Closing In On The Cereal Killer? Sentiment Too Negative, But Valuation Balanced INVESTMENT CONCLUSION: Category Leaders Backing Talk Up with Action. We believe recent plans including Kellogg’s adult health targeted cereal launches and General Mills launch of Nature Valley Protein & protein bars are on target to deliver an inflection point in the category over the next 12 months. Furthermore, the companies enjoy two major tailwinds: (1) a new round of moderate (-10%) grain cost deflation that should be felt 6-12 months out, and (2) easy 2 and 3 year volume comps in the first half of CY2014. We believe that ongoing sluggishness in the ready-to-eat (RTE) cereal category, which looks to some like a secular decline in cereal consumption is fixable. With K & GIS sporting well below average relative valuations, we’re tempted to recommend them – but note their valuations remain above (+7%,+8%) their own historical average EV/EBITDA for what remain below trend fundamentals. In short, we don’t believe the negative hype, but don’t think that negative case is priced in. Cereal companies may offer a good relative investment case based on strong returns supported by cereal’s structural advantages of high breakfast occasion share (32%), product differentiation and demographics, but need evidence of volume improvement before becoming more aggressive. KEY POINTS: • Cereal Has Lost Share of Stomach, but Problems Look Fixable. Fears that RTE cereal is undergoing a secular decline in per capita consumption are overblown, and the equities of cereal giants Kellogg and General Mills – in particular the former – look attractive based on historically wide discounts to peers. Based on our analysis of scanner data, RTE cereal has lost 4 pts of breakfast share over the last 3 years, worth ~$1.5-$1.7B in retail sales, ~$1.1-$1.3B in wholesale sales, and $330-$400M in apparent wholesale profits. We think an increase in advertising, concomitant with a renewed emphasis on adult targeted innovation can stem the onslaught of yogurt and protein bars that we believe have encroached on cereal in the breakfast occasion. • Improving Visibility to the Group. General Mills has about maintained advertising spending over the last 4 years, while Kellogg’s has decreased 80 bps in an environment of higher pricing. Now, both have plans based on growing relative spend in the year ahead where pricing will be rare. On the cash flow front, Kellogg’s free cash flow has been impressive (83% of EPS) despite one-time integration costs whose disappearance will likely allow better cash flow in 2014, while General Mills cash flow realization (95% of EPS) is already among the best in the group. • Category Problems Seem Pretty Simple – Spending & Innovation. It’s no wonder to us that cereal demand has weakened over the last 3 years, as category media spending declined 7% vs. a 3% increase in broader U.S. food & beverage (Kantar Media). We note that given the category’s superior economic architecture (50%+ GM & 30%+ Contribution Rate), any improvement in volume trend would have a big effect. Furthermore, bringing higher end consumers back to the category with protein & nutrition inclusions could help balance the presence of more price sensitive low/middle income consumers. • Only Relatively Attractive Until Volume Improves. Cereal companies probably deserve better relative valuation within the food group, but the group itself remains fully valued. For example, Kellogg is trading at an attractive 13% discount to peers on CY14E EV/EBITDA and (-18%) discount based on trailing EV/GP, well below historical premiums of 3% and 5%, respectively – but still above (+7%) its historical average EV/EBITDA of 10.2x . Likewise, General Mills offers a relative discount on both measures (-14%, -2%) vs. its usual slight premiums on both, but remains above its long-term average NTM EV/EBITDA valuation (+8%) for well below trend volume Jonathan Feeney, CFA 215-665-6679 [email protected]Mark E. Williams 215-665-6358 [email protected]Food & Beverage October 18, 2013 Equity Research Industry Report Research Analyst Certifications and Important Disclosures are on page 17 of this report
Transcript
Closing In On The Cereal Killer?
