Whitney Fogle: [email protected] Sarah Gardner...
Transcript of Whitney Fogle: [email protected] Sarah Gardner...
Whitney Fogle: [email protected] Sarah Gardner: [email protected] Zach Jacques: [email protected]
Javier Fernandez: [email protected] Robert Reese: [email protected]
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Table of Contents
1. Executive Summary 2
2. Business and Industry Analysis 6
3. Accounting Analysis 22
4. Financial Forecast and Ratio Analysis 43
5. Valuation Analysis 69
Appendices:
6. Appendix 1 82
7. Appendix 2 83
8. Appendix 3 84
9. Appendix 4 85
10. Appendix 5 88
11. Appendix 6 90
12. Appendix 7 91
13. Appendix 8 95
11. References 96
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Executive Summary
INVESTMENT RECCOMENDATION: Overvalued, Sell 5/2/07 K- NYSE (as if 4/27/2007) $53.08 52 Week Range $45.72-53.14Revenue 2006 $10.91B Market Capitalization $20.91 Billion Shares Outstanding 397.97M Dividend Yield 2.20% 3-month AVG trading volume 1,670,030 Percent Institutional Ownership 80.90% Book Value Per Share (mrq) $5.202 ROE 46.14% ROA 11.23% R2 BETA Ke Ke Estimated %12.84 5-year 0.071 0.456 0.069 1-year 0.073 0.459 0.073 3-month 0.074 0.461 0.074 Published -0.02 Kd Kellogg’s: % 5.45 WACC K: % 4.30 Altman Z-Score: 1.84
EPS: Forecast 2007 2008 2009 2010 EPS 2.71 2.90 3.10 3.32 Ratios K GMS KFT P/E Trailing 20.95 N/A 19.98 P/E Forward 17.46 N/A 17.22 Enterprise Val.25.54B N/A 64.75B Intrinsic Valuations Discounted Dividends $12.30 Free Cash Flows $1.61 Residual Income $17.62 Abnormal Earnings Growth $18.16 Method of Comparables 2006 PPS 48.43EPS 2.53 EPS Growth 6% DPS 1.137 BPS 19.78 EBITDA 1471.6 FCF 965.1 EV 8449.03
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Recommendation - Overvalued Company and Industry Analysis
Kellogg’s was formed on February 19, 1906 and was incorporated on
December 11, 1922. Kellogg’s produces ready to eat cereal and an assortment of
convenience foods such as pastries, cookies, crackers, cereal bars frozen waffles
and portable breakfast foods. In 2004 Kellogg’s outlined a new business strategy
attempting to focus on three main components of the business; growth to their
cereal business, expand their snack business, and to pursue selected business
opportunities.
Kellogg’s currently operates in the packaged and processed goods
industry. The industry as a whole has been able to experience slight growth over
the last 5 years. We began our valuation with a five forces model that showed
the potential sources of competition in the industry and also the bargaining
power of both buyers and suppliers. In the five forces model, Kellogg’s shows
that there is a relatively high concentration of competitors and thus a high threat
of substitute products. However, the threat of new entrants can be classified as
low. The barging power of buyers and suppliers was run next, with buyers
having the most barging power with the suppliers showing little bargaining
power. This five forces model indicates the key ways in which a company can be
profitable.
After the five forces model, we analyzed the key success factors for the
packaged and processed foods industry. Brand identification is the most
important factor in order for a company in the industry to be successful. Another
key success factor for any company in this industry is the research and
development of new products to be sold. Along with the development of the new
products, money spent on advertising of the new products.
Competitive advantage is the last step of the industry analysis. Kellogg’s
attempts to gain a competitive advantage by using product differentiation.
Another way to create a competitive advantage in the industry is by attempting
to be a cost leader.
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Accounting Analysis
The way Kellogg’s treats inventory is one of the most important
accounting policies. It is handled very conservatively throughout the industry and
Kellogg’s handles it no differently. Another aspect of the industry that is very
valuable is brand name and brand recognition. These are validated through
trademarks. Kellogg’s not only considers these a key success factor but talks
extensively about it in the key accounting policies. They choose a very
conservative way to test for impairment of these trademarks which shows the
true economic value of these trademarks and the company as a whole. Kellogg’s
along with other industry competitors chooses to use limited flexibility in all
accounting policies. This only adds to the idea that the packaged and processed
food operates on a conservative accounting basis.
Financial Ratio Analysis
The financial ratio analysis helps break down the liquidity, profitability,
and capital structure on not only Kellogg’s but industry wide. Liquidity refers to
the ability for cash equivalences to meet its short term liabilities. There is not
much change throughout the industry in liquidity ratios. Kellogg’s however does
hold the record of days supply of inventory throughout the industry.
Profitability is set up to show the profit margins of the company as well as
the industry. This shows who can minimize their costs the best and provide the
greatest profit margin. Kellogg’s shows a slight profitability change. Asset
turnover and return on assets seem to be the most profitable ratios for Kellogg’s.
