Prescience Point Capital Short Kellogg Company (K)

Prescience Point Capital states, “Q3’18 results indicate the financial reckoning we predicted for Kellogg in April is upon us and gaining speed. The first leg of our thesis, that K would have to cut FY’2018 guidance, has come to fruition. The second leg, that K will be forced to cut its dividend or sacrifice its credit rating, is playing out as the unwind of stuffed channels and accounting excesses accelerates. Our conviction has never been higher. We remain short Kellogg.”

Q3 hedge fund letters, conference, scoops etc

On April 26, 2018, Prescience Point published a research paper (the “Initiation Report”) on Kellogg Company (“K”, or “the Company”).  We predicted Kellogg would be forced to (1) reduce FY’2018 guidance and (2) cut its dividend or lose its credit rating.  On 10/31/18, part one of our thesis was proven correct when K slashed its FY’2018 adjusted EBIT and earnings growth guidance.  Part two is still playing out.  While recently announced asset sales, reduced disclosure, and other actions taken to obfuscate underlying results may buy K some time, we believe it only prolongs the inevitable; a dividend cut or credit downgrade.  In this report, we shed light on why K really reduced guidance and explain why we now expect a drawn out and painful period for K shareholders.

Prescience Point Opinions:

• Revenue growth is a facade, reversal of years of extended DSOs will wreak havoc on growth expectations and cash flow in FY’2019: Years of transitory benefits from extended terms and stuffed channels are starting to unwind and will be an enormous headwind in the near-term. Kellogg can either (1) spend massively on brand-building to maintain sales growth at the expense of margins or (2) let sales growth falter while trying to salvage profitability; these are the best-case scenarios.  We expect revenue growth and margins will both deteriorate.         
• CAO resignation immediately before guidance cut & working capital “unwind” is highly suspicious: We were already concerned the sudden and peculiar departures of the CEO, CFO, and President of Kellogg North America were a glaring red flag; the resignation of the CAO just months before extremely poor results just adds to our suspicions.
• FY’2018 adjusted EBIT & earnings growth guidance slashed; K’s explanation for the miss doesn’t make sense, appears deceptive: We find the rationale behind drastically lowering FY’2018 adjusted EBIT margin and earnings guidance suspect and full of contradictions with prior commentary. We don’t believe management is being forthright with investors.
• North America re-org/supply chain buildout leads to more obfuscation and a likely scapegoat for poor FY’2019 performance: It would not surprise us if these restructuring efforts take longer than the Company anticipates.  We believe this sets the stage for the re-org/supply chain to take the blame for weak results in FY’2019 (and maybe beyond).
• K remains more levered than meets eye; dividend cut/credit downgrade risk remains high: K generates barely enough cash to cover dividends and other short-term obligations.  Recently announced asset sales are not opportunistic, but necessary to fund buybacks, pay dividends, and shore up balance sheet.
• Shares are still dramatically overvalued: Based on our adjustments, K is still trading at an unjustifiably high multiple of 14.0x EV/EBITDA, while its adjusted leverage ratio of 4.5x remains in-line with high yield CPG peers.  Consensus continues to take management’s commentary at face value and incorrectly anchors estimates to K guidance; failing to adequately account for the massive unraveling of years of accounting excesses.  We reiterate our price target of $39.50, implying ~35% downside.

Thesis Update: We Believe Management is Misleading Investors, Recent Actions Raise More Questions than Answers; Our Conviction Has Never Been Higher

We remain short shares of Kellogg Company and our conviction has never been higher. After two quarters (Q1’2018 and Q2’2018) of relatively in-line results and improved investor sentiment, despite continued deterioration in the underlying fundamentals, the Company missed Q3’2018 estimates and drastically cut FY’2018 adjusted EBIT and earnings guidance.

The Company attributed weak Q3’2018 profitability and reduced FY’2018 guidance to the Direct Store Delivery (“DSD”) transition and Multi-pro impact, adverse mix shifts (pack formats and emerging markets), and higher-than-expected cost inflation. In addition, the Company discussed at length how increased re-investments and brand-building spend on single-serve formats (10% of US Snacks revenue, 2% of Kellogg revenue) created near-term margin pressure but improved top-line. Interestingly, the Company said it would not wait to find “solutions” to offset and reduce these additional costs, instead focusing solely on investments for long-term growth.

While we agree about investing for long-term growth, we find this strategy somewhat hypocritical given Kellogg is currently in the final stages of a near decade long restructuring effort (K LEAN, Project K, & Zero-Based Budgeting). Why spend years cutting costs only to throw large sums of money at a small product category without first understanding how to offset those costs? Moreover, we find it even harder to believe how a product category that accounted for only 2% of revenue was the primary driver behind cutting FY 18 adjusted EBIT guidance from 5-7% growth to flat!

Over the last few quarters, we believe management engaged in some very misleading behavior in an attempt to hide poor performance. The Company:

• Indicated it was aware “very early” in Q3’2018 re-investment and brand-building costs were tracking higher than previously communicated, yet reaffirmed FY’2018 guidance and went so far to say it was “confident” in its outlook on its Q2’2018 Conference Call (one month into Q3). Then at the Barclay’s Conference in September (two months into Q3) it said it was “confident” in its growth trajectory and margin expansion
• Unexpectedly announced a complete re-org of its entire North America business as part of Project K, despite indicating two-months ago Project K was “largely complete”
• Announced it would eliminate North America business-unit level disclosures
• Removed the working capital slide from its FY’2018 Investor Presentations and stopped discussing working capital on its Conference Calls as reported core working capital levels started to deteriorate for the first time since FY’2015

Contradictory statements and actively reducing/removing disclosures are all hallmark examples of a company trying to hide something. We have already seen the CEO, CFO, President of North America, and CAO all resign somewhat suddenly; did they know something management isn’t telling shareholders? All these activities bring more questions than answers and it’s clear to us that something doesn’t add up.

