Description

Overview

No one is eating cereal multiple times a day like we did during COVID… nor college… nor before GLP-1s nor the higher adoption of low carb diets, nor before better parenting slowed the sugar-laden bowls of “whole grains” to kids.  Plainly, cereal is in slow secular decline in America, and WK Kellogg (KLG) is a melting ice cube short that just came out of the freezer and is here to thaw in the closet.  We expect continued volume declines, a lack of pricing power and structural cost un-competitiveness that drive the stock down 50% – or worse with the future balance sheet leverage and eventual union negotiation.

Kellogg’s cereal brands include Frosted Flakes, Special K, Froot Loops, Raisin Bran, Frosted Mini-Wheats, Rice Krispies, Kashi, Corn Flakes and Apple Jacks.  In 2023, the company did $2.76B of sales and $258mm of EBITDA making ~800mm lbs of cereal. 

Thesis

Kellogg’s is solely the North America cereal business that was spun out of parent Kellanova, which levered up KLG and dumped it to public shareholders because there’s no growth and a massive investment required to hopefully turn it around.  In the meantime, KLG is at the nexus of CPG companies that are facing lower demand and got too aggressive increasing prices on weakening consumers. 

1. This is a no growth market, and KLG is losing share
2. There is no pricing left in the industry
3. KLG’s costs are substantial and increasing à recent margin outperformance is temporary
4. Reinventing the manufacturing base will cost materially more than KLG has proposed
5. Management is not credible, and their YE 2026 margins targets are highly unrealistic

Detail

1.  The cereal market has been a LSD% decliner since pre-COVID.  This is not just COVID normalization.  Secular trends are at play, as discussed above.

• In a market that is flat to shrinking (1)% in aggregate over the medium term, KLG has been ceding share to private label and will continue to do so. 
• Without the umbrella of Kellanova, KLG loses the broader insulation of other, growing areas of packaged foods and lacks the capacity to compete with larger, more diversified and highly cost-advantaged peers of General Mills and Post.
• Consumers are weaker and trading down and spending more on private label, the penetration of which still has plenty of room to increase. 

2. Cereal prices are up ~35-40% vs. pre-COVID, and KLG itself, competitors and retailers have all said they have pushed pricing as much as they can

• We’d note prices are effectively higher with promotions still well below 2019 levels.  If the market gets more competitive to keep plants full, we’d expect KLG to see further pressures.

• We assume pricing is 0% and volumes decline at 1%, though 2024 is off to an even worse start YTD for KLG, despite a likely bump from Quaker Oats’ salmonella issues in late 2023.

3.  KLG’s costs are largely fixed and higher than peers which will continue to weigh on profitability

• 2023 COGS ex-D&A were just ~$1.95B (>70% of sales)
• Rough breakdown of costs from our VAR:

• Labor = ~$550mm in COGS (>20% of sales)
  • Nearly half the entire company’s employees (1,400+) are unionized
  • KLG’s highest cost plants labor contracts provided wages + benefits that are ~$85-90 / hr vs. an industry that is closer to ~$50 à 4 of their 6 plants have uncompetitive labor costs
  • KLG folded in their 2021 negotiation with the union and did not take the opportunity to shut down its Battle Creek plant.  That is THE plant they theoretically need to shutter, but they don’t have the spine to do it.
  • The current union contract expires in 2026 and is a sword of Damocles
  • There is not a lot of redundancy across facilities to shutdown single plants without losing sales
    • Raisin Bran is manufactured solely in Battle Creek, and their flanker brands outside “the big 6” are all done in single plants.
  • Every 1% labor inflation is a 25bp headwind on flat volumes.  We assume 3% wage inflation, creating a 75bp headwind
• Variable costs will suffer due to the loss of scale and dissynergies following the expiration of the Transition Services Agreement (TSA) where KLG currently benefits from Kellanova’s scaled procurement
  • Packaging precedent from KFT/MDLZ spin suggests a 10% pricing headwind, or ~100bps headwind once the TSAs roll off.  Packaging companies have also been
  • Minor ingredients (~10% of COGS) – conversations with formers in CPG supply chain suggest they likely lose at least another 10% here as well on vitamins, minerals, emulsifiers, etc.
  • Commodities – we believe the majority of margin “progress” thus far has been the result of commodity price declines (corn, wheat) which won’t persist into perpetuity.  Nonetheless, we implicitly assume they don’t become an incremental headwind.
• In aggregate, we see ~$70mm of gross margin headwinds from spin-dissynergies and labor inflation, and that’s assuming volumes are flat… and recall, they are declining.
• Advertising was $206mm in 2023, or ~9% of sales – while this sounds high, recall, they are much smaller than competitors, and shrinking the budget makes them irrelevant
  • We view the ad budget as essentially fixed
• Likewise the R&D budget at $27mm, <1% of sales, can’t get much lower

