Pandemic conditions, stay-at-home orders and the inevitable economic downturn in the second quarter of this year, and the phased resumption of business around the country have created a dichotomy in the market. Unemployment numbers remain high, and appear likely to remain that way through most of the rest of the year as it is becoming increasingly clear that for many small and medium-sized businesses, a quick turnaround and return to “business as usual” isn’t really in the cards. One of the big reasons is that, while the stock market has rallied strongly off of bear market bottoms in March, the truth is that the risk of COVID-19, and the continued need to maintain social distancing measures isn’t going to go away. I’ve seen reports that many workers who have been furloughed or laid off are also refusing to come back to work when contacted again by employers.
The dichotomy isn’t just in the way the stock market has rebounded and has a number of people talking about accepting higher multiples for stock prices moving forward. It’s also in the way that a lot of people seem to be taking the loosening of restrictions in the country as a sign that the worst is over – and yet there are clear signs in a number of areas in the country that infections are once again on the rise. Does that mean a return to the restrictive conditions that shut down the global economy a quarter ago? Probably not, at least not in its entirety; but I think it does mean that at some point, the market is going to have to concede to the reality that pandemic conditions – which aren’t going to go away quickly, or even this year – mean a return to growth is going to take longer than expected.
I’ve been writing in this space about the value to be found in defensively-positioned industries. One of those is the Food Products industry, where a lot of established brands we all grew up can be found. As recently as last year, a lot of these traditional names were out of favor with the market and with the Millennial generation as being tired, old, and out of touch with the times. One of the specific segments of the industry this has been seen in is in cereal consumption, where consumers have been drifting away from packaged cereal products for more than a year.
The reason I like stocks in this industry is that when economic conditions get tough enough that people start losing their jobs and seeing income levels drop, a lot of assumptions about what is “cool” and “hip” start to go away. That’s because consumers have to start thinking in more drastic, critical terms about how they’re going to tighten their belts to make it through. A lot of the old, “tired” brands that we always saw in our parent’s fridges, freezers and pantries, and that are still around today, start to look a lot more attractive, because in most cases those brands have always been built around value. Tightening the belt often means these products come back into favor since they make it easier for parents to keep their kids fed.
Kellogg Company (K) is a classic example of what I mean. They do a lot more than just cereal, of course, but the truth is that the cereal aisle is where you recognize them the most quickly. After following the broad market to a bearish low around $54, the stock has rebounded almost 25% since March as stocks in the Food Products industry have shifted into favor and outperformed much of the market. Despite that increase in price, the stock is still sitting at pretty attractive valuation levels, with a fundamental profile that has actually improved during the pandemic. That means this is a stock that a smart investor should be paying attention to right now.
Fundamental and Value Profile
Kellogg Company is a manufacturer and marketer of ready-to-eat cereal and convenience foods. The Company’s principal products are ready-to-eat cereals and convenience foods, such as cookies, crackers, savory snacks, toaster pastries, cereal bars, fruit-flavored snacks, frozen waffles and veggie foods. Its segments include U.S. Morning Foods, which includes cereal, toaster pastries, health and wellness bars, and beverages; U.S. Snacks, which includes cookies, crackers, cereal bars, savory snacks and fruit-flavored snacks; U.S. Specialty, which represents food away from home channels, including food service, convenience, vending, Girl Scouts and food manufacturing; North America Other, which includes the U.S. Frozen, Kashi and Canada operating segments; Europe, which consists of European countries; Latin America, which consists of Central and South America and includes Mexico, and Asia Pacific, which consists of Sub-Saharan Africa, Australia and other Asian and Pacific markets. K’s current market cap is $22.3 billion.
Earnings and Sales Growth: Over the last twelve months, earnings declined about -1.98%, while revenues slid about -3% lower. In the last quarter, earnings improved 8.79%, while sales rose 5.86%. The company operates with a margin profile that is strengthening, which is a positive, and somewhat surprising sign since even many of the companies that have outperformed the market in the last quarter have seen margins dip. Over the last twelve months, Net Income during was 7.61% of Revenues, and increased in the last quarter, to 10.17% of Revenues.
Free Cash Flow: K’s free cash flow is about $947 million and translates to a Free Cash Flow Yield of 4.22%.
Dividend Yield: K’s dividend is $2.28 per share, which translates to an annual yield of about 3.48% at the stock’s current price.
Debt to Equity: K has a debt/equity ratio of 2.38. This is a high number, and makes them one of the most heavily leveraged stocks in the Food Products industry. Their balance sheet indicates that in the last quarter, cash and liquid assets were a little over $1 billion, versus $7.6 billion in long-term debt. That actually marks a significant improvement from the latter part of 2019, when cash was $340 million against $8.5 billion in long-term debt. This is a solid confirmation not only that profitability is improving, but also that their balance sheet is getting stronger.
Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but I like to work with a combination of Price/Book and Price/Cash Flow analysis. Together, these measurements provide a long-term, fair value target around $79.50 per share, which means that K is attractively undervalued, with about 22% upside from its current price.
Technical Profile
Here’s a look at the stock’s latest technical chart.
Current Price Action/Trends and Pivots: This chart traces the stock’s movement over the last two years. The diagonal red line traces the stock’s downward slide from a January peak at around $71 to a bear market low around $52.60 in March; it also acts as the baseline for the Fibonacci retracement lines shown on the right side of the chart. The stock rebounded strongly in April, pushing above the 61.8% retracement line and hitting a peak at around $66 before dropping back in May. It used the 50% retracement line around $62 as support late in the month and retested that $66 pivot high, but is currently dropping back a bit from that point. A break above resistance at $66 should give the stock room to test a March high around $69, with the January peak at $71 attainable if bullish momentum remains strong. Current support is at the $64 level; a drop below that point should see the stock fall to about $61 based on prior pivots seen in that range over the last year, with additional downside to as low as $56 if bearish sentiment gains strength.
Near-term Keys: If you’re looking for a short-term, bullish trade, look for a break above resistance at $66 as a good signal to buy the stock or to work with call options, using $69 as a useful, quick-hit profit target. If the stock shows weakness, and pushes below its major support at $64, consider shorting the stock or working with put options, with an eye on $61 to take quick profits. From a long-term view, K is a company that offers a very interesting value proposition and whose fundamentals are improving significantly. That improvement is at least part of the reason for the stock’s performance since March, but it is also a good sign that the stock’s surge since then could extend into a longer, even more useful bullish trend under the right conditions.