Kellogg‘s second-quarter sales growth – buoyed by snacks and frozen food – cheered the market on Thursday but analysts still have some questions about other parts of the US giant’s business. Dean Best presents the top takeaways from the Special K and Eggo maker’s latest results.

Kellogg’s profits down but sales catch the eye

The Coco Pops and Pringles owner saw its operating and net income fall in both the second quarter and first half of 2019, although the company had forecast the declines when reporting its 2018 results – and outlining expectations for this year – in February.

In the main, analysts covering Kellogg reacted positively to the group’s second-quarter sales, which beat Wall Street’s expectations.

On an organic basis, Kellogg’s second-quarter net sales rose 2.3%, a full 160 basis points higher than analysts had forecast, boosted by growth overseas and, in North America, snacks and frozen food.

Kellogg CEO Steve Cahillane said the rate of growth was “our best organic growth since 2016 – or since 2012 if you exclude the inflationary benefits of Venezuela in prior years”.

Sales volumes were lower year-on-year, with price/mix driving the growth but Wells Fargo analyst John Baumgartner remarked how, when surveying the results, it was “hard to find the incremental hole to poke”, adding: “[Wall] Street sentiment remains sour on Kellogg but Q2 provided little fuel for bears; price/mix is very encouraging in North America and while volume pressure suggests a work still in progress, solid organic revenue outside the US is encouraging”.

Cahillane joined Kellogg in the last quarter of 2017, a year that became the fourth straight year the company saw its sales fall. By the February of 2018, the former Coca-Cola and Anheuser-Busch InBev executive set out his strategy – Deploy for Growth – to improve the company’s top line – and on Thursday he said the company’s second-quarter results were evidence the group’s performance was improving.

“In a business turnaround, there is nothing more important … continuously report back to our share owners that we are executing our strategy as planned and that we are delivering our results as planned and that’s exactly what I had the opportunity to do here today. There is no more compelling evidence of this than in our organic net sales growth,” he told analysts.

“Broad-based” sales growth internationally

In 2018, North America accounted for around 65% of Kellogg’s reported net sales. The region has proven, at times, challenging for Kellogg in recent years but the company is determined to get its business growing there – and saw success in the second quarter.

At the same time, Kellogg is looking to drive growth from its international operations, not least in emerging markets, countries Cahillane said when he took the helm at the company were a focus area for the business.

Since Cahillane was given the reins in the autumn of 2017, among Kellogg’s international initiatives have been the acquisition of assets in Africa, as well as a restructuring of its operations in Europe.

Kellogg said its growth in the second quarter was “broad-based”, with sales rising in each of its four regions of North America, Europe, Latin America and a combined Africa, Middle East and Asia. Europe had its “seventh consecutive quarter of year-on-year net sales growth”, Cahillane said, with “growth … led by momentum in Pringles”, especially in the UK and France. Growth in Latin America was buoyed by Kellogg’s cereal business, with Cahillane calling out sales in Mexico.

The Africa, Middle East and Asia division saw its sales boosted by the acquisition in Africa but also generated a 9% rise in organic growth, with snacks “leading” the expansion but cereal up in most markets.

Kellogg’s soggy forecast for US cereal category

In 2018, Kellogg’s US “morning foods” business on its own accounted for just shy of 20% of the company’s reported net sales. Kellogg did not disclose the proportion of sales US cereal products generate – but that part of the business remains closely watched by analysts.

In each of the last six full fiscal years, sales from Kellogg’s US morning foods division have declined. When Cahillane joined the group, he quickly told the market the division was “not going to be the growth driver for us in the Kellogg Company”, an eye-catching statement for some given how synonymous the business is with breakfast cereal. Cahillane said the Krave maker was “confident” it could “stabilise” the sales it makes from cereal in its developed markets, pointing to the success it had had improving the performance of that part of its business in Canada, the UK and Australia.

