Kraft Results Could Mean Trouble for Kellogg

The Dow’s newest component Kraft Foods (KFT) announced 4th quarter results this morning that narrowly missed analyst estimates. Revenues were worse than expected but better than the quarter a year ago. The problem was that Kraft’s relatively cheap packaged foods were being skipped over by customers in favor of even cheaper store brands. In addition, with a substantial amount of sales coming from international markets, the strengthening dollar hurt sales abroad. The company did see an improvement in gross margins, which rose from 30.6% to 31.5% because of cost saving measures as well as a break from oppressive commodity costs they dealt with last summer. The company also lowered guidance to $1.88 EPS for 2009 from the previous estimate of $2. Kraft shares have fallen more than 9% after the disappointing results.

Kraft FoodsOne of Kraft’s closest competitors is Kellogg (K), who reports tomorrow and will be contending with some of the same currency exchange headwinds that Kraft struggled to overcome. Kellogg also gets a large portion of sales in international markets, and should see pressure on those sales from the strengthened dollar. The results could come down to whether Kellogg was able to capture a larger portion of the increased grocery store traffic. Kraft alluded to a meaningful portion of sales that were grabbed by the cheaper store brands as consumers try to stretch each dollar as far as possible. Apparently, Kraft’s increased marketing effort and spending were not as effective as they would have liked. Kellogg should face the same competition in its products, but they have not made the marketing push that Kraft did in the last few months.

Kellogg’s streak of 3 straight quarters of beating the street could be coming to an end. However, there could be a bit of good news as far as turning grocery shoppers into Kellogg buyers. Back when commodities were setting record high prices last summer, along with the rest of the industry Kellogg’s margins were getting squeezed. As other companies feared that raising prices would harm sales, Kellogg decisively increased prices to contend with the difficulties. The gamble appears to have worked in Kellogg’s favor as sales did not suffer considerably after the price hike, and it gave Kellogg the ability to offer promotions to attract buyers as commodities started to tank.

KelloggHow well the promotions were able to boost sales will be apparent as Kellogg announces fourth quarter results tomorrow morning, but we think that it may not be enough to overcome the currency exchange problems and consumers trading down to store brands. Furthermore, the current Ockham valuation is Overvalued because Kellogg’s price-to-cash flow and price-to-sales currently are well above the high end of their historically normal range, which given the current market is saying a lot. Price-to-sales at 1.28x is 28% above their historically normal range of the last 10 years of .8x and 1.0x. Similarly price-to-cash flow over the last ten years (with more current years weighted more heavily) has been between 6.27x and 7.94x, but is currently 10.32x.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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