So, what do we think actually happened?

As we discussed in our Initiation Report, under former CEO Mr. John Bryant, Kellogg instituted massive cost cuts for nearly a decade and used accounting gimmicks and financial engineering to mask its deteriorating performance and boost short-term sales and cash flow metrics. As a result, we believe new CEO Mr. Steven Cahillane faced a precarious situation. He could either work to eliminate the previous accounting excesses and gimmicks by resetting near- and long-term expectations (essentially wipe the slate clean) or continue with the status quo for a Company at the end of a restructuring cycle; shift focus to revenue growth. He chose the latter. At the CAGNY Conference in February 2018, Kellogg announced its “Deploy for Growth” strategy which called for low-single-digit revenue growth and mid-single-digit EBIT growth.

While it may have seemed like a logical decision for Kellogg to focus on revenue growth after years of restructuring, the Company has a bigger problem; the reversal of all the prior accounting excesses including years of stuffing the channel via extended payment terms. The Company may blame high trade inventory on the DSD transition, but we would argue it’s only the tip of the iceberg. DSOs have unsustainably benefited from factoring for several years and as the factoring programs slow, the “unwind” will wreak havoc on sales. We believe the aggressive accounting tactics finally caught up with Kellogg in Q3’2018 and we anticipate things may get much worse before they get better.

Kellogg has told investors its growth trajectory would be “markedly different” from prior years and will feature steady, consistent top-line growth and margin expansion. In reality, we believe the Company is at a crossroads. Kellogg can either (1) spend massively on brand-building/re-investment to maintain sales growth at the expense of margins or (2) let sales growth falter while trying to salvage profitability. Moreover, these are the best-case scenarios! It’s highly probable revenue growth and margins will both deteriorate.

Finally, what about buybacks, the dividend, and investment grade credit rating?

Our initial claim Kellogg would have to cut its dividend or risk losing its investment grade credit rating was met with heavy skepticism. However, in the last month we witnessed two stalwarts cut their dividend to shore up the balance sheet. General Electric (GE) cut its dividend by 92% and AB-InBev (BUD) by 50%. Could Kellogg follow suit? We think so.

In some respects, Kellogg already started to reduce shareholder return by drastically slowing share repurchases this year. In the LTM ended Q3’2018, Kellogg spent approximately 5x less on share repurchases than it had in each of previous five years.

While slowing buybacks helped Kellogg’s liquidity a little bit, at the end of Q3’2018, it still had barely enough cash to cover its dividends and short-term debt obligations. So, what did Kellogg do? It announced it would divest its cookies, fruit-flavored snacks, pie crusts, and ice cream cone businesses and use the proceeds for debt reduction and/or share buybacks. Kellogg indicated these assets were “freed up” after the DSD exit and had difficultly competing for resources/investments within the portfolio. However, we believe these asset sales were not opportunistic, but necessary to fund buybacks, pay dividends, and shore up the balance sheet.

While this may buy Kellogg some precious time, we don’t think it can solve the problem; Kellogg is still substantially less profitable, more levered, and more expensive than meets eye.

High Trade Inventories Blamed on DSD Transition, But That’s Just the Tip of the Iceberg; Reversal of Years of Extended DSOs will Wreak Havoc on Revenue Growth Expectations

When a company extends payment terms (i.e. increases DSOs) and incentivizes customers to purchase more inventory than they need and/or typically purchase (i.e. “stuffing the channel”), it effectively pulls forward revenue from future periods. So, if a company continuously expands DSOs, it can continue to pull forward revenue. However, this benefit is transitory and will dissipate/reverse as DSOs “unwind” and return to more normalized levels. This process is not instantaneous and can take time (sometimes several quarters), but it can lead to “revenue misses” as the pulled forward revenue creates a “gap” in current/future period revenue. This “gap” can be further exacerbated if a company used additional levers that created other transitory benefits (e.g. change from “sell-through” to “sell-in” model).

Stuffed channel blamed on DSD transition, guided for trade inventory rationalization to negatively impact growth

On its Q3’2018 Conference Call, the Company effectively admitted to stuffing the channel, confirming suspicions outlined in our Initiation Report. We believed the US Snacks business unsustainably benefited from earlier revenue recognition and the one-time “sell-in” benefit from switching to the warehouse model vs. the Direct Store Delivery (“DSD”) model. We started to see these benefits reverse in the last few quarters.; US Snacks revenue declined in each of the last five quarters and were below consensus estimates in three of them.

In terms of inventory, when we exited DSD, obviously, it was a major transition that we’ve been talking about for some time now, where the inventory went from our system into the customer’s warehouse system. And over time, we expected that they would have a higher level of inventory as they got used to, obviously, carrying a whole new line of goods, and that would be optimized over time, which we would expect. So we’ve been expecting inventory to come down, and it has not come down. So we’re not calling that it will come down in Q4, but it may because we’re just expecting that retailers like us would look for optimal levels of inventory. So we’re not saying that it will happen. But just to be precautionary, we’re pointing out that it is possible at some point in time, and it’s U.S. Snacks that we’re talking about.

CEO Mr. Steven A. Cahillane, Q3’2018 Conference Call, 10/31/18 [emphasis added]

Read the full article here by Prescience Point Capital