Should You Acquire Kellogg?

Berkshire Hathaway has been rumored to be looking at Kellogg as a potential acquisition. Maybe the cereal maker should be on your list too.

Jul 21, 2014 at 6:22PM

Kellogg (NYSE:K) has been rumored to be on Berkshire Hathaway's list of potential acquisitions, and for good reason. The cereal maker generates stellar returns on equity as well as capital, and perennially yields free cash flow. Nonetheless, these characteristics alone do not mean Kellogg's stock is a great buy. The stock's valuation has to align with its superior investment returns and financial position to make it a worthwhile buy.

Perhaps some of Kellogg's competitors such as Kraft Foods Group (NASDAQ:KRFT), ConAgra Foods (NYSE:CAG), or General Mills (NYSE:GIS) would be better investments -- even if they have lower investment returns or inferior financial positions.

Not really any bad apples

 

ROE (5-yr. avg.)

ROC (5-yr. avg.)

Debt/Equity

FCF positive (5 yrs.)

Kellogg

58.2

17.6

1.54

Yes

Kraft

29.78*

14.71*

1.88

Yes*

ConAgra

15.5

9.6

1.56

No

General Mills

28

14.1

1.14

Yes

Data Sources: MSN Money & Morningstar (ROE & ROC in %)

*Kraft separated into Kraft Foods Group & Mondelez, so only three fiscal years are available for Kraft as a separate company.

Kellogg has generated a remarkable 58.2% average return on equity, or ROE, over the last five years and the other companies have generated solid returns on equity as well, but to a lesser degree. Moreover, Kellogg's ROE is almost double the industry average of 29.14 %. Management can manipulate return on equity, however, by using debt to decrease equity while maintaining relatively stable earnings. Therefore, return on capital, or ROC, is an important metric to help investors discern the amount of earnings a company generates over its equity and debt capital bases.

Kellogg maintained its superior reputation by generating the highest average return on capital over the last five years among the four companies; its ROC of 17.6% over the last five years is significantly above the industry average of 12.82%. Its superior average ROC is also a good metric for the company as it carries a significant amount of debt with a debt/equity ratio of 1.54. Moreover, Kellogg has been free cash flow positive looking back five years, which gives it the cash to service any debt.

What about valuation?

 

P/E

Forward P/E

P/CF

EV/EBITDA

Kellogg

12.6

15.6

13.7

8.1

Kraft

13

17.4

17.4

8.4

ConAgra

16.1

12.9

8.4

14

General Mills

19.5

16.5

13.5

11.6

Data Source: Yahoo Finance & Morningstar

Both Kellogg and Kraft carry similar valuations on a P/E basis, and their P/E multiples are both under the industry average of 19.7 and the S&P 500 average of 18.6. ConAgra's P/E is also below both averages but is slightly higher than those of Kellogg and Kraft. ConAgra looks the most attractive on a forward P/E basis but the other companies are not far behind, and Kellogg has a modest forward P/E at 15.6.

ConAgra is the cheapest stock on a cash flow basis with a P/CF of 8.4, while Kellogg and General Mills are not far behind with P/CF ratios of 13.7 and 13.5, respectively. The opposite is true on an EV/EBITDA basis with ConAgra being the most expensive stock on this basis. Kellogg has the cheapest valuation with an EV/EBITDA multiple of 8.1, with Kraft about the same at 8.4.

Which one should you buy?
Kellogg's average ROE over the last five years is truly outstanding at around double the industry average. Kraft has generated an average ROE over that same span which is just above the industry average, but it is still far under that of Kellogg. The companies' returns on capital are more bunched together, but Kellogg still comes out ahead by generating the greatest returns over its total investor base among the four companies.

Kellogg carries a substantial debt load, but it is evident from its ROC and free cash flow generation that this is not a problem for the company. The company also looks attractive on a valuation basis and none of its competitors really outshine the company on a combined valuation and financial profile basis. Although the other companies are good in their own right, Kellogg appears to be the best investment when considering the valuation and return metrics explored here.

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Andrew Sebastian 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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