Kellogg: Perfect Play or Played Out?

In trying times like the ones now giving stockholders indigestion, sector strategists typically direct investors to increase their weighting of consumer staples shares like those of Kellogg (NYSE:K). The logic is clear: As economic risk shakes loose hands from cyclical and otherwise risky shares, suppliers of basic needs often offer safety. On the surface, Kellogg fits the bill. After all, people have to eat. Let's take a closer look to make sure.

Kellogg is the world's leading cereal producer and a significant provider of snack foods. Some of the company's most recognizable brands include Kellogg's, Pop-Tarts, Keebler, Eggo, Nutri-Grain, Rice Krispies, Special K, Mini-Wheats, Famous Amos, and Kashi. When you think cereal, you doubtless think of plenty of great Kellogg's brands like Frosted Flakes, Corn Pops, Frosted Mini-Wheats, and others.

While cereal is a mature market in the U.S., the company has found renewed opportunity through innovation, for instance through health-focused brands like Smart Start. At the same time, the international market offers Kellogg plenty of growth opportunities for its traditional products.

Good signs
The company recently reported second-quarter earnings, exhibiting an ability to move products through established and expanding distribution channels. As a result, Kellogg improved both sales and margins despite rising food cost pressures. Overall sales rose 9%, and after taking out the beneficial impact of currency -- the Michigan-based company sells into Europe, Latin America, and Asia -- "internal sales" rose a still-healthy 6%.

Cereal sales in the mature North American market edged up 3%, as the company benefited from price increases and more sales of new products. Total North American internal sales rose 6%: I believe the company leveraged economies of scope to move higher-margin products through its channels. Internal sales of retail snacks in North America grew 9%, while sales of frozen and specialty channels increased 8%. 

Kellogg International drove sales of 13%, 6% when accounting for currency translation. Cereal sales in the U.K. and double-digit growth in the sales of snack products contributed significantly. During its conference call, management cited solid performance in the U.K., France, Spain, and Italy. While total European internal sales grew 7%, sales in Latin America rose 8% and those in Asia declined 1%.

The gross margin expanded 120 basis points, helped by operating leverage, cost savings, and a favorable impact from pricing actions. However, the operating margin expanded less, by 60 basis points, mostly because of up-front investments in new products and greater advertising spending.

Kellogg's management anticipates increased pressure on food costs in the second half of the year and also sees an impact of $0.26 to $0.30 a share for the full year from cost inflation. This is $0.08 more than it had expected. During the call, management said it anticipated some margin pressure as a result of these factors. Still, it maintained its $2.71 to $2.74 EPS forecast for 2007. 

Not-so-special K
In terms of valuation, it looks like plenty of investors have the same "safety" idea, as Kellogg and its peers seem fully valued. Kellogg is clearly no secret, with P/E and price-to-book ratios atop the small group of close peers we selected. Its dividend doesn't offer anything special compared with peers, either.

So, do we have a great company whose shares are perhaps fully valued or overvalued and may lack the potential for superior appreciation, or is there good reason for the valuation premium and is it sustainable? Also, we must decide whether the industry could experience expanded valuations if the macroeconomic picture weakens further and capital seeks safety.

Foolish final thoughts
I believe a good deal of the value premium Kellogg enjoys is because of management's focus on improving how the company generates free cash flow, and its success in doing so in the past. However, even management agrees that improvement on that opportunity may be limited. For instance, working capital as a percentage of revenue may be tapped out, but in saying so during a recent presentation, management was also clear to point out that it believes that Kellogg is among the leaders in the industry in that area.

This Fool thinks that in light of the likely capital flow into staple names, holding on to Kellogg, despite its valuation, is a good idea. It may in fact be deserved, because the company is so good at generating cash flow. And we definitely like management's style, and the opportunity to grow around the world. Still, we think a closer look at smaller peers might bring to light an individual story offering more of an opportunity to create value -- a new idea with more pep for your portfolio.

For further Foolishness:

• Kellogg Pours a Healthier Bowl
• Kellogg's Q1 Not So Gr-r-reat
• General Mills: Generally Good

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Fool contributor Markos Kaminis has no ownership interest in any of the companies discussed here, but his childhood Wiffle-ball buddies nicknamed him Special K. The Fool has a disclosure policy.