Capital structure shows growth in two different areas, internally and
externally. Growth occurs through debt and equity financing activities. The
company could choose to finance through debt which means applying for loans
and obtaining bonds. There are two other ratios we thought were important to
Kellogg’s. One is property, plant and equipment turnover which shows how
efficient the company’s equipment is. The other ratio we choose to use was
earnings before income taxes, depreciation and amortization (EBITDA) margin.
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Some analysts choose to use this margin because it focuses on “cash” operating
items.
Another part of the financial analysis is forecasting. We took the industry
average of sales and forecasted it out. The growth turned out to be 7%. We
then applied this number to the rest of the financial statements to show a
consistent growth throughout all financial statements.
Intrinsic Valuations
Four different valuation models were run for Kellogg’s, discounted
dividends, free cash flow, residual income, and abnormal earnings growth. In
order to run these models, the weighted average cost of capital (WACC), cost of
equity and cost of debt have to be calculated. To find the cost of equity, a
regression analysis was run but had no explanatory power for Kellogg’s because
all of their risk is firm specific. Therefore, cost of equity was calculated with the
long run residual perpetuity. The discounted dividends model produces the least
explanatory power for stock prices, while residual income and abnormal earnings
growth have the highest predictive power. Kellogg’s valuation for discounted
dividends was $11.94, free cash flow $1.59, residual income $18.16 and
abnormal earnings growth $17.62. Altman’s Z-score is used for credit analysis to
predict whether a company will be able to service their existing debt. A Z-score
below 1.8 has a high probably of bankruptcy and Kellogg’s Z-score was 1.84.
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Business and Industry Analysis
Company Overview
Kellogg’s is a 101 year old company formed on February 19, 1906 by Will
Keith Kellogg and incorporated on December 11, 1922. Kellogg’s has grown
from a company that began with 44 employees to now 25,600 and is the world’s
leading producer of ready-to-eat cereal. Kellogg’s also produces a vast
assortment of convenience foods such as pastries, crackers, cereal bars, cookies,
portable breakfast foods, and frozen waffles. Kellogg’s now manufactures
products in 17 countries and sells goods to 180 countries. The company has
several well known brands such as: Keebler, Pop-Tarts, Eggo, Cheez-It, Club,
Nutri-Grain, Rice Krispies, Special K and Mini-Wheats. There world wide
headquarters is in Battle Creek Michigan where Kellogg’s performs all product
creation and initial testing from their research and development facility.
Kellogg’s is split into two different entities, Kellogg North America and Kellogg
International. Kellogg’s North America has control of every aspect of the Kellogg
business, and Kellogg’s International is focused just on ready to eat cereal and
wholesome snacks in the markets they are involved in.
In 2004 Kellogg’s made sweeping changes across all Kellogg’s businesses
to ensure Kellogg’s is moving in the right direction and at the proper pace. They
outlined a new business strategy with three different components. Fist they
want to grow their cereal business, but not grow as fast as physically possible.
Kellogg’s applies a volume to value approach to insure an increase in revenue,
but also with higher margins. Second they wish to expand their snack business
by edging ever closer to the number one spot in the cookie and cracker business.
Kellogg’s also would like to invest the money from the higher margins mentioned
in the first aspect into brand building for snacks and ready to eat cereal. Lastly
Kellogg’s would like to pursue selected growth opportunities. These growth
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opportunities include small acquisitions and expansion in markets they already
have a business in, but do not want to borrow or create large amounts of debt
by creating an entire new sector of the Kellogg’s business portfolio.
(Kellogg’s.com/history/mediaroom/)
Industry Analysis
Kellogg’s currently operates in the Processed and Packaged Goods
industry and has established itself as one of the industry leaders. An important
aspect to recognize when valuing Kellogg’s is that competition comes from
companies that are not classified as operating in the Processed and Packaged
Goods industry. Most of Kellogg’s products can be classified into two different
categories, ready-to-eat cereal and convenience foods. When looking at the
ready-to-eat cereal, Kellogg’s main competition comes from companies such as
General Mills, Sara Lee and Quaker Oats. Quaker Oats, which was recently
purchased, and now operates under the PepsiCo brand. This scenario makes it
more difficult to value the industry because PepsiCo is such a dominant player in
the Processed and Packaged Good industry. Of PepsiCo there are four
subdivisions of their business, only Quaker Oats presents a threat to Kellogg’s.
The second category of Kellogg’s business is convenience foods. There is more
competition coming from General Mills and Sara Lee, but other companies such
as Kraft and ConAgra Foods also pose a threat.
Market capitalization for Kellogg’s and all its competitors have a relatively
high market capitalization. Kellogg’s and General Mill’s market capitalization
fluctuate around $20 billion, with numbers presently being $19.6 and $19.8
billion respectively. Sara Lee and ConAgra Foods both operate at a lower market
capitalization both ranging in the $12.75 to $13 billion total capitalization. The
dominant players in terms of market capitalization are PepsiCo and Kraft, with
their capitalization being $106 billion and $55 billion respectively. These numbers
can be slightly misleading due to the sheer size of these companies and the fact
that they operate in many different industry sectors. These market capitalization
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figures show that Kellogg’s and its competitors should have no problem if they
need to raise capital in order to further their business.
