A Soggy Reception for Kellogg

Investors sold the shares Tuesday after the cereal titan reported lower fourth-quarter earnings. One big worry: margin pressure

For Kellogg (K), commodity inflation is giving the cereal maker some soggy results. The Battle Creek (Mich.) cereal titan reported lower fourth-quarter earnings on Jan. 30, with part of the blame falling on rising food and energy costs.

Kellogg announced net earnings for the fourth quarter of $182.4 million, or 45 cents per share, vs. 47 cents one year earlier, on a 7.9% increase in revenues to $2.6 billion. Results for the 2006 period included a 3-cent charge for the expensing of stock options and investment in "up-front" costs -- brand-building investments -- of 8 cents per share, an amount significantly greater than was invested in the fourth quarter of 2005.

The shares fell 1.2% to $50.21 in New York Stock Exchange trading Jan. 30.

Kellogg posted solid sales growth from its North American Retail Snacks unit, up 12% year over year. But sales at its flagship North American cereal division were down 3%, reflecting customer inventory reductions.

"In 2006, our company posted another year of strong, above-target rates of growth," said Kellogg CEO David Mackay in a press release. "We managed this while continuing to invest in future growth and while absorbing another year of significant cost inflation."

Significant may be an understatement in the case of one of the company's key inputs, corn, which has soared nearly 80% in the past year (see BusinessWeek.com, 1/10/07, "Commodities: Who Profits from Corn's Pop?"). Higher costs for fuel, energy, commodity, and benefit costs has dampened Kellogg's profitability: gross margin in the fourth quarter fell to 43.3% from 43.6% a year earlier. Kellogg expects its gross profit margin to decline by less than 50 basis points in 2007 from 44.2% in 2006 as inflation pressures persist.

Kellogg now expects full-year 2007 earnings in a range of $2.68-2.73 per share, taking into account "significant commodity cost-inflation and continued investment in brand building and innovation." It expects that full-year internal sales growth (i.e., from existing operations) could be 4%, slightly greater than its long-term targets.

"We will face more inflation in 2007, but we remain confident that we have the right strategy, operating principles, and business model," Mackay said. "It is our continued focus and strong execution, driven by the strength of our organization, that give us confidence that we will deliver dependable rates of growth in 2007, and beyond."

Standard & Poor's equity analyst Thomas Graves kept his buy rating on the shares. In a Jan. 30 note, he said that fourth-quarter EPS came in 4 cents below his estimate, and profit margins were lower than he expected, but he was encouraged by overall revenue growth. Noting expected pressure from some commodity costs, Graves lowered his 2007 EPS estimate to $2.71 from $2.75. But he likes the company's projected "strong" 2007 company cash flow (after capital expenditures) of close to $1 billion. (S&P, like BusinessWeek.com, is a unit of The McGraw-Hill Cos.).

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