November 19, 2018

Kellogg Company | K – Update

Q3'18 results indicate the financial reckoning we predicted for Kellogg in April is upon us, and gaining speed. Our conviction has never been higher. We remain short Kellogg.

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On April 26, 2018, Prescience Point published a research paper (the “Initiation Report”) on Kellogg Company (“K”, or “the Company”).  We predicted Kellogg would be forced to (1) reduce FY’2018 guidance and (2) cut its dividend or lose its credit rating.  On 10/31/18, part one of our thesis was proven correct when K slashed its FY’2018 adjusted EBIT and earnings growth guidance.  Part two is still playing out.  While recently announced asset sales, reduced disclosure, and other actions taken to obfuscate underlying results may buy K some time, we believe it only prolongs the inevitable; a dividend cut or credit downgrade.  In this report, we shed light on why K really reduced guidance and explain why we now expect a drawn out and painful period for K shareholders.

Prescience Point Opinions:

  • Revenue growth is a facade, reversal of years of extended DSOs will wreak havoc on growth expectations and cash flow in FY’2019: Years of transitory benefits from extended terms and stuffed channels are starting to unwind and will be an enormous headwind in the near-term. Kellogg can either (1) spend massively on brand-building to maintain sales growth at the expense of margins or (2) let sales growth falter while trying to salvage profitability; these are the best-case scenarios.  We expect revenue growth and margins will both deteriorate.         
  • CAO resignation immediately before guidance cut & working capital “unwind” is highly suspicious: We were already concerned the sudden and peculiar departures of the CEO, CFO, and President of Kellogg North America were a glaring red flag; the resignation of the CAO just months before extremely poor results just adds to our suspicions.
  • FY’2018 adjusted EBIT & earnings growth guidance slashed; K’s explanation for the miss doesn’t make sense, appears deceptive: We find the rationale behind drastically lowering FY’2018 adjusted EBIT margin and earnings guidance suspect and full of contradictions with prior commentary. We don’t believe management is being forthright with investors.
  • North America re-org/supply chain buildout leads to more obfuscation and a likely scapegoat for poor FY’2019 performance: It would not surprise us if these restructuring efforts take longer than the Company anticipates.  We believe this sets the stage for the re-org/supply chain to take the blame for weak results in FY’2019 (and maybe beyond).
  • K remains more levered than meets eye; dividend cut/credit downgrade risk remains high: K generates barely enough cash to cover dividends and other short-term obligations.  Recently announced asset sales are not opportunistic, but necessary to fund buybacks, pay dividends, and shore up balance sheet.
  • Shares are still dramatically overvalued: Based on our adjustments, K is still trading at an unjustifiably high multiple of 14.0x EV/EBITDA, while its adjusted leverage ratio of 4.5x remains in-line with high yield CPG peers.  Consensus continues to take management’s commentary at face value and incorrectly anchors estimates to K guidance; failing to adequately account for the massive unraveling of years of accounting excesses.  We reiterate our price target of $39.50, implying ~35% downside.                 

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