Kellogg’s stock price performance over the past 5 years has been superior
to that of its competition in the industry and those outside. Kellogg’s stock price
has experienced a gradual yet consistent growth in price free from many major
fluctuations over the last five years. Kellogg’s past history is not the model for
stock prices in the industry, with General Mills being the only major competitor to
show considerable growth over this same time. Most companies, including Sara
Lee, Kraft, ConAgra Foods and even PepsiCo, have all seen their stock prices
either stay relatively constant or even fall over this five year span.
Kellogg’s has also experienced success in the S&P stock index. While all of
Kellogg’s main competitors have fallen short of the S&P index on the five year
scale, Kellogg’s has experienced a 60% increase compared to that of roughly
22% for the S&P 500.
The packaged and processed goods industry has experienced sales
increases across the board. Kellogg’s and all of their major competitors have
seen gradual and consistent increases in sales volume no matter the size of the
company. These sales increases show that the market for both ready-to-eat
cereal and convenience foods is increasing and allowing the industry to show
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consistent growth over the past 5 years. Kellogg’s has been able to be extremely
successful in terms of annual net sales, showing increases ranging from 5% to
10% annually. These sales increases numbers can only depict half the real story,
with the other half lying in the industries total assets. Over this same 5 year span
in which annual net sales have continued to increase, Kellogg’s and all major
competitors have not invested much capital into total assets. When breaking
down the companies total assets, analysts can see that property, plant and
equipment have remained consistent with little growth or evident decrease.
These numbers show that Kellogg’s and its competitors are no longer attempting
to increase in terms of operations, but instead have found ways to become more
efficient in production. By becoming more efficient in production, the industry
has been able to see notable sales increases in recent history.
Analysis of Market Share (Industry Wide)
2001 2002 2003 2004 2005 Net Sales 7,548.40 8,304.10 8,811.50 9,613.90 10,177.20 Total Assets 10,368.60 10,219.30 10,230.80 10,790.40 10,574.50 *millions of dollars
Five Forces Model
A true analysis of the ready to eat cereal and convenience foods industry
can not be analyzed with just numbers. The five forces model gives a qualitative
analysis of the industry so that the numerical analysis will have meaning. These
explanations of the industry will give an analyst the ability to explain the current
condition of the industry and can also be helpful in forecasting the future. The
five forces model can be broken down into two different sections. The first is
potential sources of competition in an industry, containing: rivalry among
existing firms, threat of new entrants, and threat of substitute products.
Secondly there is the bargaining power in input and output markets containing:
bargaining power of buyers and the bargaining power of suppliers. These two
large sections containing the five forces model show how an industry is
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profitable. It is vital to contain the industry analysis portion of the valuation
because industries throughout the world have different profitability structure,
and an investor has the right to know how and why an industry gives them a
certain average return.
Competitors Moderately High
Threat of New Entrants Low
Threat of Substitute Products Moderately High
Bargaining Power of Buyers High
Bargaining Power of Suppliers Low
Rivalry Among Existing Firms
In the ready to eat cereal and convenience food industry there are three
different firms that inundate the market. Kellogg’s, Post (Kraft company), and
General Mills hold those positions. Kellogg’s is responsible for starting the
industry with the corn flake in 1906. Of the three potential sources of
competition in the industry, rivalry among existing firms is the most viable of the
three competitive factors. Rivalry among existing firms sets the benchmark for
how companies in the industry will calculate their profitability. In the ready to
eat cereal and convenience food market brand identification is the key rivalry
point among the firms involved. This allows price to not account for a large
portion of the competition so that profitability and market share can be gained
elsewhere.
Industry Growth
Rivalry among existing firms is beneficial because it will keep each firm
actively inventing and reinventing new and old products. Highly competitive
firms have different aspects to compete on and in the ready to eat cereal and
convenience food industry brand identification is the leading advantage.
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Kellogg’s dominates the industry of ready to eat cereal and convenience foods
with the vast array of brands like Kellogg's®, Keebler®, Pop-Tarts®, Eggo®,
Cheez-It®, Club®, and Nutri-Grain®. General Mills competes with their brands
of Cheerios®, Wheaties®, and Lucky Charms®. Post cereal brands which are
owned by the Kraft Corporation have many brands that give Post their spot in
the market. Grape Nuts, Raisin Bran, Shredded Wheat, Toasties Bran Flakes
Fruit & Bran are some of the brands that Post makes.
Concentration
This industry has a steady growth rate over the past five to seven years of
operation. Changes have come from new products and buy outs of smaller
companies so that the portfolio of each major player has grown steadily.
Kellogg’s has done more buy outs of smaller companies in recent years to take
over the number one position in the ready to eat cereal category of the market.
