Iconic food maker Kellogg (K 0.38%) had a tough year in 2021. Investors were very downbeat on the stock, with the share prices up just 3.5% or so when the S&P 500 index gained 14%. Meanwhile, the consumer staples group, using Consumer Staples Select Sector SPDR ETF as a proxy, rose a huge 27%. So it makes some sense that Kellogg is looking to make changes, but the path that management has decided on is a huge shift. Is it a good direction?
The problem
One of the biggest headwinds for Kellogg in 2021 was its U.S. cereal business. This category of the food sector is not exactly known for being a highflier. In fact, the niche has been kind of out of favor for years as consumers shifted toward other breakfast options. Although cereal is bouncing back some now, the biggest fight in the cereal aisle over the past few years has really been over market share as players fight for a piece of consumers' wallets.
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In 2021 Kellogg had one arm tied behind its back as it fought. That was because there was a fire at one of its plants, limiting its ability to supply customers with products. And then there was the strike that closed all of its U.S. cereal plants, which further curtailed its ability to fulfill demand. Without products on the shelf, it simply couldn't keep up with peers. To be fair, Kellogg has experienced a long-term decline in market share in cereal. That's bad, but not unusual when you have intensely competitive markets. Given Kellogg's long history in cereal, it's likely that it will eventually figure out how to gain back what it has lost.
Another headwind for Kellogg has been in the fast-growing plant-based protein space, where it competes with its Morningstar Farms brand. Although the brand has been doing well overall, Kellogg didn't have the capacity it needed to keep up with demand. All in, meanwhile, this is a pretty tiny brand, with sales of just $340 million. That makes it hard to stand out in a company with around $14 billion in sales that is dealing with a troubled U.S. cereal division that generates $2.4 billion of that total.
The solution
The long-term shift at Kellogg has been for the company to sell slower-growing brands and products, like Keebler cookies, while shifting into higher-growth categories, such as snacks like Pringles. That transition has largely taken place, though the timing of the shift basically coincided with the start of the coronavirus pandemic. That made it more difficult to suss out the success the company was having because of the impact on consumer buying habits during the early days of the health scare. However, the higher-growth investments have largely lived up to expectations.
Cereal has lagged behind and isn't expected to match snacks even when its operations are back to normal. So management is spinning off the U.S. cereal business as a stand-alone entity. It makes up around 17% of sales and 10% of earnings before interest, taxes, depreciation, and amortization (EBITDA). It is a sizable business, and the company was founded around it, but it's clearly not the driving force for Kellogg anymore. That said, because the division is working back from difficulties, organic sales look pretty good right now, up 8% year over year in the second quarter. While that lagged the 18% organic sales gain in snacks, Kellogg's namesake cereal products are clearly back on their front foot. It looks like now is a good time to make this move because investors will be more receptive in the face of business strength than they would in the face of weakness.
Tiny Morningstar Farms is also going to get spun off or sold. The idea is that under a more focused management the brand will get the attention it needs to grow, which makes sense. With consumers still interested in the non-meat protein space, now appears a good time to make this change, as well.
What will remain behind at Kellogg, which may change its name, will be higher-growth snacks and higher-growth foreign businesses (notably in emerging markets). It is basically keeping its biggest and best brands. That seems fairly compelling for investors, as it will make far more clear the growth the company has built into its business.
There's one problem left to consider
All of that said, Kellogg's shares have been doing quite well in 2022, with its stock up 16% while the S&P and the broader consumer staples space are both down for the year. So Wall Street appears to approve of the plan, which is good for investors. However, if you are an income investor, you need to watch what happens on the dividend front. Kellogg is lopping off a material division and it could end up cutting the dividend as part of a larger corporate reset. It might be worth holding through that, but it is a potential negative to watch for so you aren't surprised if your quarterly check comes up lighter than expected.
