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Why Kellogg Is Not A Real Value Stock

A few weeks back we examined Kraft (KRFT), a Magic Formula® Investing (MFI) stock that we were not sure deserved that status. Sure enough, we found that Kraft's treatment of pension assets severely skewed the results of its underlying businesses, making the stock look far cheaper than it actually was. It has performed fairly well since, but NOT because of a deep value valuation.

Today I want to examine another, very similar MFI entrant, Kellogg (K). If this is truly a value stock, I'm interested. But is it really?

Everyone Knows Kellogg

... so let's just go over the basics here. Kellogg is a packaged food manufacturer, with its major product lines being: cereals (Raisin Bran, Special K, Frosted Flakes, and about a dozen others) at 44% of total sales; snacks (Pringles, Keebler, Nutri-Grain, etc.) at 45%; and frozen/specialty (Eggo, Morningstar Farms) comes in at about 12%.

Companies like Kellogg are very attractive for a number of reasons. One, food is largely recession proof... Kellogg's revenues during the 2009 recession fell less than 2%. Two, the firm's market position and portfolio of top notch consumer brands (Kellogg is the #1 cereal maker and #2 in snacks behind Pepsico) give it a solid economic moat against competitors. Finally, the company pays a decent 2.8% dividend yield that has been raised every year over the past decade.

Why The Stock Is Not That Cheap

At first blush, Kellogg seems to fulfill the attributes of a value stock. Its P/E ratio is 12.5, well below the S&P 500's 17.0. Its EBIT/EV earnings yield, at 9%, is reasonably cheap for the current market and very cheap for the quality of the business.

However, like Kraft, Kellogg insists on throwing mark-to-market effects of its pension plan assets right into its selling, general and administrative accounting line item. This introduces a significant amount of volatility into what should be very stable and easy-to-predict operating margins. Observe:

MetricWith PensionWithout Pension
Operating Margin20.1%12.8%
Earnings Yield9.0%5.7%

Like Kraft, the excellent investment market in 2013 led to a swelling of pension assets - almost $1.1 billion in Kellogg's case. This adds a lot of non-recurring, non-operating "income" to the company's profit and loss statement.

Unfortunately, it also skews the Magic Formula statistics. Without pension effects, Kellogg's earnings yield falls to 5.7%, which wouldn't get the stock anywhere near MFI. It just really isn't that cheap at present.

What Is It Worth?

No MagicDiligence stock analysis would be complete without a stab at a fair value price, so let's do the exercise now.

Kellogg has fairly predictably grown its revenue at about a 2-5% annual rate for a decade, and I see this continuing at the low end of the range, driven by price increases and acquisitions to fill out its portfolio of brands. Kellogg has been investing in "Project K" to drive operating efficiencies, but I don't see operating margins budging much given competitive pressures and rising food costs. Kellogg has been a modest share repurchaser, with share count down about 1% annually since 2009, and the dividend will likely continue to be increased by 2-4% per year.

Put it all together and we get about 4-6% annual earnings growth. Using a 10% discount rate and assuming about a 6.5% earnings yield for the stock (in line with its 6.7% 5-year average), I get a target price of about $60 per share. That puts Kellogg into the "overvalued" bucket at present. This is one MFI stock that does not look particularly attractive at current prices.

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