Sentiment Too Negative, But Valuation Balanced
INVESTMENT CONCLUSION:
Category Leaders Backing Talk Up with Action. We believe recent plans including Kellogg’s adult health targetedcereal launches and General Mills launch of Nature Valley Protein & protein bars are on target to deliver an inflectionpoint in the category over the next 12 months. Furthermore, the companies enjoy two major tailwinds: (1) a new round ofmoderate (-10%) grain cost deflation that should be felt 6-12 months out, and (2) easy 2 and 3 year volume comps in thefirst half of CY2014. We believe that ongoing sluggishness in the ready-to-eat (RTE) cereal category, which looks tosome like a secular decline in cereal consumption is fixable. With K & GIS sporting well below average relativevaluations, we’re tempted to recommend them – but note their valuations remain above (+7%,+8%) their own historicalaverage EV/EBITDA for what remain below trend fundamentals. In short, we don’t believe the negative hype, but don’tthink that negative case is priced in. Cereal companies may offer a good relative investment case based on strong returnssupported by cereal’s structural advantages of high breakfast occasion share (32%), product differentiation anddemographics, but need evidence of volume improvement before becoming more aggressive.
KEY POINTS:
• Cereal Has Lost Share of Stomach, but Problems Look Fixable. Fears that RTE cereal is undergoing a seculardecline in per capita consumption are overblown, and the equities of cereal giants Kellogg and General Mills – inparticular the former – look attractive based on historically wide discounts to peers. Based on our analysis of scannerdata, RTE cereal has lost 4 pts of breakfast share over the last 3 years, worth ~$1.5-$1.7B in retail sales, ~$1.1-$1.3Bin wholesale sales, and $330-$400M in apparent wholesale profits. We think an increase in advertising, concomitantwith a renewed emphasis on adult targeted innovation can stem the onslaught of yogurt and protein bars that webelieve have encroached on cereal in the breakfast occasion.
• Improving Visibility to the Group. General Mills has about maintained advertising spending over the last 4 years,while Kellogg’s has decreased 80 bps in an environment of higher pricing. Now, both have plans based on growingrelative spend in the year ahead where pricing will be rare. On the cash flow front, Kellogg’s free cash flow has beenimpressive (83% of EPS) despite one-time integration costs whose disappearance will likely allow better cash flowin 2014, while General Mills cash flow realization (95% of EPS) is already among the best in the group.
• Category Problems Seem Pretty Simple – Spending & Innovation. It’s no wonder to us that cereal demand hasweakened over the last 3 years, as category media spending declined 7% vs. a 3% increase in broader U.S. food &beverage (Kantar Media). We note that given the category’s superior economic architecture (50%+ GM & 30%+Contribution Rate), any improvement in volume trend would have a big effect. Furthermore, bringing higher endconsumers back to the category with protein & nutrition inclusions could help balance the presence of more pricesensitive low/middle income consumers.
• Only Relatively Attractive Until Volume Improves. Cereal companies probably deserve better relative valuationwithin the food group, but the group itself remains fully valued. For example, Kellogg is trading at an attractive 13%discount to peers on CY14E EV/EBITDA and (-18%) discount based on trailing EV/GP, well below historicalpremiums of 3% and 5%, respectively – but still above (+7%) its historical average EV/EBITDA of 10.2x .Likewise, General Mills offers a relative discount on both measures (-14%, -2%) vs. its usual slight premiums onboth, but remains above its long-term average NTM EV/EBITDA valuation (+8%) for well below trend volume
Before Rags in Valuation, There Were Riches in Margin
The decline in relative valuation of cereal companies within food dates back to 2009, when Kellogg lost its
reputation as among the most profitable, dependable growth vehicles in packaged food and General Mills
U.S. Retail business stopped growing volume after a year of outstanding profit growth (+27%) in the wake
of a financial crisis that sent costs plummeting and consumers to the grocery store at the same time. It
seems that the profit growth of Kellogg far in excess of volume for the prior 5 years, and certainly the one
year windfall for General Mills got the category out of balance. The companies’ brand equities are strong
in terms of relative pricing and profit per unit, and its stands to reason that a rebase of spending, alongside
innovation would allow for visible growth once again.
Figure 3: Prolonged Softness in Cereal Consumption
Source: Nielsen XAOC; GIS 1Q14 Presentation
The ongoing sluggishness in the ready-to-eat cereal category has compelled some observers to call for a
secular decline in cereal consumption, and with K nearing its all-time low relative valuation versus peers,
apparently this fear is shared by many. Instead, we see a cereal category benefitting from strong product
differentiation, attractive health & wellness positioning, and favorable underlying demographics as the
population ages. As for Kellogg, we believe its portfolio remains relatively well supported by advertising
and innovation and continues to generate superior returns, at least partially the result of its leading share
position in cereal. General Mills has gained share in recent years while outperforming Kellogg, albeit in a
tough category.
