Drip Portfolio Report
Wednesday, November 26, 1997
by Jeff Fischer (TMFJeff@aol.com)

ALEXANDRIA, VA (Nov. 26, 1997) -- Yum. Reading and writing about Kellogg makes me hungry. As we continue to spoon through leading food and beverage companies (with Campbell, Bud, and -- no surprise -- Coca-Cola all looking tasty), now it's time to look at the Cereal King. Let's see how Mr. Cereal King compares to Mr. Almost Cereal King -- #2 General Mills -- following Tuesday's review of that company.

Oh, first -- Happy Thanksgiving! Anybody here to read that? Hello? Anyone?


The Cereal King: Kellogg (NYSE: K)

Description: Kellogg's first product was developed by mistake. The story is interesting enough to plagiarize it right here: "W. K. Kellogg first made wheat flakes in 1894 while working for his brother, Dr. John Kellogg, at Battle Creek's famed homeopathic sanitarium. While doing an experiment with grains (for patients' diets) the 2 men were interrupted; by the time they returned to the dough, it had absorbed water. They rolled it anyway, toasted the result, and accidentally created the first flaked cereal."

The company now sells 12 of the most popular cereals in the world and has a 40% share of the world's cereal market.

Major brands include: Kellogg's Corn Flakes (#1 in the world, simple as it is), Rice Krispies, Raisin Bran, Froot Loops, Frosted Flakes (#1 in the U.S.), Apple Jacks, and Special K. Kellogg also sells Eggo waffles, Lender's Bagels, Nutri-Grain cereal bars, and Pop-Tarts, to name a few of the unhealthy convenience foods that the company pushes on unsuspecting consumers (just kidding -- Nutri-Grain is healthy).

Core Moneymaker: A majority of the Cereal King's $6.6 billion in fiscal '96 sales came from selling _____________. (Fill in the blank.)

Financials: If you've been reading the column for the past week, you certainly don't want to read the following general paragraph again! The one after it is interesting, though. But first, here goes...

Because this is an overview, we'll only look at a few key things: how is the company priced relative to sales, earnings per share, and the expected growth rate (valuation); what are the current operating and net margins (margins); how much long-term debt does the company have (leverage); and what does management do with the cash that it generates (capital allocation).

Valuation and Growth, and Share Performance: At $45 1/2 per share, Kellogg's market cap is $18.7 billion (share price multiplied by 410 million shares outstanding). With trailing sales of $6.7 billion, the company trades at 2.79 times sales.

Tony the Tiger has $203 million in cash and $1.2 billion in long-term debt. Any acquiring company would consider the cash and debt in its valuation of Kellogg, so we subtract the cash and add the debt to the market cap to get a more accurate value for the company -- the enterprise value. (An acquiring company would get the cash and have to pay the debt, so it needs to include these when valuing the company.) The enterprise value of Kellogg is closer to $19.7 billion, and that value in relation to sales is 2.94. This is moderately higher than average.

On the earnings per share side, Kellogg trades at 30.4 times trailing earnings. While anticipated to grow earnings per share 10% annually for the next five years, the stock trades at 26.5 times earnings estimates for this year, and 23.9 times fiscal 1998 estimates. Over the past ten years the stock's price-to-earnings multiple has ranged from 12 (in 1987) to 35 (last year). It's definitely been on the high end of the range the past few years, even with a flat stock price.

You'd think that a leading name like Kellogg would perform well in this soaring bull market, but over the last five years the stock has returned only 5.9% annually. The company has been facing some of the same pressures as General Mills, covered on Tuesday. Namely, cereal prices haven't risen at a rate even equal to the tame rate of inflation, but have actually declined, while competition has heated up. It was only in the last twelve months that a soggy Kellogg stock finally became crispy again and gained 26%.This still leaves the stock well behind the S&P 500, which has gained over 107% in the last three years. (This type of dull performance is what we're trying to avoid with our new investments, because once you have such a slow of a start -- even in a twenty-year investment -- it would take real fireworks for a large cap company to over-compensate for those years of underperformance in the following years.)

Margins Reviewed: Again, operating earnings divided by revenue gives us the operating margins. This number shows what the company is earning after the cost of the product and all the costs of running the business are subtracted. It indicates how efficient management is at running the business "operations" -- hence, operating margins.

