Supply Chain Investments Stand to Buoy WK Kellogg's Profits Over Time Even as Sales Growth Stagnates

Associate Equity Analyst

Grace Na

Despite the intended benefits more focus should unlock, we fail to see an enduring competitive advantage in WK Kellogg as a stand-alone business. For one, we surmise its leading market share position in the North American cereal aisle is diluted as its entire portfolio sits in a shrinking category. In our view, this dents its relationships with retailers that strive to stock shelves with key traffic drivers. Further, without ties to the faster-growing snacks arm (which now sits inside narrow-moat Kellanova), WK Kellogg is left with subpar scale (generating less than $3 billion in annual sales), which likely weakens its bargaining power when sourcing key ingredients, negotiating slotting fees, and securing advertising placements.

Following the spinoff, WK Kellogg’s top priority is anchored in upgrading its outdated supply chain, which we view as appropriate. The firm intends to spend $450 million-$500 million in incremental capital expenditures over the next three years to realign its manufacturing and facilities network and invest in technology and automation. We think upgrading its fixed assets will structurally enhance the firm’s operational efficiencies and lift its profitability profile, with our midcycle adjusted EBITDA margin reaching around 14% by fiscal 2027, near management’s midteens target.

As WK Kellogg yields benefits from optimizing its fixed asset base, we expect the firm will prioritize directing a portion of its excess cash to shareholders through a dividend. Specifically, we forecast free cash flow as a percentage of sales will approximate a mid- to high-single-digit level annually longer term, with the dividend payout ratio hovering in the 40%-60% range. However, management has also expressed it hungers to tap into other categories with higher growth prospects in the medium to long term. This aligns with the paths undertaken by narrow-moat General Mills and Post Holdings historically to offset the depressed volume dynamics in cereal. In our view, though, such attempts would run counter to the stated benefits of the split (a heightened focus on cereal) and may prove value destructive as the firm ventures beyond its core competencies.

Business Strategy & Outlook

We don’t believe WK Kellogg has carved out a durable competitive edge in the mature and secularly challenged North American cereal market. Despite its strong foothold in the cereal aisle (boasting the number-two position with 29% market share in the US, per Euromonitor), we contend competitive pressures within the aisle (leading, established players and smaller, niche startups) and the plethora of breakfast alternatives weaken our confidence that it will continue extracting excess economic rents. Further, we fail to see how its exposure to a category that is in precipitous decline will enable WK Kellogg to gain much rapport with leading retailers that are working to drive customer traffic to their outlets. Although we expect the company to deliver returns on invested capital (including goodwill) above our estimated 8% weighted average cost of capital, we think this merely reflects operational improvements from the firm’s planned supply chain modernization initiative rather than suggesting a durable competitive edge.

From our vantage point, WK Kellogg’s leading position in the North America cereal aisle alone is an insufficient gauge of the strength of its brand intangible asset. The category has been beleaguered by competitive angst for years as healthier, on-the-go fare, such as yogurt and snack bars, have been winning at the shelf in the breakfast daypart. This is evidenced in the fact that the yogurt and snack bar categories have been growing by flat to mid-single-digit rates annually, far outpacing the low-single-digit percentage declines that have characterized the cereal aisle (preceding the pandemic). We continue to believe that cereal alternatives will encroach on the category’s prospects even as WK Kellogg and its peers continue to invest in innovation and marketing to cater to consumers’ evolving trends; on a proforma basis, WK Kellogg expended a high-single-digit percentage of sales, or just under $225 million, on average in brand spending over the past three years, and we think the firm will continue to direct a similar level of sales to research, development, and marketing over our 10-year explicit forecast. However, we view this spending as a competitive necessity, versus a mechanism to ignite its trajectory. In this context, the firm tapped into the natural cereal category when it acquired Kashi in 2000, but the brand’s cache was dampened as efforts to expand the fare to appeal to a broader cohort fell flat. Further, even Special K, long regarded as a healthy alternative in the cereal space, struggled at the hand of consumers’ shift away from dieting. Against this backdrop, we are skeptical that a heightened focus will enable WK Kellogg to win with consumers.

