The Special K: Is it Kellogg or Kraft?

Both Kraft Foods Group and Kellogg reported weak sales recently. However, one of them might still be an attractive long-term investment option--but which one?

May 14, 2014 at 9:31PM

Both Kraft Foods Group (NASDAQ:KRFT) and Kellogg (NYSE:K) reported earnings the other week. While both of them reported weak sales and this affected their stock prices, Kraft's shares managed, on May 7, to regain the ground they had lost over the last few days. Kellogg was also still down compared to its price before it announced earnings.

So let's take a look at Kraft Foods Group and compare it to one of its industry peers, Kellogg, in order to see if it is as a good investment option.

Kraft Foods Group: Product innovation is key

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With a $33 billion market cap, Kraft is a food and beverages company (North America's fourth-largest) that was formed in October 2012 when it was spun off from its parent company -- now called Mondelez International. While the latter now controls Kraft´s former global snacks and candies businesses, Kraft Foods Group owns the North American grocery portfolio, which includes beverages, cheese, and convenience meats. In addition to the Kraft brand, the company owns several others, like Oscar Mayer, Maxwell House, and Jell-O.

Although Kraft´s revenue came in low (its sales fell 3.3% in the first quarter, mainly due to a late Easter), earnings growth, fueled by lower overhead costs and an increase in productivity, helped offset the trend. First-quarter earnings of $0.85 per share surpassed the consensus estimate by $0.09. Kellogg's revenue also fell, by 3.1%, on account of the decreasing consumption of breakfast cereal in developed markets. Management expects sales growth to intensify in the ongoing quarter, mainly on the back of a greater advertising budget which aims at incentivizing cereal consumption in the U.S., parts of Europe, and Australia. However, analysts' projections do not look encouraging.

Going forward, analysts expect Kraft's revenue growth to reach 1.6% in 2014 and 2.4% in 2015. However, these discouraging figures find their counterparts in the EPS growth projections. Analysts expect EPS growth of 22.7% for 2014 and 7.80% for 2015 from Kraft, almost tripling the compound growth expected from Kellogg. Over a five year time-frame, analysts anticipate average annual EPS growth rates of around 8%-9% (on the back of cost-saving and efficiency-improving initiatives), which looks just fine, given the limited risk involved in this investment. However, which risks are involved?

The packaged foods company generates the bulk of its sales in North America, a mature, highly competitive market. In addition, about 42% of Kraft´s sales come from its five largest customers (with 25% coming from Wal-Mart). All of these factors not only limit Kraft´s pricing power and margin expansion, they also limit its bargaining conditions. These are further restricted by the increasing commoditization of some of its main products, like packaged meats and cheeses, which account for about 50% of its total sales.

Despite this, the company seems poised to deliver sustainable growth over the next few years. A wide product portfolio and relative scale advantages (especially in the U.S.) provide it with an important lead over most of its competitors, although Kellogg also enjoys these advantages. Furthermore, the latest earnings report revealed an adjusted operating margin of 19.9% (down 70 basis points). 

That decline reflects higher marketing investments, which is usually seen as positive spending. In fact, the company spends about 5% of its annual revenue on product innovation and brand promotion, focusing its resources on a few high-impact product launches. These efforts should drive top-line growth over the medium and long-term, as they have in the past couple of years.

Kellogg and the declining cereal industry
Unlike Kraft, Kellogg offers its products in more than 180 countries and derives about one-third of its sales from international markets. Nonetheless, this kind of reach does not come without risk; currency fluctuations could certainly hurt Kellogg´s earnings. Furthermore, getting the preferences of so many and such different countries right is not always an easy task. In order to better tackle this matter, Kellogg constantly looks to acquire -- or participate in joint ventures with -- local companies around the world.

In addition, strong competition from both branded manufacturers and lower-priced private label products could cap Kellogg's development. Plus input costs continue to rise, forcing the company to either sacrifice its margins or increase its prices, which could in turn affect its sales.

Valuation
Kraft stock trades at 12 times its earnings, while its peers exchange at an average valuation of 17.4 times their earnings and Kellogg trades at 12.5 times its earnings. However, some analysts sustain that the stock is still overvalued in relation to its fair value. Moreover, as explained at MagicDiligence's CAPS Blog, Kraft's real valuation, when pension gains are not included in its EPS, ascends to approximately 21 times the company's earnings.

On the other hand, Kraft yields about 3.75% of its current stock price in the form of quarterly dividends (vs. Kellogg's 2.82%) and boasts a return on equity of 61.3% (vs. Kellogg's 60.5%), which makes it a highly attractive option for income investors. Furthermore, the company expects its cost-saving initiatives to provide it with cash for both reinvestment in the business and returns to shareholders (the distribution will go 50/50), while acquisitions will remain a lower priority.

Foolish Takeaway
Although these companies' valuations can trick you into thinking that they are undervalued, entry points at both of them look somewhat unattractive. However, Kraft holds the better hand as it offers decent growth potential and a "moated" business run by an effective management team. A wide portfolio, scale advantages, and big investments in product innovation and marketing should drive growth over the next few years. In the meantime, a generous dividend yield and share repurchase plans will make your wait worthwhile.

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patricio kehoe has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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