Differentiation/Switching Costs
The degree of differentiation in the industry are such that the products
produced are different enough that price is not a reason that switching would
occur unless the product is priced too far above or below industry average. The
industry giants; Kellogg’s, General Mills, and Post compete on brand
identification and introduction of new products instead of engaging in price wars.
One of the big issues that all three companies have tried to profit from is the
organic and healthy eating push that is being made.
Scale/Learning Economies
In the industry leaders are so big that they are able to acquire newer
smaller companies to grow their already multi billion dollar businesses. The race
for grabbing the market share of organic, natural, and health conscious ready to
eat cereal and convenience foods is the competition of late. There is not a high
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fixed to variable cost ration in this industry therefore prices among competitors
remains extremely close and price wars do not occur.
Exit Barriers/Excess Capacity
It is very rare that the ready to eat cereal and convenience food industry
would have excess capacity because many of the products they produce have a
short shelf life. Also the amount of product produced is closely monitored to
insure that a profit is turned. Unless one industry giant could come up with the
resources to buy out another giant than the exit barriers of the industry are high
because the manufacturing process and the plants they are held in are
specialized facilities. Since the facilities for manufacturing are specialized
liquidating property, plant, and equipment would be very difficult.
The rivalry among the existing firms is moderately high and each company
that is considered an industry competitor is working hard every day to create
new products. Also more money is spent making sure that existing products are
branded and continue to hold their market share or gain an even larger foot
hold.
Kellogg's worldwide market share
Kellogg's Competitors
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Threat of New Entrants
The threat of new entrants into the industry is very low, but there is a
possible threat of creating a smaller niche market; like the natural, organic, and
health conscious market, and then being bought out by a large industry player.
The reasoning behind the industry having a low threat of new entrants is due to
the industry being old, established, and the industry leaders having such large
percentages of market share.
Scale Economies
With large economies of scale with for Kellogg’s, General Mills, and Post
the threat of having a new competitor is very low. The amount of capital that
would need to be raised alone would make it near impossible to enter in to the
industry and be a true competitor. Also the amount of money that is invested
into brand identification is astronomical. Another part of the business that needs
a large amount of funding is research and development. At the end of 2005
Kellogg’s spent over 118 million dollars on R&D. Physical plants and equipment
are also very expensive items a company would need to be a player in the
market and unless a new mover had a huge contract with Wal-Mart or a huge
grocery store chain it would not be feasible to invest a large dollar amount into
property, plant, and equipment.
First Mover Advantage
The first mover advantage is has been an important factor for the ready
to eat cereal industry, because the faster any of the top three companies can get
a quality product developed, marketed, and on the shelves of a local grocery
store or Wal-Mart, the faster people recognize that Kellogg’s, General Mills, or
Post made that product. According to the Kellogg’s website fifteen percent of all
sales are from products introduced in the last three years.
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Channels Of Distribution/Relationships
With Kellogg’s inventing the ready to eat cereal industry it is very difficult
for a competitor to take over the shelf space they have created and intrude on
the relationships that they have created with their clients over the last one
hundred years of business. General Mills and Post also have the advantage of
longevity in the industry to keep their position on the shelf and to make sure
contracts are renewed.
Legal Barriers
The only legal barrier that would affect the industry is the Food & Drug
Administration’s strict regulations for ready to eat cereal and convenience food
products. These regulations are strict but not costly nor difficult to adhere to.
This would make it easier for a new competitor to enter into the industry.
In the ready to eat cereal and convenience foods industry the threat of a
new company to move in and take away Kellogg’s, Post, General Mills, Sara Lee,
or Conagra market share is so low that it is not a concern on the radar for any of
the above mentioned industry giants. The reason for this is that they spend so
much money on R&D and brand advertisement that a new company could not
find a way to effectively create and market a product that would take a
considerable chunk of the market share in the industry.
Threat of Substitute Products
The threat of substitute products for the industry is very high. Each
company in the market has an equivalent product to that of their competitors.
Each product performs the same service as the other; they nourish and satisfy
the consumer. The threat explains why the industry invests so much money into
brand identification and R&D.
The threat of substitute products is the highest ranking danger to the
ready to eat cereal industry. If the consumer is an economical shopper the off
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brand plastic bag of cereal on the bottom shelf is just as satisfying as the
branded product that is eye level on the shelf. That is why the industry puts
hundreds of millions of dollars into the branding of their products. Another tactic
of Kellogg’s, General Mills, and Post is to advertise on children’s television
networks and pair their cereals with different shows and their characters’ so that
mothers and fathers will have to buy the box of cereal with the free toy on the
inside. To keep the customer coming back to purchase the same box of cereal
or a new one they can collect UPC codes on the back of the boxes and mail them
in to receive an even larger prize that features their favorite character and
Kellogg’s, General Mill’s, or Post’s name cleverly plastered across the front and
back of the t-shirt, bag, or DVD movie. According to Jared Hansen, professor of
marketing at Texas Tech University, large companies like the ones mentioned
above spend lots of money to ensure that their products are eye level with the
customer. All of these tactics are employed by the companies to keep their
customers loyal and ensure no products will be substituted for their own.