- 4 -
Figure 4: Cereal Consumption Should Benefit from Aging Population in Developed Markets
Source: NPD, United States Census Bureau; K 2012 Analyst Day Presentation
Cereal Has Lost Share of Stomach, but Problems Look Fixable
Fears that the ready-to-eat cereal category is undergoing a secular decline in per capita consumption are
overblown, and the equities of cereal giants Kellogg and General Mills – in particular the former – look
attractive based on historically wide discounts to peers. Based on our analysis of scanner data, the cereal
category has lost 4 points of breakfast dollar share over the last three years, worth approximately $1.5-
$1.7B in retail sales, ~$1.1-$1.3B in wholesale sales, and $330-$400M in wholesale profits. While the
category’s velocity and share trends remain unfavorable, distribution remains steady, price competition and
private label penetration continue to be non-factors, and superior gross margins mean these problems can
be spent against. While it seems unlikely that cereal can regain the entirety of its lost breakfast share over
the medium term, we think an increase in advertising, concomitant with a shift away from line extensions
and health-based marketing and toward a strategy of meaningful innovation (i.e., Special K with Red
Berries) and taste-focused advertising, can stop the onslaught of yogurt and protein bars on the breakfast
occasion.
Figure 5: Fears of Declines in Per Capita Consumption Seem Overblown
*Peak year for concern
Source: The NPD Group/National Eating Trends – U.S;, years through Feb 2012; K 2012 Analyst Day Presentation
- 5 -
Category Still Open to Advertising, Value-Added Innovation Since advertising is the lifeblood of CPG brands, it’s no wonder to us that cereal demand has weakened
over the last 3 years, as category media spending declined 7% compared to a 3% increase in broader U.S.
food & beverage, according to data from Kantar Media. Relative advertising spending has declined
steadily for both Kellogg and General Mills from 2010 (K 9.1%, GIS 6.2%) to this year (K 7.9%, GIS
5.0%), now sitting about 50 bps below the 5-year average for both companies. While share of voice likely
remains ahead of share of category for both players, prompting a counterargument that ad spend can be
pared down with little impact on volumes (a la Campbell 2012-13), given the category’s superior economic
architecture (40% gross margin when broken out in GIS in early 2000’s), it appears that an increasing level
of brand support can be justified.
Figure 6: Cereal Category Advertising Trends
Source: Media Spending - Kantar, Latest 12 Month Period Ended May 2013; GIS 1Q14 Presentation
- 6 -
Figure 7: Relative Ad Spend for K and GIS Has Fallen Below 5-Year Average Levels
¹GIS ad spend prior to FY05 included certain fees paid to third-parties and excluded certain media content development costs.
Source: Company reports, Janney Capital Markets estimates
The cereal category was the poster child of trading up the consumer in the 1990’s and early 2000’s, for
example Kellogg moving Special K consumers over and up to Special K with Red Berries. Lately, a lack
of differentiated new product offerings (Cheerios Peanut Butter! Raisin Brand with Omega 3 from
Flaxseed!) have relegated cereal to a background role among the chorus of new product news, increasingly
skewed toward breakfast alternatives, such as Greek yogurt, protein bars, and granola. We think cereal’s
lack of participation in a growing desire for protein and a heavier exposure to a squeezed low/middle
income consumer could be responsible for a heightened focus on price-based competition, and a move to
target the higher end with more premium innovations could help renew interest in the category.
In particular, based on our analysis of web search and scanner data trends, we think cereal missed out on
the consumer’s growing desire for protein, as consumers appear to be awarding more breakfast occasions to
higher-protein (in reality or by perception) offerings, such as Greek yogurt and protein bars. First, we ran
an analysis of web search interest (2004-present) in the following terms: cereal, yogurt, Greek yogurt,
granola, protein bars. The correlation between cereal and the other terms averaged 60%, with yogurt the
lowest (55%) and protein bars the highest (67%). Then, we ran a second screen, but this time added the
term protein. The correlation between searches for protein and those for cereal, yogurt, Greek yogurt, and
protein bars increased to the 80% range, with cereal (81%) just behind Greek yogurt (84%). We believe
this relationship reveals a growing desire for protein at the breakfast occasion. While we question whether
the category can deliver protein in an authentic way, we think a return to taste-focused, differentiated new
product innovation can remind the consumer why cereal continues to be the breakfast option most often
chosen, whether it be whole grains, cost, convenience, or variety.
