It's a compelling argument at first glance. Kellogg's $24 billion market cap is large enough to move the needle at Berkshire. The company fits alongside brands like Coca-Cola (NYSE: KO ) and Heinz as a quality consumer foods company. And free cash flow consistency is top-notch, surpassing $1 billion per year in the past three years.
It seems like a dream company for Berkshire. That is, if you ignore everything Charlie Munger has ever said about cereals.
A competitive disaster waiting to happen
In a now-famous speech to business school students at USC, Munger explained his perspective on the cereal business.
He compares cereals to airlines, noting that the industry is commoditized and highly competitive. Cereals are so commoditized, in fact, that the premium and discount products in any particular category are often made by the same manufacturer.
But I digress; let Charlie Munger do the talking:
[I]n other fields -- like cereals, for example -- almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%. But why are cereals so profitable -- despite the fact that it looks to me like they're competing like crazy with promotions, coupons and everything else? I don't fully understand it.
Obviously, there's a brand identity factor in cereals that doesn't exist in airlines. That must be the main factor that accounts for it.
And maybe the cereal makers by and large have learned to be less crazy about fighting for market share -- because if you get even one person who's hell-bent on gaining market share....For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I'd ruin Kellogg in the process. But I think I could do it.
It's in the last paragraph that I think Munger really hits on the reason why Berkshire Hathaway wouldn't own Kellogg, or any cereal business, for that matter. The product is so commoditized, and consumers are so price sensitive, that one bad actor in the industry could ruin the profits for everyone.
A bet on Kellogg is also a bet on General Mills and the many private-label brands in existence. Once one industry player shoots for market share, rational pricing goes out the window. Declining profits would follow.
While I'm perfectly willing to admit this quote is old -- 20 years old, in fact -- the economics of the business have hardly changed. If anything, the economics are more challenging. Personal incomes have flatlined for more than a decade. Private-label brands have improved in quality and in quantity. And cold cereal volumes have been in a consistent decline, especially among health-conscious families, who take issue with the fact kids' cereals contain up to 56% sugar by weight.
Kellogg passes the smell test for the rumor mill, but it seems unlikely to ever be a Berkshire brand.
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