After careful scrutiny of each product on the isles of local Wal-Mart’s and
grocery stores proves that the products that are the newest, most popular, and
advertised the most frequently are eye level with flashy color packaging. This
proves that the threat of substitute products is one of the leading concerns of
Kellogg’s and its competitors. They constantly fight for market share by trying to
increase brand image.
Bargaining Power of Buyers
The bargaining power of buyers is less of a concern than expected due to
the adamant position that industry leaders take when talking about price. They
swear that price is not a concern and that brand identification is the key factor in
making a product successful. The price sensitivity does not need to be watched
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too carefully, but is taken into consideration. The relative bargaining power is
near non-existence.
Price Sensitivity
The price sensitivity issue of cereal can be a real factor if a product is
priced to high or too low. If Kellogg’s prices a box of Corn Flakes considerably
higher than Post Toasties then the average consumer will choose the Post
product. Also most all consumers have a sense of quality and if a product is
priced too low then they will perceive the product as inferior to their quality of
life.
Relative Bargaining Power
On the topic of relative bargaining power not one single customer can
change Kellogg’s bottom line. The customer’s switching costs are very low
because another product is an arm length away. Even though all three industry
moguls swear that price is not an issue they do compete on the purchaser of the
product and that is taken into account. Taking into account the commercial
buyers for Wal-Mart, grocery store chains, and other non-retail customers they
try and drive the wholesale price down so that when they turn around and sell to
the end user they can also make a profit. According to Modern Marvels, in any
given grocery store across the country the average profit on any single item
chosen from the shelves is .01 cent. That just proves that no matter if it is the
end user or the wholesale buyer the price is determined by the producer.
The bargaining power of buyers is not a threat in the industry of ready to
eat cereal and convenience foods. The price sensitivity is a concern if a
Kellogg’s, Post, or General Mills gets greedy and wants to make too much of a
profit or sells too far below their marginal cost and gets in trouble with the law.
The relative bargaining power can not be taken into account as any type of a
concern.
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Bargaining Power of Suppliers
The bargaining power of suppliers can be looked much the same as
bargaining power of buyers. The suppliers for this industry do not hold very
much power for this industry due to the magnitude of materials that the industry
purchases.
Since almost all of Kellogg’s, General Mill’s, and Post’s raw materials are
commodities all three companies can get them any where in the world. They
can also bargain for the cheapest price possible due the shear volume of grains
and sugars purchased. This gives virtually no power to the suppliers. According
to the 10-K reports of Kellogg’s, for the past five years hedging contracts and
futures have been used to keep the cost of raw materials low and predictable.
The industry is so large and purchases so many basic materials that
suppliers are not able to attain higher prices out of Kellogg’s, Post, and General
Mills. The raw materials are handled so closely due to the fact that the price of
grain and sugars is a large percentage of the price. The next most important
cost is the cardboard and graphics printing on the boxes, but since they give so
much business to the printing industry the printing industry is unable to charge a
premium for their services. In conclusion the multi billion dollar industry holds
the upper hand on all suppliers in turn giving them no power to negotiate prices
in their favor.
Conclusion
The ready to eat cereal and convenience food industry is classified
through the utilization of the five forces model. This outlined how the industry
as a whole is profitable. More importantly it showed that the rivalry among
existing firms is extremely high, the threat of new entrants is low, the threat of
substitute products is also high, the bargaining power of buyers is high, and
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lastly the bargaining power of suppliers is low. The straightforward view of the
five forces model proves that the industry pores money into creating ways to
keep an upper hand on its’ existing rivals and also construct ways to have a
customer choose their product over another.
Value Chain Analysis
Key Success Factors
In the highly concentrated ready to eat cereal and convenience food
industry being able to identify what sets one industry apart from another, and
why, is an integral part of the valuation process. There are many factors within
an industry that allow it to be the frontrunner. The first and most important
factor for the ready to eat cereal and convenience foods industry is brand
identification. This guarantees that sales will be made and customers will return
time and time again to buy the same product or another product that carries the
same label. All companies inside the industry value this key success factor as
the most important arm of their business. With over 100 trademarks and sixteen
different brand names Kellogg’s leads the way. The brands that each company
holds work for them on an international level. Each company is spending more
money to invest in their international business operation. This recognition allows
consumers to easily recognize the brand name of their preferred company and
relate that name with quality.
Another factor that creates value for the industry is the numerous
products that are created in the research and development facilities that
Kellogg’s, Post, General Mills, and others put hundreds of millions of dollars into
each year. Kellogg’s alone spent 190 million dollars on research and
development at it’s facility in Battle Creek, Michigan. The lengthy amount of
time that goes into the process of conceptualizing, creating, and testing a new
product is well worth it’s’ weight in gold, because that one product can be sold
all over the world. That one product is able to be made the exact same way
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from New York to New Delhi. The only difference is the advertising and name of
the product. This investment insures that the products that are developed and
put into production will be highly sought after in the ready to eat cereal and
convenience food markets.
