If WK Kellogg’s management can deliver on its promise of higher margins, an investment today could outperform over the long run.
Corporate spinoffs can be an odd investment proposition. Often, when companies split up, one of the resulting businesses seems like the “desirable” asset to own, while the other gets spurned by investors. Typically, that unloved company is the one that winds up with the parent’s less exciting operations or the businesses with lower projected growth. Indeed, the performance gaps between stodgy business units and higher-growth ones are often used as key justifications for spinoffs.
However, as counterintuitive as it sounds, sometimes, when the market seems to want nothing to do with a newly spun-off company, that just makes it a more interesting investment option to me.
That’s now the case with WK Kellogg (KLG -0.67%) — the pure-play cereal business that was spun off a year ago from the former Kellogg, which renamed itself Kellanova. In August, privately held behemoth confectioner Mars agreed to acquire the snack-centric Kellanova. But WK Kellogg is still fending for itself — and it is being viewed skeptically by the market.
Here’s why I think that the market’s current disdain toward WK Kellogg positions it as an excellent buy for investors seeking out a lifetime of passive income.
The market doesn’t like the new Kellogg — and that’s perfect
WK Kellogg owns more than a dozen well-known cereal brands, but considers the following to be its “core six:” Frosted Flakes, Special K, Fruit Loops, Raisin Bran, Frosted Mini Wheats, and Rice Krispies. These big brands are responsible for its leadership position in the cereal industry alongside peers General Mills and Post. Those three companies alone are responsible for roughly three-quarters of total sales in the niche.
While this leadership position is excellent, Statista projects that cereal sales overall will only grow by 2% annually through 2029 — a tepid rate that has left the companies trading at sub-market valuations. However, WK Kellogg’s valuation, in particular, is deeply discounted — not just relative to the market but to its two main peers.
KLG GIS POST’s PE and EV to EBITDA Ratios (Forward) data by YCharts
Following the company’s 29% dip from its previous highs set in May, WK Kellogg trades at a mere 11 times next year’s earnings, indicating that the market sees minimal growth potential. Just how little growth?
With management stating that it has historically converted 100% of its net income into free cash flow (FCF) on average over time, WK Kellogg would only need to grow by 2% in perpetuity to live up to this valuation. That means WK Kellogg would only need to maintain its share of the cereal industry to produce market-beating returns.
But management has grander plans than just holding serve.
Over the next two years, it plans to invest roughly $500 million into modernizing and consolidating its supply chain, adding automation and new digital capabilities that could dramatically improve efficiency. Should these upgrades go according to plan, management believes its earnings before interest, taxes, depreciation, and amortization (EBITDA) margin — lately 9% — will improve to 14% by 2026.
Given that General Mills and Post have been achieving EBITDA margins of 20% and 16% already, I don’t believe 14% is out of reach for WK Kellogg — especially considering that it should be able to streamline its operations as a pure-play cereal unit. Should it land anywhere near this 14% margin, the company would fly past the 2% growth it needs to live up to its current valuation.
Image Source: Getty Images.
WK Kellogg’s passive income potential
Best of all for investors, despite its plan to spend heavily on those supply chain upgrades, WK Kellogg still intends to reward shareholders handsomely for their patience. Its dividend at the current share price has a generous 3.7% yield. But its dividend payouts will equal roughly 35% of the company’s projected net income, so the payout’s sustainability does not appear to be at risk.
However, with the company’s debt-to-EBITDA ratio expected to rise to 3 by 2026 as it spends on its supply chain, investors shouldn’t expect significant dividend increases over the next year or two. If its improvements go to plan, though, and WK Kellogg’s profitability rises by roughly 50% or more as projected, it will be well-positioned to engage in major dividend hikes over a decade-long time frame.
In addition to this passive income potential, WK Kellogg’s higher margins would also allow for it to pay down debt and consider tuck-in acquisitions of better-for-you cereal upstarts that could modernize its offerings. With natural and organic brands like Kashi and Naked Bear already in its lineup, WK Kellogg recently launched a new high-protein, zero-sugar, premium cereal called Eat Your Mouth Off.
Ultimately, investors who are interested in WK Kellogg will want to be laser-focused on its earnings reports over the next two years, monitoring those readouts to see whether or not its projected EBITDA margin growth takes place. Thanks to the company’s pure-play focus on cereal, I’m optimistic that it can get its margins closer to those of its peers — and maybe one day surpass them — which would make the stock at today’s price a steal.
While investors will need to have patience with this stock, WK Kellogg’s combination of a deeply discounted valuation, its leadership positioning, a hefty dividend yield, and the potential for higher margins make it a great candidate for those seeking a passive income stream that can last a lifetime.