General Mills 31.6 31.9 30.7 29.7 -3.4 -16.1 1.5 0.0
Post Holdings 10.4 10.4 10.6 10.8 -1.2 1.4 2.0 -1.2
Private Label 8.9 9.3 8.6 8.8 -1.4 -3.0 -3.5 -4.5
Mom Brands 7.1 7.2 7.2 7.3 0.2 0.3 -2.6 -0.8
PepsiCo 6.3 6.2 6.2 6.5 7.4 15.4 2.5 2.0
Category - - - - - - - -
ColdCereal 3Q12 4Q12 1Q13 2Q13
Kellogg 0.2 0.6 0.2 -0.6
General Mills -0.9 -0.5 -0.4 0.0
Post Holdings 0.1 -0.5 -0.1 0.3
Private Label -0.1 -0.4 -0.4 -0.5
Mom Brands 0.4 0.3 0.3 0.1
PepsiCo 0.2 0.4 0.1 0.3
Category - - - -
$ Share
$ Share (Y/Y Chg)
Demand Elasticity
- 11 -
Figure 13: The Consumer Expenditure Squeeze
Source: BLS, Consumer Expenditure Survey (2011); Janney Capital Markets research
Source: BLS, Consumer Expenditure Survey (2011); Janney Capital Markets research
Still, Brand Equities Appear In Tact Cereal brands are still some of the strongest in the store, as their products are difficult to replicate and
compete largely on the basis of value and taste. Since 2009, base dollars as a percentage of total dollar
sales has actually increased for cereal, while price per volume and private label share are both about flat.
Distribution also remains steady, suggesting that retailers still view this as one of its key drivers of traffic
and profit. It appears that more volatile input costs, in particular grains, have resulted in more frequent
tactical shifts in promoted prices, and while we view the recent drop-off in grain costs as ultimately
ambiguous for the category – a one-time benefit followed by inviting lower priced competition from private
label and smaller brands – perhaps the factors driving costs down such as larger global supplies of grain
could at least bring stability to the category’s key input cost, which has experienced two rollercoaster rides
since 2006.
Only Relatively Attractive Until Volume Improves
Cereal companies probably deserve better relative valuation within the food group, but the group itself
remains fully valued. For example, Kellogg is trading at an attractive 13% discount to peers on CY14E
EV/EBITDA and (-18%) discount based on trailing EV/GP, well below historical premia of 3% and 5%,
respectively – but still above (+7%) its historical average EV/EBITDA of 10.2x . Likewise, General Mills
offers a relative discount on both measures (-14%, -2%) vs. its usual slight premia on both, but remains
above its long-term average NTM EV/EBITDA valuation (+8%) for well below trend volume growth.