During the second quarter of 2019, Kellogg’s global cereal sales were “down”, Cahillane said, “mainly because of our US business”, with some pressure on sales in Australia due to the timing of shipments. That said, sales in another long-challenging market, the UK, rose, which would have pleased management.

Cahillane cited Kellogg’s work in the US to “harmonise” the pack sizes of its cereal as the reason for falling sales there (in order, the company says, to improve aisle and shelf “shop-ability”), with the initiative meaning the company held back from taking part to the usual extent in promotions.

As ever, Kellogg’s US cereal business was the focus of some analyst questions on the conference call with management to discuss the quarter. However, Stifel Nicolaus’ Chris Growe wanted to know how Kellogg is viewing the growth trajectory of the overall category.

“The category is currently running at about minus 1%. I think that’s a reasonable forecast,” Cahillane said. “We have been losing share as we’ve gone through this price-package harmonisation because of our significant pull-back on promotions as we went through it. We are not in the shared donation business.

“We would expect to be back exactly where we would like to be, which is at a minimum growing with the category or staying right at the category at a minimum.”

The Kellogg CEO did use the opportunity to underline the other parts of the company’s North America business that are growing. “Despite the challenges and headwinds in the US cereal, the fact that North America was able to post a solid 1% growth,” he said. “It really again shows the strength of the snacks portfolio, the frozen portfolio, the speciality portfolio and the different balance they were achieving in North America – and indeed around the world.”

Gross margins down but Kellogg sticks to forecast

In his note to clients, Wells Fargo’s Baumgartner pointed out how Kellogg’s second-quarter gross margins had come in at 33.4%, a fall of some 2.4 percentage points year-on-year – and below the consensus forecast among Wall Street analysts.

Sanford Bernstein’s Howard pointed to increased expenses related to new pack formats, unfavourable product mix and higher input costs as factors for the fall in gross margins.

Kellogg CFO Amit Banati said the company had warned gross margins would be lower “especially in the first half” – but he said the company’s prediction there would be “sequential improvement” in the second quarter had been borne out.

He added Kellogg has forecast its gross margin will fall year-on-year in 2019 but with declines to “moderate as the year goes on”.

The company believes, Cahillane added, the “best performance” in its gross margin will be “in the fourth quarter and then entering into 2020

Brand investment to continue

When Kellogg reported its 2018 financial results in February, Cahillane said the company planned to “continue increasing our investments through the first half”, moves he added would contribute to lower operating profit in the opening six months of 2019.

Investment behind brands has been a central plank of Cahillane’s growth agenda since taking the Kellogg hot seat and, discussing the company’s second-quarter results, he said the spending behind brands such as Cheez-It has been paying off. “Deploy for Growth and the investments behind it were intended to bring us back into organic net sales growth. It’s clearly working,” he said.

Some of the investment planned for the first half of the year has been moved into the second six months. Kellogg had delayed some of the spending as it brought on extra capacity in certain parts of its business.

“We’ve got really good momentum in the top line. We definitely plan on sustaining that. So from a brand building standpoint, we’ll be looking at the third quarter as a good opportunity to take some of that shift from the first half of the year,” Cahillane said.

Kellogg keeps “prudent” guidance

Kellogg stuck to its forecasts for 2019, updated in May (from initial guidance given in February) in the wake of the company’s sale of a clutch of assets to Ferrero.

The company still expects its net sales to fall by around 2-3% in 2019, its adjusted operating profit to decrease by approximately 4-5% and its adjusted earnings per share to drop by “less than” 5%.

Piper Jaffray analyst Michael Lavery asked Kellogg if it was “erring on the conservative side” by maintaining the May guidance, given the company had said its first-half EPS were ahead of expectations.

“I would not characterise our guidance for the back half of the year as conservative. I would characterise it as prudent. And it was always back-weighted,” Cahillane said.

“What gives us confidence is the return to organic net sales growth across all four regions and the fact that the investments that we put in place are working. I wouldn’t characterise it as conservative. I would say it’s straight down the middle.”