The next success factor that is vital to the success of the industry is the
amount of money that the industry leaders invest into advertising for each one of
the hundreds upon thousands of products in a companies’ portfolio. In the fiscal
year of 2006 Kellogg’s spent 915 million dollars on advertising and each of
Kellogg’s competitors invested close to the same amount in terms of their ratio of
advertising to net sales.
Lastly all of the competitors in the industry speak adamantly that there is
no time or money spent on price. Each competitor of Kellogg’s and Kellogg’s
themselves have information on their websites’ and 10-K reports discussing that
there is no competition within the industry on price. This frees up time and
money so that new products can be developed, advertising dollars can go to
work, and brand identification can be empowered.
The need to understand how an industry is designed and ultimately
successful is paramount, because when that is determined an industry leader can
be valued against the overall industry blueprint.
Competitive Advantage Analysis
The competitive advantage takes the industry outline and then compares
a specific firms’ outline to that industry. With Kellogg’s as the industry leader
many of the key success factors that summarize the industry have been devised
and implemented by Kellogg’s.
Kellogg’s main strategy to their competitive advantage is product
differentiation. They offer a wide variety of products all emblazoned with the
Kellogg’s logo on every box, bag, or wrapper that comes out of a Kellogg’s plant.
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Kellogg’s spent almost ten percent of total net sales on advertising, and that
dollar amount represents how committed Kellogg’s is to having their name
recognized over the entire globe.
Kellogg’s is the leading ready to eat cereal brand in the world holding a
52% market share. One of the reasons for such success is their worldwide
expansion since the beginning of their operation. They have open a plants in
Canada (1914), England (1920), Australia (1934), Mexico (1951), and New
Zealand (1951). Now they have plants in South America, Scandinavia, Europe
and Asia. Kellogg does not only expand globally, they also expand domestically.
Kellogg’s completed the largest acquisition in its history, the $4.56 billion
purchase of Keebler Foods Company, a leading producer of cookies and crackers.
Kellogg’s also has benefited from the acquisition of health foods leader Kashi
Company. Kellogg’s product line now represents 52 percent of worldwide sales,
with 32 percent coming from snacks and the remaining 15 percent from other
grain-based foods. Kellogg’s has worldwide recognition that allows them to keep
introducing new products into the market, acquisitions are made easier because
all the new products are backed with the Kellogg’s brand name.
Kellogg’s spends more money on advertising than their closest
competitors. Kellogg’s flexed their muscles in 2006 by spending 915 million
dollars on advertising and brand identification. They teamed up with numerous
children’s movies to create a customer base that had to eat their cereal in the
morning and have their snacks at lunch and after school. Kellogg’ makes sure
that their differentiation strategy goes to work for them throughout the day with
their customers by offering numerous products that can be consumed morning,
noon, and night. With Kellogg’s competitive advantage resting highly in the
differentiation category they are able to excel as the industry leader in the ready
to eat cereal and convenience food industry.
Kellogg’s also uses some aspects of the cost leadership advantage by
working very hard in the last six years to run their production facilities more
efficiently without spending large amounts of capital on new equipment and
21
new facilities. That change that Kellogg’s made was part of a new strategy that
they wanted to use to run their business. The other aspects they wanted to
implement were growing their cereal business, expanding their snack business,
and making small intelligent acquisitions.
Kellogg’s in the Future
Kellogg’s wants to keep their annual growth in the single digits, and has
accomplished that goal for the last four years. As they grow they will hope to
gain more market share worldwide in ready to eat cereal and convenience foods.
To attain their goals Kellogg’s will have to keep costs low by continuing to find
more ways to run their production facilities efficiently. They will also need to
continue to spend large amounts of money on research and development to
create new products. Another way to keep costs down Kellogg’s will continue
engage in long term contracts for most of the commodities they purchase. With
corn prices on the rise due to the increased use of ethanol for fuel; the contracts
will be key in reducing costs. Another way to guarantee their number one spot
Kellogg’s will have to again continue to use futures to hedge their expense on
grains and sugars
Conclusion
Through the process of identifying the industry classifying it and its key
success factors, and finally identifying how Kellogg’s is successful inside the
industry it has been proven that Kellogg’s differentiates themselves through
better products, investment into brand identification, research and development,
and advertising that Kellogg’s will be able to retain the leadership role they hold
in the ready to eat cereal and convenience foods industry for many years to
come.
22
Accounting Analysis
Key Accounting Policies Kellogg’s Company follows an accounting policy that is generally accepted
in the United States (US GAAP). The goal of an accounting policy analysis is to
see if the firm’s accounting practices show the actual and true financial actions of
the company. Some estimates are made to the financial statements that are
based on historical experience, future outlook, or other assumptions they feel are
reasonable. Kellogg’s key accounting factors are shown through; inventory (low
costs), goodwill (trademarks), property (equipment), and revenue recognition.