For the last twelve months, Kellogg had $6.7 billion in sales and $1.1 billion in operating income, giving operating margins of 16.8%. These are decent. General Mills (NYSE: GIS) had 15.4%, Campbell Soup (NYSE: CPB) and Anheuser Busch (NYSE: BUD) 18%, and Coca-Cola (NYSE: KO) is at 27%. Johnson & Johnson's are 22% and Intel's 41%.

Leverage reviewed: With $1.2 billion in long-term debt and $6.7 billion in sales, Kellogg has a 17.9% debt-to-sales ratio. This is fair. Nothing to write home about.

Capital allocation: Management pays a moderate 1.9% dividend. Similar to General Mills, Kellogg needs to constantly invest in marketing its brand names, while pricing continues to present challenges. In Britain Kellogg has lost market share to strong competition, while Philip Morris (NYSE: MO) has taken market share in the U.S. with price cuts. To stem some of these problems, Kellogg recently targeted markets in Asia (uh-oh!). The currency situation doesn't presently bode well for substantial profits in the Pacific Rim. Overall, the company will continue to fight for mind share and market share with new products and heavy promotion. Volume must compensate for stale or declining pricing environments.

The Snapshot for The Cereal King:

Ticker: K
Recent Price: $45.50

Trailing 12-month sales: $6.7 billion
Trailing 12-month oper. earnings: $1.2 billion
Operating Margins: 16.8%
Trailing 12-month EPS: $1.49

Fiscal '97 EPS estimates: $1.72
Fiscal '98 EPS estimates: $1.90

Enterprise value to sales: 2.94
Current P/E: 30.4
P/E on 1998 EPS: 26.5
P/E on 1999 EPS: 23.9
Long-term expected growth rate: 10%
Yield: 1.90%

Conclusion: Much like General Mills, the Kellogg brand name is of no question. It's great. But the business itself isn't as strong as we'd like to see. We all know that a box of good cereal is pretty damn expensive. With the high prices, you'd think that margins in the industry would be better. They're strong, but not blowout. So where will margins go next?

Perhaps most worrisome is that there is room for margins to move lower if the competition is willing, and as resurgent price wars have proven, some competitors are willing. Meanwhile, that generic box of corn flakes sure looks inexpensive sitting there on the shelf next to Kellogg's Corn Flakes. With 40% of the market, Kellogg arguably has the most to lose in price wars and to generics. That, and -- this is minor and a questionable point -- the country has gone from a "cereal and milk" breakfast culture to a "coffee and bagel" breakfast culture in short order. What changing tastes in breakfast will mean for the industry years down the road -- maybe nothing -- is something to at least think about over coffee and a bagel some morning. What are your habits telling you?

Companies that primarily sell cereal are not making the cut to our food list for these reasons:

1. Slow sales growth.
2. Competitive pricing and product environment.
3. Little chance of improving gross margins.
4. Above average valuations.

Tomorrow is Thanksgiving. Have a great one. We'll be back on Friday with extreme Foolery. Hope to see you then or over the weekend. Meantime, see you on the Fool's new Web message boards or on AOL's boards.

Fool on!


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Stock   Close    Change
INTC  $76 5/8    +3/16
JNJ   $62 11/16  -1 5/16
            Day    Month   Year    History
Drip     0.19%    (2.28%) (10.97%) (10.97%)
S&P 500  0.09%     4.05%   28.47%    0.03% 
Nasdaq   0.34%     0.06%   23.51%    0.04%    

Last Rec'd   Total #   Security   In At   Current
11/03/97      4.835     INTC     $81.623   $76.625
11/14/97      1.000     JNJ      $62.125   $64.688

Last Rec'd  Total#  Security  In At    Value   Change
11/03/97      4.835   INTC   $394.69  $370.52 ($24.17)
11/14/97      1.000   JNJ     $62.13   $64.69   $2.56     

Base:   $900.00
Cash:   $389.75**
Total:  $824.96

GOAL: The portfolio began with $500 on July 28, 1997, 
adds $100 on the 15th of every month, and the goal 
is to grow the port to $150,000 by August of the year 2017. 

**Transactions in progress:
11/24/97: $100 sent to purchase more Intel.

The Drip Portfolio has been divided into 
37.063 shares with an average purchase
price of $24.283 per share.