Are Consumer Companies Doomed?

Kellogg (NYSE: K  ) shareholders are likely battling sour stomachs after last week's earnings release, which not even a merry band of Keebler elves could couch in a positive light.

Second-quarter sales fell 5%, to $3.1 billion. Earnings per share fared worse, declining 14% -- or $0.13 -- to $0.79. A variety of factors contributed to the stale performance, including a product recall in the last several days of the quarter.

On June 25, Kellogg announced a voluntary recall of U.S.-shipped cereals, including Apple Jacks, Corn Pops, and Honey Smacks, owing to an "uncharacteristic off-flavor and smell" emanating from the package liner.

Management estimates that this snafu was responsible for $0.10 of the $0.13 EPS dip. Well, OK, manufacturing errors do happen. But we still need to account for the other three cents, plus the additional six cents or so that would've been necessary to produce mid-single-digit EPS growth -- the absolute bottom of what I'd consider to be a winning level.

And this is where things get really ugly. Kellogg cited deflationary forces in the U.S. and U.K. cereal category, a reduction in North American retailer inventories, and lower Eggo sales, the latter resulting from a production interruption in late 2009. It's those first two factors that really have me worried.

In North American Retail Cereal, a subsegment of the company's largest reporting division, sales fell by a currency-neutral 13%. Now, only an estimated 5% of that sales decline owed to the recall, with the balance coming from negatives such as retailer inventory pullback and lower consumer consumption. In other words, not only are consumers once again growing cautious, but retailers, too, appear to be stepping back into cash-conservation mode.

In fact, grocer SUPERVALU (NYSE: SVU  ) recently reported that its item-per-customer sales metric was down, while food stamp usage has risen to the "highest levels since we've been tracking it." Signs of deflation -- that dreaded D-word -- are popping up elsewhere in the consumer landscape. Amazon.com (Nasdaq: AMZN  ) has slashed prices on its Kindle e-reader at what The New York Times calls an "unusual" rate, pushing a price war with Barnes & Noble (NYSE: BKS  ) and Sony (NYSE: SNE  ) into overdrive.

I don't mean to spark a panic here, but for investors whose portfolios are heavily weighted toward U.S. consumer names, I'd digest Kellogg's results as reason for concern. Major concern.

Based on management's downward revised guidance of $3.41-$3.48 in 2010 EPS (excluding currency effects), Kellogg shares are trading at a current-year price-to-earnings ratio of roughly 14. That's below the five-year average and average low P/Es of 17.8 and 15.4, respectively. However, it's a notch above the current fiscal-year multiples of General Mills (NYSE: GIS  ) and J.M. Smucker (NYSE: SJM  ) , both of which I view as better equipped to outperform in an exceedingly tough consumer environment.

Until Tony the Tiger can prove his stripes, Kellogg shares are a hold.

Amazon.com is a Motley Fool Stock Advisor pick. Kellogg is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Mike Pienciak holds no financial interest in any company mentioned in this article. The Fool has a disclosure policy.


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