More critically, we don’t think WK Kellogg will benefit from the negotiating clout and sticky retailer relationships that it once enjoyed when tied up with the global snacking arm of the former Kellogg business. Prior to the split, we surmise the cereal arm benefited from the larger throughput of the faster-growing snacks portfolio and higher brand investments (on an absolute dollar basis), serving as a trusted partner for retailers reluctant to risk costly out-of-stocks in multiple categories. However, as a pure-play cereal manufacturer, the firm is now left with subpar scale, generating less than $3 billion in net sales annually, noticeably trailing its closest competitors wide-moat Pepsi ($52 billion in sales on its home turf), narrow-moat General Mills ($19 billion), and Post Holdings (around $6 billion). Consequently, we anticipate the firm’s bargaining power will deteriorate, which could necessitate higher slotting fees to secure shelf space.

In assessing the firm’s pricing power, we looked at average price per ounce of the top 50 selling cereal brands at wide-moat Walmart, due to the limited price/mix data that has been provided by the company. Our price checks indicate that WK Kellogg’s average price per ounce exceeds the prices charged by narrow-moat General Mills and Post Holdings, but only marginally so (just $0.02 and $0.06, respectively). When married with its more persistent market share demise, we fail to see how these modest premiums suggest WK Kellogg boasts pricing power.

Looking beyond brand intangible assets, we think WK Kellogg has failed to demonstrate a cost advantage. As quantitative evidence, despite boasting a comparable sales base of $2 billion-$3 billion, WK Kellogg’s single-digit operating margins lag the low- to mid-20s Post’s consumer brands segment (which houses its cereal mix) chalks up. Although we acknowledge management’s aims to modernize its supply chain and unlock 500 basis points of profitability improvement by fiscal 2026, we don’t believe that these investments alone will eliminate the profit differential. Rather, we think its depressed profit profile is a manifestation of the firm’s inferior negotiating power that is only exacerbated as a smaller, stand-alone entity. In addition, due to its smaller scale relative to other leading cereal manufacturers, we contend WK Kellogg operates with higher unit and distribution costs, which impede the firm’s ability to leverage its brand spending effectively.

Lastly, we expect that WK Kellogg will generate ROICs (including goodwill) of around 20% on average over the next five years, in excess of our 8% estimate for its cost of capital. However, we believe this purely reflects its revenue growth management initiatives and the operational efficiency gains from its pending supply chain modernization, as opposed to suggesting a competitive edge.

None

Economic Moat

WK Kellogg Co

Earnings data Q3 2023

Earnings data Q4 2023

Earnings data Q1 2024

Earnings data Q2 2024

WK Kellogg Co reports Q1 results, affirms 2024 guidance confidently

KLG's Q1 performance showed mixed results with sales decline but EBITDA growth, highlighting strategic goals and core brand strength. The company faces challenges in managing seasonality and achieving margin expansion targets. Opportunities exist in EBITDA growth, supply chain modernization, and advertising strategy.

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WK Kellogg Co. produces and sells cereal based breakfast products. Its products include Frosted Flakes, Special K, Froot Loops, Raisin Bran, Frosted Mini- Wheats, Rice Krispies, Kashi, Corn Flakes, and Apple Jacks. The company was founded on November 23, 2022 and is headquartered in Battle Creek, MI.

WK Kellogg Co. (NYSE:KLG ) Q1 2024 Earnings Conference Call May 7, 2024 9:30 AM ET Company Participants Karen Duke - Vice President, Planning and Investor Relations Gary Pilnick - Chief Executive Officer and Chairman of the Board Dave McKinstray - Chief Financial Officer Conference Call Participants Ken Goldman – J.P. Morgan Peter Galbo - Bank of America Andrew Lazar – Barclays David Palmer - Evercore ISI Max Gumport - BNP Paribas Robert Moskow - TD Cowen Robert Dickerson - Jefferies Operator Good day and welcome to the Q1, WK Kellogg Co. Earnings Conference Call.

WK Kellogg Co. (KLG) Q1 2024 Earnings Call Transcript

WK Kellogg Co beat Wall Street estimates for quarterly sales on Tuesday, as higher product prices offset pressure from slowing demand for the Froot Loops maker's ready-to-eat breakfast items and snacks.

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WK Kellogg's stock KLG, +1.47% rose 1.5% in premarket trading on Tuesday after the breakfast cereal giant said its first-quarter profit rose to $33 million, or 37 cents a share, from $24 million, or 28 cents a share, in the year-ago quarter. WK Kellogg matched the FactSet consensus estimate of 37 cents a share.

