K - Kellanova: An Intriguing Spinoff Of WK Kellogg

2023-10-03 16:28:09 ET

Summary

• Kellanova has spun off its WK Kellogg Co business, with investors receiving one share in WK Kellogg for every four shares owned in Kellanova.
• WK Kellogg is a $2.7 billion business focused on cereal, with plans to turn around its business in a huge way in the coming years.
• Kellanova is the larger remaining business, expected to generate $13 billion in sales this year and trade at a reasonable multiple.

The start of the fourth quarter makes a busy time for corporate America, with many big firms announcing substantial spin-offs of their businesses.

Kellanova ( K ) , to many people still better known as Kellogg's, has spun off its WK Kellogg Co (KLG) business. The separation was approved by the board in September, and investors in Kellanova will receive one (1) share in WK Kellogg for every four (4) shares owned in Kellanova.

With the combination seeing further share price declines, I am quite compelled to shares of both firms, one struggling turnaround story and a better-positioned diversified food business, although I want to see some results post the spinoff before considering an allocation in either of these firms.

About WK Kellogg

In a recent investor presentation , WK Kellogg describes itself as a 117-year-old start-up, once being the core of Kellogg's as a pure play on cereal. WK Kellogg is a $2.7 billion business which employs some 3,000 workers and produces some 800 million pounds of cereals each year. The company is a North American play on cereal, with U.S. retail operations responsible for about 80% of sales, complemented by other U.S. operations as well as minor activities in Canada and the Caribbean.

The company is a bundle of cereal brands which includes Kellogg's, but many variants like Frosted Flakes, Special K, Froot Loops, Pops, and many other varieties. Despite waning popularity, cereals remain the breakfast of choice among many children and adults, and WK Kellogg plays a major role in this, with over 60% household penetration.

In terms of the financial picture, it has been quite a mixed bag in recent years. In the pandemic year 2020, WK Kellogg's reported $2.8 billion in sales and EBITDA margins coming in just a few basis points short of 10%. Sales fell to $2.4 billion in 2021, as EBITDA margins fell to just 2% and change. Last year, sales recovered to $2.7 billion with EBITDA margins of 6.5% resulting in an EBITDA number close to $175 million.

For the fiscal year 2024, WK Kellogg aims to post flattish sales at $2.7 billion, but EBITDA is seen around $260 million, with margins near 10%. Following a massively required upgrade, and nearly half a billion investment program in the coming three years, the idea is to grow EBITDA margins to the mid-teens, which over time might result in $400 million in EBITDA.

Operating with a $465 million net cash position, the company claims 2 times gross leverage based on a gross debt load of $500 million, which reveals that the company works with a $250 million EBITDA number, an achievement of course not seen just yet. Of course, the near-term outlook will be a bit sloppy with standalone costs to be incurred, as well as further separation costs seen, all while the investment requirements will weigh on cash flows in the years to come.

With its former parent Kellanova operating with 342 million shares outstanding following the offering, an estimated 85.5 million shares of WK Kellogg will be trading here. Trading around $15 based on the pre-split trading, shares now trade at $11 and change, granting the business a roughly billion valuation, or $1.5 billion valuation if we factor in net debt. Needless to say, valuations look quite non-demanding, certainly if the company can revamp the business.

With a $250 million EBITDA number, I arrive at pre-tax earnings of around $100 million after accounting for separation costs, interest rates, and statutory tax rates might result in net earnings of $75 million, just shy of a dollar. This makes it understandable why shares trade at $11 and change, given the dismal performance of the unit, but a turnaround could do wonders here.

About Kellanova

Kellanova is the remaining business, which is much larger, of course. The company generates pro forma sales of $13 billion and EBITDA of around $2 billion, with the business having a stronghold in snacks. Brands like Pringles, Pop-Tarts, RX Bar, and Cheez-It are responsible for about 60% of sales.

This is complemented by frozen foods, noodles & others, and the international retail business. Besides the better diversification in end categories, the company is split pretty even between North American and International operations, creating a more balanced and higher growth opportunity as well.

Excluding WK Kellogg, the business is on track to generate about $13 billion in sales this year. Adjusted operating profits are seen at $1.75 billion, which results in earnings of around $3.35 per share. While WK Kellogg is a real turnaround story, Kellanova is expected to be a secular growth play, more to the likes of well-run businesses like PepsiCo ( PEP ) .

Shares of Kellanova have fallen from the $60 mark to $53 here. This is quite telling, as shares of WK Kellogg trade at $11, and change given the exchange ratio, every investor in Kellanova owns about $3 per share in value for every share which they own in Kellanova. With shares of Kellanova down some seven dollars, it is clear that the market sees this as a negative.

Based on a share price of $53 and about $3.35 per share in earnings power, the better-positioned Kellanova trades around 15-16 times earnings.

And Now?

The reality is that I am quite intrigued by this spinoff. The combined valuation of both companies has fallen to quite low levels, with shares quite frankly trading stagnant for decades. The spinoff is interesting as we have WK Kellogg, a small business with a big heritage and brand name, trading at non-demanding valuations.

Kellanova itself will become a better business, trading at a reasonable multiple, although some parts of the business will be, or might become, challenged as well.

Given this, I am quite intrigued to follow both names, although I am awaiting the results for the standalone business in the coming quarters before considering a potential interest in any of these firms.

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