The way a company treats and records its inventory allows a small portal
to view what the firm is doing. Kellogg’s conforms to US GAAP, International
Accounting Standards, and SFAS No. 151 to make sure their inventory is valued
right. This clarifies that abnormal amounts of idle facility expense, freight,
handling costs, and spoilage should be recognized as period charges, rather than
as inventory value. This makes inventory valued at the right economic and true
value. This standard also provides that fixed production overheads should be
allocated to units of production based on the normal capacity of production
facilities, with excess overheads being recognized as period charges (Kellogg’s
10-K 2007). The company adopted this standard starting in the fiscal year after
June 2005. Management believes the Company’s pre-existing accounting policy
for inventory valuation was generally consistent with this guidance and does not,
therefore, currently expect the adoption of SFAS No. 151 to have a significant
impact on 2006 financial results (Kellogg’s 10-K 2007). This shows that
management is changing accounting policies to make sure a fair value of
inventory is shown. They do not try to overvalue it to make assets look bigger,
which is more on the conservative accounting side.
23
Inventory Analysis
0
500
1000
1500
2000
2500
2002 2003 2004 2005 2006year
Inve
ntor
y (in
mill
ions
)
General MillsKellogg'sKraft
As the graph above demonstrates, Kellogg’s keeps the smallest amount of
inventory on hand. This could mean two things, Kellogg’s either keeps little share
of inventory on hand, or they have the smallest market share of the industry
therefore not having as much inventory as the rest of the industry. As we saw in
the Business strategy and analysis Kellogg’s does not hold much market share,
so this inventory analysis shows it does not hold much inventory. But Kellogg’s is
a market leader, so their inventory is selling they just do not keep as much on
hand as everyone else. It also displays how they do not over estimate their
inventory, which would ultimately overstate their assets.
Trademarks are also a huge factor in brand name recognition. Kellogg’s
thrives on its ability to market to everyone, which means brand name is vital.
Goodwill and intangible assets are mostly made up of the trademarks Kellogg’s
has acquired, “Keebler Foods Company.” Management expects the Keebler
trademarks, collectively, to contribute indefinitely to the cash flows of the
Company. Accordingly, this asset has been classified as an “indefinite-lived”
intangible pursuant to SFAS No. 142 “Goodwill and Other Intangible Assets”
(Kellogg’s 10-K 2007). Under this standard goodwill is not amortized but tested
at least annually for impairment. This kind of testing requires a comparison
between the fair value and the carrying value of each unit. If carrying value
24
exceeds fair value, goodwill is considered impaired and is reduced to the implied
fair value. Kellogg’s devised its own standard for testing intangible assets. They
test it at least once and year to make sure that the fair value is the actual value.
This keeps their assessment of assets to its true economic value.
The company property is mostly made up of plant and equipment used for
manufacturing needs. These assets are recorded at cost and depreciated over
the estimated useful life using the straight-line method, and accelerated methods
where permitted for tax reporting purposes. Plant and equipment are reviewed
for impairment when conditions indicate that the carrying value may not be
recoverable. These are true when there is an extended period of idleness and
plan of disposal of the asset.
Assets to be sold are written down to realizable value at the time the
assets are being actively marketed for sale and the disposal is expected to occur
within one year. As of year-end 2004 and 2005, the carrying value of assets held
for sale was insignificant (Kellogg’s 10-K 2007). This policy allows for the assets
of Kellogg’s to be depreciated over time and checked for impairment. This makes
this accounting policy key in showing how useful their equipment is and what the
life-span of each piece can be.
Kellogg’s recognizes sales after delivery of the product to the buyer, net of
discounts, allowances, and returns. This shows that Kellogg’s does not overstate
its actually sales because it is not even recorded until delivery is done. “Where
applicable, future reimbursements are estimated based on a combination of
historical patterns and future expectations regarding specific in-market product
performance. The Company classifies promotional payments to its customers, the
cost of consumer coupons, and other cash redemption offers in net sales”
(Kellogg’s 10-K 2007). The cost of these promotional payments is recorded in
cost of goods sold. This insures that all payments and sales are recorded at
actual cost. Other types of consumer promotional expenditures are normally
recorded in selling, general, and administrative (SGA) expense (kelloggs.com).
25
In conclusion, Kellogg’s uses inventory (low costs), goodwill (trademarks),
property (equipment), and revenue recognition to show the true financial actions
of the company. We can easily tie these policies back to the key success factors.
These factors suggest that brand recognition is vital within the industry making
goodwill (trademarks) a very important thing allowing accounting policies to be
very precise in how they are accounted for. Also, they industry analysis suggests
that there is no price competition between firms. This links back to revenue
recognition and how Kellogg’s accounts for it. The key accounting policies say
that revenue is only recognized after sales are delivered. US GAAP moderates
that they do all of these policies correctly and Kellogg’s sets their own standards
to make sure the true economic value is shown.
