K - WK Kellogg Co: A Mixed (Cereal) Bag

2023-12-28 11:18:33 ET

Summary

• WK Kellogg Co, the spinoff of Kellanova, faces challenges but benefits from lower expectations.
• The company is a $2.7 billion business that produces 800 million pounds of cereal annually.
• The cereal market has been tough, but WK Kellogg has strong brand recognition and a plan to improve performance.

When Kellanova (K) spun off the WK Kellogg Co (KLG) business in October, I found the spinoff to be intriguing. WK Kellogg, which comprises the legacy cereal business of the infamous company, has become the smaller unit of the food conglomerate. The business faces real challenges, yet benefits from lower expectations. With many factors and developments at work, and uncertainty remaining, I am still a bit in doubt on the shares, but intrigued to closely follow this spinoff.

A Recap

Under terms of the separation, investors in Kellanova received one shares in WK Kellogg for every four shares they held in Kellanova, with the separation taking effect at the start of the fourth quarter.

WK Kellogg described itself as a 117-year-old startup, which really is a $2.7 billion business which employs some 3,000 workers which produce about 800 million pounds of cereal per annum. The U.S. operations are responsible for about 80% of sales, complemented by smaller activities in Canada and the Caribbean.

These cereal brands include the namesake Kellogg's brands, as well as variants like Special K, Froot Loops, Pops and Frosted Flakes, among others. Even as the popularity of cereal at large is on the decline, cereal remains the breakfast of choice with many children and adults, with WK Kellogg enjoying great brand recognition.

The cereal market has been tough for quite a few years, with 2020 sales reported at $2.8 billion, accompanied by relative modest EBITDA margins around 10% of sales. Revenues fell to $2.4 billion in 2021, with EBITDA margins down to just 2% of sales, as revenues recovered to $2.7 billion in 2022, with EBITDA margins reported at 6.5% of sales.

Ahead of the separation, the company guided for fiscal 2024 sales to come in flattish around $2.7 billion, and EBITDA margins seen close to 10%, with EBITDA expected at $260 million. To improve the performance further, the company earmarked a half a trillion investment program in the coming three years, in order to modernize the operations and boost EBITDA margins to the mid-teens, which if achieved would imply an EBITDA number around $400 million.

Valuation Thoughts

WK Kellogg operated with a $465 million net debt load at the time of the spinoff, which the company claims would result in a 2 times gross leverage ratio based on $500 million in gross debt. This is, however, based on a $250 million EBITDA number, as EBITDA was only reported around $175 million in 2022.

The issue is that valuation was furthermore complicated by near-term separation costs, but more important the standalone costs to be incurred by the business going forward, as well as rather aggressive net capital investments plans being announced for the coming years, with the latter putting a drain on cash flow generation.

As Kellanova had 342 million shares outstanding, there would be some 85 million shares of WK Kellogg outstanding, given the exchange ratio. These shares were trading at $15 pre-split, and traded at $11 per share in the immediate aftermath, granting the company a $1.5 billion enterprise valuation. These looked like non-demanding valuations given the sales and EBITDA numbers reported, but there were many moving parts.

If the company could deliver on $250 million in EBITDA, I saw pre-tax profits around $100 million, which after taxes works down to earnings of less than a dollar per share, but this was a highly uncertain number.

Trading Flattish

An $11 stock early in October has fallen to lows of $9 and change, before gradually recovering to $13 just before the end of the year, aided by a rally in markets at large, in its turn the result of a huge decline in interest rate. This has lifted the share price of many stocks, certainly more leveraged players.

At the start of November, the company declared a quarterly dividend of $0.16 per share, as the annual payment of $0.64 per share provides quite a nice dividend yield, trending around 5% at $13 per share.

A week later, WK Kellogg posted softer third quarter results. Reported sales fell some 2% to $692 million, standing in sharp contrast to a 5% increase in year-to-date sales of $2.11 billion.

The company did post an improvement in margins, with so-called standalone adjusted EBITDA margins improving by some three points to 7.5%, coming in at $51 million. For the first three quarters of the year, these margins improved by a similar percentage to 9.9% of sales, with EBITDA reported at $206 million. The big margin improvement and sales decline comes from anticipated price elasticities with pricing up 11% and change, more than offset by a 13% decline in volumes.

Similar trends were seen in the first half of the year, but price increases are actually levelling off, while volume declines are worsening. Despite this observation, the company proudly claims that it has gained market share over the past year, as is evident in the third quarter earnings presentation .

For 2023, the company guided for revenues at the midpoint of the guidance at $2.73 billion, as the fourth quarter is seasonally softer, with adjusted EBITDA margins seen around 9.1-9.2%, for an EBITDA number around $250 million. The company furthermore outlined a guidance for 2024 already, sales come in flat with adjusted EBITDA seen at a midpoint of $260 million.

And Now?

While it is comforting that the company is delivering on its 2023 targets, the reality is that not much growth is seen for 2024. Moreover, the quality of the composition of sales and margins is not comforting either, as leverage is a bit higher than I expected. Net debt of $551 million, as of the second day of October, is higher than I anticipated, as this furthermore excludes $145 million in post-retirement liabilities, with debt being higher than anticipated as investments into the business have already started.

Based on the $260 million EBITDA guidance for 2024, realistic operating earnings are still only seen around $100 million next year. This however excludes expenses related to pension related assets, as the picture is all a bit cloudy, just as I anticipated at the time of the spin-off. Moreover, a mere $10 million improvement in EBITDA for 2024 looks light as the company aimed to grow EBITDA to $400 million some three years down the road, following investments into the properties of the business.

With an 86 million share count, the market value has risen to $1.1 billion, or nearly $1.7 billion if we factor in the higher net debt load. This still results in dirt cheap sales multiple and non-demanding EBITDA multiple, yet the financial situation remains rather complicated, with prospects for free cash flows generated being very limited.

A Final Word

Given all the trends, I am not convinced on WK Kellogg Co shares here. While EBITDA is improving, it is the composition of growth, or better said lack of quality of this growth, which is a major concern. I observe this, even as the company claims that it gains market share in its key markets.

Concerns on the health of its products hurt the business here, as free cash flow is very modest, certainly given the significant investment program to be executed upon, all in combination of a relative fat 5% dividend yield being paid out here.

Amidst all of this, I am still taking a wait-and-see approach, certainly given the disappointing 2024 EBITDA outlook and increase in the net debt load, which means that I continue to take a wait-and-see approach.

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