2.3% 2.9%
4.2%
4.2%
8.6%
9.9%
7.7%
14.8%
44.6%
Percentage of Total Food at Home Expenditures
Less than $5,000
$5,000 to $9,999
$10,000 to $14,999
$15,000 to 19,999
$20,000 to $29,999
$30,000 to $39,999
$40,000 to $49,999
$50,000 to $69,999
$70,000 and more
Food at
home
10%
Food away
from home
5%
Housing
39%
Apparel and
services
4%
Transportation
15%
Health care
8%
Entertainment
5%
Personal
insurance and
pensions
3%
Miscellaneous
11%
Consumer Expenditures by Type of Spend - Less
than $30K
- 12 -
Figure 14: General Mills Valuation History
Source: Company reports, Janney Capital Markets estimates
7.5x
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GIS High Value-Added Food GIS Historical Average
(25.0%)
(20.0%)
(15.0%)
(10.0%)
(5.0%)
0.0%
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Diff. btwn Current Premium/(Discount) and Historical Average
GIS Fwd EV/EBITDA GIS Fwd P/E
- 13 -
Figure 15: Kellogg Valuation History
Source: Company reports, Janney Capital Markets estimates
7.5x
8.5x
9.5x
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Forward EV/EBITDA (Consensus)
K 10.5x K Historical Average
(30.0%)
(25.0%)
(20.0%)
(15.0%)
(10.0%)
(5.0%)
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Diff. btwn Current Premium/(Discount) and Historical Average
K Fwd EV/EBITDA K Fwd P/E
- 14 -
Figure 16: Group Valuation History
Source: Company reports, Janney Capital Markets estimates
PEP
MDLZ
KRFT
GIS
K
HNZ
HSY
CAGCPB
SJMMKC
WWAV
HAIN
PF
LNCEJJSFBNNY
SNAKHRL
TSNHSH
FLO
SFD
DF
THS
FDP
DOLE
CQB
CVGW
(50.0%)
(40.0%)
(30.0%)
(20.0%)
(10.0%)
0.0%
10.0%
20.0%
Diff. btwn Current Premium/(Discount) and Historical Average
EV/EBITDA
High Value-
Added Food
Commodity Food
Food
PEP
MDLZ
KRFT
GIS
K
HSY
CAG
CPB
SJMMKC
WWAV
HAIN
PF
LNCE
JJSF
BNNY
SNAK
HRL
TSN
HSH
(20.0%)
(10.0%)
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
Percentage Above/(Below) Historical Average Multiple
EV/EBITDA
- 15 -
Figure 17: Feeney’s Food Cost Factor – Proprietary Index of Spot Commodity Inputs (9.30.13)
Source: Company reports, Janney Capital Markets estimates
- 16 -
IMPORTANT DISCLOSURES
Research Analyst CertificationI, Jonathan Feeney, the Primarily Responsible Analyst for this research report, hereby certify that all of the views expressed inthis research report accurately reflect my personal views about any and all of the subject securities or issuers. No part of mycompensation was, is, or will be, directly or indirectly, related to the specific recommendations or views I expressed in thisresearch report.
Janney Montgomery Scott LLC ("Janney") Equity Research Disclosure LegendIndividual disclosures for the companies mentioned in this report can be obtained by accessing our Firm’s Disclosure Site
Disclosure Site
Definition of RatingsBUY: Janney expects that the subject company will appreciate in value. Additionally, we expect that the subject company willoutperform comparable companies within its sector.
NEUTRAL: Janney believes that the subject company is fairly valued and will perform in line with comparable companieswithin its sector. Investors may add to current positions on short-term weakness and sell on strength as the valuations orfundamentals become more or less attractive.
SELL: Janney expects that the subject company will likely decline in value and will underperform comparable companieswithin its sector.
Janney Montgomery Scott Ratings Distribution as of 9/30/13
IB Serv./Past 12 Mos.
Rating Count Percent Count Percent
BUY [B] 244 51.80 38 15.60
NEUTRAL [N] 221 46.90 21 9.50
SELL [S] 6 1.30 0 0.00
*Percentages of each rating category where Janney has performed Investment Banking services over thepast 12 months.
Other DisclosuresJanney Montgomery Scott LLC, is a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission and amember of the New York Stock Exchange, the Financial Industry Regulatory Authority and the Securities Investor ProtectionCorp.
This report is for your information only and is not an offer to sell or a solicitation of an offer to buy the securities or instrumentsnamed or described in this report. Interested parties are advised to contact the entity with which they deal or the entity thatprovided this report to them, should they desire further information. The information in this report has been obtained or derivedfrom sources believed by Janney Montgomery Scott LLC, to be reliable. Janney Montgomery Scott LLC, however, does notrepresent that this information is accurate or complete. Any opinions or estimates contained in this report represent the judgmentof Janney Montgomery Scott LLC at this time and are subject to change without notice.
Investment opinions are based on each stock's 6-12 month return potential. Our ratings are not based on formal price targets,however, our analysts will discuss fair value and/or target price ranges in research reports. Decisions to buy or sell a stockshould be based on the investor's investment objectives and risk tolerance and should not rely solely on the rating. Investorsshould read carefully the entire research report, which provides a more complete discussion of the analyst's views. Supportinginformation related to the recommendation, if any, made in the research report is available upon request.
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