioned in these markets,” he says. “2019 was not a typical year for Kellogg in Latin America, and we expect to be back in growth in both top line and bottom line in 2020.”

And, in Asia, Kellogg is seeing “good growth” in cereal and Pringles.

Looking to win in cereals

Finance chief Amit Banati says the impact from the divestitures will impact sales on the downside this year by about four percentage points.

Cahillane reiterated Kellogg’s commitment to cereal, despite a decline in sales in North America, while a drop-off in demand in Europe has only started to stabilise. “Make no mistake, with respect to cereal, we are in it to win it,” he emphasises.

Kellogg is developing the health-and-wellness aspect in cereal, led by Special K, and a recently-launched marketing campaign saw that brand’s decline “moderate” in the fourth quarter, the CEO says. In more indulgent areas, Cahillane said consumption is picking up in Europe for its Crunchy Nut, Coco Pops and Tresor cereal lines. 

More promotional drivers are planned for 2020, including more innovation and brand-building, and “more exciting in-store activity”, he says, adding “I want to emphasise our confidence in our ability to perform much better in 2020”. 

Erin Lash, a director of consumer equity research at Morningstar, holds a balanced view on the potential marketing spend and what it will mean for the business from both positive and negative perspectives.

She writes: “Continued inflationary pressures and a step-up in marketing costs (which is expected to persist through fiscal 2020) also weighed on profits. While this spend will constrain margins, we think opening the spigot on its brand investments if opportunities arise is favourable and evidences a commitment to supporting its fare and retail relationships.” 

The UK was a stand-out performer for Kellogg’s cereal business in 2019, posting year-on-year growth of 2%.

“So we’ve got good reasons to believe we can be at least stable on cereal in Europe in 2020,” Cahillane says. “There is still more work to do, and we have good plans for continuing to stabilise this business.

“We had another very good year in Europe, and the fourth quarter was our ninth straight quarter of organic net sales growth in this region, a region with some very mature markets and challenging retailer environments.” 

Bernstein’s Howard comments: “Today, the company seems to be going all in to win in this business [cereals], which is perhaps not surprising given the mid-single digit decline in 2019. However, we still wonder how much investment will be required and how much margin compression could still be ahead and whether the returns on this investment will be positive if consumers are being lured away into more convenient on-the-go options like snack bars.” 

Planted-based burgers fill a gap

Like cereals, snacks – Kellogg’s largest category in North America – are also getting the promotional treatment to boost sales, along with innovation.

Cahillane says its new Cheez-It Snap’d product helped drive double-digit growth in crackers in North America during the year, while its Club cracker brand returned to growth. 

“North America snacks is in a good position to sustain its growth,” he says, after Rice Krispies Treats, described as a “powerhouse brand”, saw growth accelerate. And Pop-Tarts “bounced back to growth”, while Nutri-Grain is getting a makeover.

In Europe, Pringles led the way, with demand increasing across the region, but with a standout performance in the UK and Spain, where sales were up in the double-digit area. 

The company is also putting weight behind its on-the-go pack formats.

In frozen foods, a new alternative-meat product is about to hit the markets late in the first quarter – plant-based Incogmeato, including ‘burgers’ and ‘chicken nuggets’, made by Kellogg-owned MorningStar Farms, which “built on its accelerated growth” across the rest of its range during the year.

For frozen breakfast products, the Eggo line-up of waffles, pancakes and French toast saw sales climb by almost 2%, with an impressive gain of 30% for Eggo’s Thick & Fluffy waffles.  

However, Cahillane says: “Overall, including all sub-categories, our frozen breakfast consumption declined as expected, but this reflected our continued phasing out of certain non-core products.”

He continues: “As we invest behind the momentum and expansion of Morningstar Farms and sustained steady growth in Eggo, we expect continued growth in North America frozen foods in 2020.”

Huge spend on R&D

Lash at Morningstar predicts Kellogg may have to spend around $1bn – the same amount it just used to cut debt – on research and development and innovation, to keep abreast of the rest of the market, particularly its well-established peers, and those operating in private label. 

She says: “We forecast the firm will expend around 8% of sales, or more than $1 billion annually, toward research, development, and marketing over the next ten years, as a means to ensure it weathers competitive pressures from other branded operators, small niche peers (that have proved more agile in responding to evolving consumer trends), and private-label fare.”

And Lash suspects that now the snacks and cookie asset disposals are out of the way, Kellogg will direct its brand spending toward its “highest-return opportunities” such as Pringles, Pop-Tarts, and Cheez-Its, as well as the new Incogmeato brand.

Looking ahead, Cahillane believes a 1-2% organic growth rate is sustainable, but he expects more of a balance between volume and price mix in 2020.

And underlying profits should also swing back to growth, as gross profit margins “gradually improve”, but only after taking out the impact of the recent asset disposals, he says.

Kellogg’s operating profit slumped almost 18% last year and was down 6% on an adjusted basis.

“Our goal is to grow both net sales and operating profit, leaving aside the negative mechanical impact of our divestiture,” Cahillane explains. “There are good reasons to be confident we can do this. First of all, our portfolio is more geared toward growth today than it was even a couple of years ago. Second, we’re not only seeing multi-quarter momentum in organic net sales growth, but it’s been broad-based. [And] third, we’ve improved our execution with a realigned organisation, enhanced capabilities and improved service. Fourth, we’re gradually improving our profitability.” 

CFO Banati says the outlook for organic growth doesn’t take into account an extra trading week in 2020, which, based on his previous experience, could amount to an additional 1.5 percentage points.

He envisages adjusted operating profit will decline by about 4% on a currency-neutral basis “as the absence of the divested businesses has a mechanical impact of approximately negative 6%, more than offsetting a return to operating profit growth for our base business”. 

And earnings per share will likely fall by around 3% to 4% due to the same reasons, he says. 
Cahillane imbued positive undertones throughout his presentation for the year ahead, but a lot would seem to rest on the cereal business and whether it can hold its own in a world where food appetites are rapidly changing, and with consumers increasingly turning to alternative breakfast products. And, if cereals fail to deliver, snacks and frozen foods will be left to pick up the slack.

“In short, we’re planning for a more balanced delivery with prudent forecasts as we build a foundation for sustainable growth,” Cahillane concludes.