Food Fight: Why Kellogg Stock Beats General Mills

In the past week, General Mills (NYSE:GIS) and Kellogg Co. (NYSE:K) both made public statements about their respective businesses. Comments by the former were far more positive than the latter. On the surface, General Mills and Kellogg appear to be two businesses heading in different directions. The safe play is to take General Mills. The contrarian move is to buy Kellogg instead. Here’s why you should consider going contrarian:

General Mills

The first page of General Mills’ presentation for the Morningstar Stocks Forum trumpets its global growth. Investors in attendance learned that General Mills’ long-term return to shareholders since 1960 has easily outpaced the S&P 500. In the past decade, GIS has delivered compound annual growth of 8% — 700 basis points higher than the index.

That’s excellent for sure, but how is General Mills achieving this growth? According to the company, it’s as simple as growing sales, segment operating profits and earnings per share by low- to high-single-digit compound annual growth rates, then adding its dividend yield to the mix. That might be so, but if General Mills wants this to continue, its brands will have to do it outside the United States.

Presently, General Mills’ international revenue accounts for about 20% of its overall business. The opportunity exists to develop a more balanced business where revenues outside the U.S. account for a bigger portion of its overall revenue. However, that same opportunity exists for every large processed and packaged goods company — including Kellogg.

General Mills paid $1.2 billion for a 51% controlling interest in Yoplait’s European business in July, as well as a 50% interest in the worldwide rights to the brand. Two questions come to mind about the acquisition. The first is how much additional revenue General Mills can generate from the Yoplait brand in Europe, and secondly, how much profit.

In the first quarter ended Aug. 28, the deal added $171 million in international revenue. Overall, its international business generated $80.7 million in operating profit on $856.3 million in revenue for a margin of less than 10%. Meanwhile, its U.S. retail business has an operating profit of 23%.

Looking at the glass half-full, I suppose one could surmise that General Mills management feels it can do more with the Yoplait brand overseas. Maybe so, but that’s not the real problem. The dilemma here is that its legacy brands don’t generate enough profits outside the U.S. Going after more international business could be seriously detrimental to its future profitability. Only time will tell.

Kellogg

Read through Kellogg’s third-quarter conference call transcript, and the words �supply chain� are mentioned 23 times. CEO John Bryant, at the company for less than a year, was hammered mercilessly by analysts. It wasn’t the company’s shining moment. Kellogg reduced its work force during the past few years in an attempt to cut costs, and in the process, Bryant came to the realization that the company was underspending when it came to quality control and its supply chain.

In the conference call, Bryant suggests the upfront cost for these supply chain investments is 12 cents per share, or approximately $43 million. Analysts seem to portray this sudden increase in spending as some sort of ambush. If analysts were actually paying attention, they probably should have known that Kellogg’s plants were running on vapors. Far better for the CEO to recognize its deficiencies now before things really got out of hand.

Valuation

What does all this mean? Kellogg will earn less this year and possibly into 2012 as well. Worst-case scenario, its forward 2012 earnings per share are around $3.10. That’s a forward P/E ratio of 15.8, below its five-year average.

At the end of the day, this is nothing more than a bump in the road. Kellogg generates almost as much EBITDA as General Mills using less debt, its return on invested capital is several percentage points higher than General Mills and its stock has seriously underperformed General Mills during the past five years. Once Kellogg gets its plants working more efficiently, it will move well above $50 once again.