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An Investment Opinion
by Alex Schay

Two Scoops of Competition

At first blush, building a multi-billion dollar business on corn grits, oats, rice, various dehydrated fruits, sweeteners, wheat, and wheat derivatives seems a bit flaky. It seems intuitive that in such a business comparable products would be abundant, and low-price products would reign. However, up until recently cereal companies used to be shining examples of rational competition. Virtually every one of the name brands could make money due to a reluctance to engage in the kind of debilitating price wars that cripple other industries, like airlines -- to use an extreme example of irrational pricing. The thing is, not much has changed on the high-end, but there have been other developments.

Kellogg (NYSE: K), the company that brings consumers Frosted Flakes, Apple Jacks, and Pops corn puffs has been hurt recently not so much by price wars on the brand name box front, but rather by inexpensive knock-offs like Frosted Flakers, Apple Zaps, and Sweet Puffs made by Quaker Oats (NYSE: OAT) and other "bag cereal" purveyors, whose wares typically sell for roughly $0.75 less than their "square" relatives. Is it dastardly and underhanded to minimize marketing costs by copying best sellers? Sure, but it's also a tried and true business practice.

Even though Kellogg has seen market share losses for most of this decade, accelerating to roughly 1% per year over the last four years, really painful manifestations of this phenomenon have been muted. However, today Kellogg dropped $2 3/16 to $33 1/4 after announcing that Q2 earnings fell 17% to $143.2 million, or $0.35 per share, compared with estimates for $0.37 per share. Hardly awful considering that Kellogg forecast grim numbers during its first quarter conference call, but what really has investors down is the fact that Kellogg reported that 1998 earnings will drop as much as 15% to $1.45 per share, a little stark when compared with current estimates for $1.77. The company has stated that it will spend more on promotions to regain sales that have been lost to store brands and the bag people.

The costs of combating discount brands is estimated to be in the range of $225 million pre-tax. While some of this may be spread across research and development (R&D) expenses, there are some fears that these changes may not be one-time competitive increases but rather a reflection that cereal margins have been unsustainably high. Kellogg has operating margins of 17.47%. Trade promotions, of course, affect the net price that the company receives, but at some point the more drastic issue of price cuts needs to be addressed. The price-value proposition for Kellogg's high-end cereal brands has eroded, but the company is understandably reluctant to slash prices across the board. An across the board price cut would cut 1999 EPS by about a fifth. Price cuts of 10% on selected brands would probably be the more judicious route.

Many skeptics feel that bagged cereals are a waste of time, and certainly their potential penetration seems to have an upper limit. In 1997 Quaker earned a skimpy $5 million (pre-tax) on baggy sales of $160 million, or margins of 3%, compared with supermarket brand margins in the neighborhood of 7% and branded box cereals raking in 20% margins. In spite of the low profitability, Quaker gained 2% cereal market share last year and seems on track to do the same this year. One problem for the growth of bag cereals might be saturation if the private label and grocery brands get in on the act full time, like privately held Malt-O-Meal or Ralcorp Holdings (NYSE: RAH).

All of this doesn't help Kellogg much if it can't return to volume growth. Seeing Kellogg drop this year has this columnist taking a closer look at possible share buy-backs -- even though some form of promotional expenses will probably take priority. At the end of last year the company announced the authorization of a $400 million share repurchase, which is quite an aggressive figure and acknowledges the minimal capital investment needs of the firm and its large EBIT after capital expenditures (around $400 million). Although the company has less room to swap equity for debt than say at the end of 1996 when it had the lowest debt to capital in its peer group and EBITDA to interest expense coverage of 26 times, the firm may be able to take on some more of the great evil. Considering that it could achieve a lower cost of capital, a larger tax shield, small EPS accretion, and positive market signaling, it might be worth it -- but then again the company probably doesn't want to mess with its credit rating.

At some point Kellogg may have to resign itself to growing off of a lower EPS base, with all the accompanying share price headaches that might entail. However, let's take a look at those brands again:

All-Bran(R), Kellogg's Squares(TM), Apple Jacks(R), Apple Raisin Crisp(R), Apple Cinnamon Rice Krispies, Bran Buds(R), Complete(R) Bran Flakes, Cocoa Krispies(R), Common Sense(R), Cruncheroos(TM), Kellogg's Corn Flakes(R), Cracklin' Oat Bran(R), Kellogg's(R) Cinnamon Mini-Buns, Crispix(R), Double Dip Crunch(R), Froot Loops(R), Kellogg's Frosted Bran(R), Kellogg's Frosted Flakes(R), Frosted Krispies(R), Frosted Mini-Wheats(R), Fruitful Bran(R), Fruity Marshmallow Krispies(R), Just Right(R), Kellogg's(R) Low Fat Granola, Nut & Honey Crunch(R), Nut & Honey Crunch O's(R), Mueslix(R), Nutri-Grain(R), Pops(R), Product 19(R), Kellogg's(R) Two Scoops(R), Raisin Bran, Rice Krispies(R), Rice Krispies Treats(R), Smacks(R), Special K(R) and Kellogg's Honey Crunch Corn Flakes(TM).

They're Greaaatttt!

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