Throughout the last several months, it has been interesting to sit back and observe the dichotomy between price action in the stock market and actual economic growth. Increasing infection rates across the United States along with still historically high unemployment numbers showing that economic recovery is much slower than the market would prefer to see. With extended unemployment benefits that helped a lot of struggling, out-of-work Americans get by expiring while politicians continue to bicker about the need for additional benefits on any kind of basis, targeted or otherwise, many experts are forecasting that things will only get tougher as we move into the colder months of the year. In the meantime, the market has picked up a new wave of bullish momentum that is pushing the major market averages near to their latest all-time highs yet again.
The dichotomy isn’t just in the way the stock market has rebounded with an increasing number of analysts talking about accepting higher multiples for stock prices moving forward. It’s also in the way what I like to call “COVID exhaustion” is more and more of a thing. Tired of restrictive conditions that include social distancing, mask-wearing and working from home, more and more people just seem to be ignoring infection rates and trying to resume normal activities. The celebration in Los Angeles of the Lakers’ NBA title win Sunday night, where thousands thronged the streets, many without masks and practically no attempt to social distance is just the most obvious recent example. What does this mean for the economy going forward? While it’s clear that the world isn’t likely to go back to the kind of stay-at-home restrictions we dealt with earlier this year, I do think that small business activity will remain depressed and unemployment is going to remain high. I don’t think the United States is going to chart a quick path to the end of the pandemic – even if optimistic forecasts about COVID vaccines prove true.
I’ve been writing in this space throughout the year 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 peaked at a July high at around $73 – which was actually above its pre-pandemic high – before dropping back to a recent pivot low around $61. The stock has picked up some bullish momentum since then, but is still several dollar below that high point. Even with the stock’s recent rally it is still offering a pretty attractive valuation level, with a fundamental profile that has actually improved during the pandemic, with management putting a specific focus on cost control, debt management and dividend maintenance. 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 $22.8 billion.
Earnings and Sales Growth: Over the last twelve months, earnings increased a little over 25%, while revenues were flat, but positive by 0.12%. In the last quarter, earnings improved 25.25%, while sales rose 1.55%. The company operates with a margin profile that is strengthening, which is a positive, and somewhat surprising sign since 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 8.09% of Revenues, and increased in the last quarter, to 10.13% of Revenues.
Free Cash Flow: K’s free cash flow is about $1.1 billion and translates to a Free Cash Flow Yield of 4.99%. The yield is modest, but the total number also marks an improvement from $947 million int the quarter prior and $590 million at the beginning of 2020.
Dividend Yield: K’s dividend is $2.28 per share, which translates to an annual yield of about 3.46% at the stock’s current price. Management’s stated priorities right now are debt reduction first (which is covered next), and paying its dividend. I think it is noteworthy that these are priorities over capital expenditures, mergers and acquisition (M&A), and share repurchases. It underscores the disciplined approach management is taking to keep the company operating successfully in the midst of broadly difficult economic conditions.
Debt to Equity: K has a debt/equity ratio of 2.03. This is a high number, and makes them one of the most heavily leveraged stocks in the Food Products industry; but it really doesn’t tell the most important part of the debt story. Their balance sheet indicates that in the last quarter, cash and liquid assets were a little over $1.2 billion, versus $6.9 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, and the last quarter when cash was just a little over $1 billion and long-term debt was around $7.6 billion. 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 $106 per share, which means that K is extremely undervalued, with about 59% 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 year. The diagonal red line traces the stock’s upward trend from its March, bear market low around $53 to its late July peak at around $73. It also provides the baseline for the Fibonacci retracement lines shown on the right side of the chart. From that July high point, the stock retraced back to the 61.8% retracement line before bouncing, and in the last couple of days has pushed back above the 38.2% retracement line at around $65. That puts support back at that most recent resistance at $65, with new, immediate resistance at around $68. A continued push above that level should see the stock test its 52-week high around $73, while a drop below $65 could give the stock room to drop to somewhere between $62 and $63 before finding new support, with additional downside to around $60 if bearish momentum accelerates.
Near-term Keys: If you’re looking for a short-term, bullish trade, you could use the stock’s current momentum to consider buying the stock or working with call options, using $68 to $69 as a useful initial profit target, and $73 beyond that point if bullish momentum picks up. If the stock reverses its bullish momentum and starts to show weakness, use a drop below $65 to consider shorting the stock or working with put options, with an eye on $62 to take quick profits or $60 if bearish momentum accelerates. From a long-term view, K is a company that offers a compelling value proposition and whose fundamentals are improving significantly. That improvement is at least part of the reason for the stock’s current bullish momentum, but it is also a good sign that the stock’s current, short-term rally could extend into a longer, even more useful bullish trend.