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BATTLE CREEK, Mich. , May 7, 2024 /PRNewswire/ -- WK Kellogg Co (NYSE: KLG), today published its 2024 first quarter results in documents posted to the company website at  https://investor.wkkellogg.com/news-events/events-and-presentations/default.aspx.

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BATTLE CREEK, Mich. , May 2, 2024 /PRNewswire/ -- WK Kellogg Co (NYSE: KLG) today announced that its Board of Directors declared a dividend of $0.16 per share on the common stock of WK Kellogg Co, payable on June 14, 2024, to shareowners of record at the close of business on May 31, 2024.

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BATTLE CREEK, Mich. , April 18, 2024 /PRNewswire/ -- WK Kellogg Co (NYSE: KLG) announced today that it will host a conference call on Tuesday, May 7, 2024, at 9:30 a.m.

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BATTLE CREEK, Mich. , April 17, 2024 /PRNewswire/ -- WK Kellogg Co (NYSE: KLG) will host a live virtual webcast of its 2024 Annual Shareholder Meeting on Thursday, May 2, 2024, at 1:00 PM ET.

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WK Kellogg has been undervalued since its split from parent company Kellanova in September last year. Unlike some spinoffs, KLG carries a strong balance sheet and pays a respectable and well-covered dividend. KLG's focus on modernizing its supply chain and introducing innovative products positions it for potential growth in 2024 and beyond.

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WK Kellogg Co. (KLG) Q4 2023 Earnings Call Transcript

WK Kellogg Co.'s stock KLG, +1.45% rose 4.5% in premarket trades Tuesday after the cereal company reported better-than-expected fourth-quarter revenue despite a year-over-year sales decline impacted by price elasticity and lower promotional spend. WK Kellogg, which was previously part of snack giant Kellanova K, +2.17%, said its net income was $15 million, or 18 cents a share, after a loss of $152 million or a loss of $1.77 a share in the prior year's period.

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BATTLE CREEK, Mich. , Feb. 13, 2024 /PRNewswire/ -- WK Kellogg Co (NYSE: KLG), today published its 2023 fourth quarter and full year earnings results in documents posted to the company website at  https://investor.wkkellogg.com/news-events/events-and-presentations/default.aspx.

WK Kellogg Co Announces Strong Fourth Quarter and Full Year 2023 Financial Results, and increased 2024 EBITDA Guidance

BATTLE CREEK, Mich. , Feb. 9, 2024 /PRNewswire/ -- WK Kellogg Co (NYSE: KLG) announced today that the company will present at the Consumer Analyst Group of New York Conference live at 8:00 am ET, Wednesday, February 21, 2024.

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BATTLE CREEK, Mich. , Jan. 18, 2024 /PRNewswire/ -- WK Kellogg Co (NYSE: KLG) announced today that it will host a conference call on Tuesday, February 13, 2024, at 9:30 a.m.

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WK Kellogg Co holds the second-largest market share in the U.S. ready-to-eat cereal sector and leads in Canada and the Caribbean. The spin-off from Kellogg ParentCo aims to streamline operations and focus on individual market segments. KLG reported a slight decrease in net sales for Q3 2023 but remains confident in its direction and aims to increase EBITDA margins to the mid-teens by 2026.

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BATTLE CREEK, Mich. , Nov. 29, 2023 /PRNewswire/ -- WK Kellogg Co (NYSE: KLG) today announced that Gary Pilnick, Chairman and Chief Executive Officer, and Dave McKinstray, Chief Financial Officer, will participate in a fireside chat at the Morgan Stanley Global Consumer & Retail Conference on December 6, 2023, at 3:00PM ET.

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WK Kellogg's (KLG) third-quarter 2023 results reflect the rise in earnings. However, net sales decline on reduced volumes.

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WK Kellogg impressed investors with its first financial report as a standalone company after it was spun off from Kellanova, formerly known as the Kellogg Company (NYSE:K), in October. Shares of the cereal giant - whose brands include Kellogg's, Frosted Flakes, Froot Loops, Mini-Wheats, Special K, Raisin Brand, Rice Krispies, Corn Flakes, and Kashi – moved higher as WK Kellogg's third quarter revenue and earnings topped estimates, up 3.5% at US$10.83.

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