All Signs Point Toward a Bright Future for Kellogg

Kellogg  (NYSE: K  )  is among the world's leading cereal and convenience foods companies. The company's performance was challenged in recent years because of weak consumer spending and input cost inflation. However, the company is likely to expand its margins and earnings in the future due to an expected improvement in consumer spending, decreasing grain (inputs) prices, and increased productivity.

Dropping grain prices
Kellogg will perform better in the future because a drop in grain prices will likely result in gross margin improvement. Corn, wheat, and soybean oil prices recently trended downward. Since the beginning of May last month, prices for corn, wheat, and soybean oil dropped by 11%, 13%, and 11.5%, respectively.

The company expects  low single-digit inflation in 2014. Management believes the company will realize the benefit of the drop in grain prices in the ongoing second quarter, and expects it to result in gross margin expansion of 40-50 basis points in 2014.

Kellogg's margins should improve as key input prices fall, and because of this it can direct its input cost savings toward strengthening its product portfolio and increasing its advertisement and promotional spending. Kellogg could also opt to reduce prices across its product portfolio, which would augur well for its sales volume and market share in upcoming quarters. 

Kellogg's peers, including Post Holdings  (NYSE: POST  )  and General Mills  (NYSE: GIS  ) , are also likely to benefit from a drop in input prices. Post Holdings expects modest net deflation in commodities in the back half of 2014, which is likely to result in gross margin improvement in the second half of 2014. In the recent first calendar quarter, the company observed a 2% decrease in cost of goods sold per pound, which will accelerate further in upcoming quarters due to the input price drop.

General Mills anticipates strong margin expansion in upcoming quarters, as it expects low inflation in the fiscal fourth quarter of 2014. General Mills expects full-year inflation of 3%. Aside from lower input prices, a lower share count and a lower tax rate will drive earnings growth. General Mills has repurchased 29 million shares for a total of $1.4 billion in fiscal 2014 YTD.

The future sales volumes of Kellogg, General Mills, and Post Holdings will also benefit from expected improvements in the U.S. GDP growth rate and consumer spending. The Fed expects U.S. GDP to grow by 2.8%-3% in 2014, in contrast to 1.9% in 2013.

Other earnings growth drivers
Aside from the drop in grain prices, Kellogg's productivity enhancement initiatives remain an important driver of its earnings growth. The company has been working on 'Project K', a $1.4 billion restructuring program, to improve productivity. It anticipates that Project K will result in annualized cost savings of $425-$475 million by 2018. The company is making progress on Project K and remains on track to achieve the target in 2014.

Under Project K, Kellogg generated savings of $15 million in 2013 and expects to generate incremental savings of $50-$60 million in 2014. In order to achieve the desired cost savings under Project K, the company has opted to reduce its workforce, close or reduce facilities in developed markets, and improve its supply chain and distribution in several emerging markets.

The cost savings that Kellogg expects to realize under the program will help expand margins and allow Kellogg to make brand-building investments for the long term. Kellogg is likely to start making these investments in the current second quarter and they will increase over time.

Moreover, the savings will allow the company to make investments consistent with the growth opportunities available throughout the world. Furthermore, management has guided that Kellogg is likely to repurchase 1.5%-2% of its current common shares outstanding, which will prove to be a tailwind for earnings-per-share growth; share repurchases are likely to have a positive impact of $0.08 per share on Kellogg's 2014 EPS.

Final take
Kellogg has struggled to deliver impressive returns for the past few years because of a weak consumer spending environment and input cost inflation. However, the future for Kellogg looks bright because of the drop in grain prices, expected improvements in the U.S. GDP growth rate, and the solid execution of Project K. The company will not only be able to expand its margins and earnings because of cost savings, it will also be able to make brand-building investments that will positively impact its performance in the long term. 

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