4.  KLG management has announced a vague plan to spend $450-500mm to reinvent their supply chain and drive 500bps of margin expansion – we think they’re high on sugar.

• This management and board have been in place for a year, and they haven’t announced what the plans are for their reinvention
• We don’t see how they can spend ~$500mm to build a new plant and get a ~$115mm return on capital in year 1, or a ~20-25% return on that capital – the implied uplift vs. their 2023 guide.  And that’s net of any dissynergies from moving volumes from existing plants. 
  • Our conversations suggest steady-state Y4 ROICs at non-union plants are in the 20% range, NOT year 1
• KLG can’t just invest in new equipment at the existing facilities due to the unionized labor – they need new plants in new geographies
• So with that in mind, gross PP&E is ~$2.7B, including $1.8B of machinery and equipment that’s probably close to 30 years old
  • VAR suggests that to rebuild the network from scratch with new plants in non-unionized geographies would be ~$2B, not too far from their undepreciated (and very old) cost base…
  • And that’s precisely what previous supply chain managers proposed, but Kellanova didn’t want to spend that capital

5.  This brings us back to management…  

• The CEO is the former Kellanova corporate lawyer with no operating experience
• The VP of Supply Chain (reportedly very smart) was a former plant manager, but she has never run a full supply chain before
• Frankly, we think that’s all we need to know.

The Numbers

Putting it all together, with volume declines and cost inflation, we think sales are ~$2.6B in 2026+.  With $70mm+ of cost inflation – before any union renegotiation in 2026 – and deleveraging on other $230mm of fixed costs, they will need to find $150-200mm in cost savings to hit their targets and street numbers.  Meanwhile, if they spend the $500mm on capex, pro forma leverage would be ~4x, or ~$1B, and they would be generating ~$75mm in free cash flow annually.  We think they will tread water at this $250mm level after the capex, and they are a dead man walking.  PF for the capex outlay, KLG is a $2.5B EV, or 10x EBITDA.  For a negative growth, over-levered CPG company, we don’t see why anyone would pay much more than option value, and we think the stock has 50% downside, potentially more after the union negotiation. 

Even if PE wanted LBO this company, there’s not much upside in an LBO.  We struggle to make the math work at $20, even using generous exit multiples.

Disclosure

At the time of its publication, funds and accounts managed by the author’s employer were short KLG.  Both before and after the publication of this post, without making any public or other disclosure or giving notice to any party, except as may be required by applicable law, such funds and accounts may, at any time, buy and sell securities of KLG (and other companies mentioned in this post), including by changing to a long in KLG. The information set forth in this post does not constitute a recommendation to buy or sell any security, or legal, tax, investment or other advice. This post represents the opinion of the author as of the date of this post. This post contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential,” “outlook,” “forecast,” “plan” and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This post is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. The author makes no representation as to the accuracy or completeness of the information set forth in this post and undertakes no duty to update its contents.

Catalyst

announcement of larger capital spend w/leverage hitting the balance sheet, cut guidance, earnings misses