Accounting Flexibility
Managers are given the ability to have flexible ways to report their current
economic transactions, in order to make the financials informative to an outside
analysis. The accounting flexibility shows how conservative or aggressive
Kellogg’s reports its key accounting policies. Kellogg’s has numerous areas in
which reporting of their accounting numbers offers some flexibility and estimates
based on their best beliefs. These five categories only elaborate on Kellogg’s key
accounting policies and how flexible they are in accounting for those policies.
Estimates
In its notes to the financial statements, Kellogg’s shows that “the
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates”. Estimates play a
role in a large number of accounting numbers, which gives managers the ability
to manipulate the numbers or create an accurate description of what is
happening. Because some of these numbers are based on estimates, it is
possible that these estimates are incorrect. It is up to management to use this
power in order to create an accurate description of what is happening in their
26
business and to not use it to manipulate the financial statements. This ties into
the key accounting policies in many ways, if they estimate their revenue
recognition to high this could mean that their company is ultimately overstated
and in the end overvalued. Another aspect of estimating that keys into the
accounting policies is the way they estimate for their trademarks. If they
estimate their value as more than their worth that represents flexibility they have
to overvalue their assets and ultimately overvalue their company.
Accounts Receivable
Kellogg’s has a large degree of flexibility in reporting its accounts
receivable. The flexibility arises from the mangers ability to set the allowance for
doubtful accounts. Kellogg’s reports that its allowance for doubtful accounts is
determined from a “review of past balances and other specific account data.”
This simply means that Kellogg’s looks at its previous records to determine what
amount of accounts receivable it did not collect and bases its number on that.
Other specific account data encompasses a large amount of data from a number
of Kellogg’s customers. Given their ability to generate this allowance for doubtful
accounts, Kellogg’s mangers have the ability to underestimate this in order to
overstate assets or vise-versa. This also ties into the key accounting policies. If
they have large degree of flexibility in reporting accounts receivable then they
could be recognizing revenue before it is received. They consider revenue
recognition a key accounting policy but a flexible accounts received could mean
that they are recognizing revenue before it is actually incurred.
Inventories
One area in which Kellogg’s is given flexibility is in inventories. Kellogg’s
chooses to report its inventory at the lower of cost or market. This only adds to
the idea that they use a conservative accounting base. Kellogg’s could report
inventories in any way they see fit, such as LIFO or FIFO, but they feel that by
using lower of cost or market they present a accurate description of their
situation. By using the lower of cost or market, Kellogg’s insures that their
inventory is never overvalued eliminating any large write downs of inventory.
27
One factor to consider is how the market price is computed using lower of cost
or market, since different buyers pay different prices for the same product. The
lower or cost or market value of inventory is a way to stay in between LIFO and
FIFO; it keeps a company from leaning one way in terms of higher profits vs.
higher expenses. As stated in the key accounting policies Kellogg’s does operate
on the lower scale of inventory on hand. It does not however suggest a “just-in-
time” inventory but more of a smaller market scale. Kellogg’s direct competitors,
General Mills and Kraft, do operate on a larger inventory scale, but that does not
make them an industry leader. Kellogg’s holds fewer inventories and has the
flexibility to report it however they want. They choose to not utilize that flexibility
and use lower cost of market to report it, adding to the idea of conservative
accounting.
Goodwill
Kellogg’s has a large amount of goodwill on its financials due to a recent
acquisition of Keebler Foods Company. Kellogg’s expects that by purchasing
Keebler, they will receive future economic benefits. Under SFAS No. 142,
goodwill does not have to be amortized but should be tested annually for
impairment. In order to test for impairment Kellogg’s compares the fair market
value to the current carrying value of goodwill. In the event that the carrying
value is larger then the fair market value, impairment exists and a subsequent
impairment expense will be charged in order to drop the carrying value.
Management has much control and flexibility over the treatment of goodwill. As
mentioned in the key accounting policies Kellogg’s is responsible for determining
what the true fair market value of the assets is equal to, this creates another
important area in which management is allowed to determine if a write-down will
occur. It is possible for Kellogg’s to delay a write-down of goodwill which would
again overstate the assets for the company. Referring again to the key
accounting policies Kellogg’s impairs their goodwill at least annually to make sure
the true economic value is portrayed. In order to help self regulate, Kellogg’s
acknowledges that is does occasionally hire a third-party to calculate the fair
28
market value of their goodwill, but even this could be misleading considering
Kellogg’s still has the ability to determine what is reported.
Property
Most of Kellogg’s property consists of facilities and equipment used to
manufacture products. These are recorded at time of sale at the historical cost
then depreciated over useful life of the asset. Kellogg’s acknowledges that these
useful lives are estimated with some having a wide range to years. Kellogg’s key
accounting policies suggest that they after several years of use they are
reviewed for their recoverability and if it matches the depreciation life accurately.
Manufacturing machinery and equipment have a useful life of anywhere from 5
to 20 years depending on certain variables. These useful lives are generally
precise but since they are determined by management they have the potential to
manipulate them in order to over or under state their assets. By choosing a
useful life that is obviously longer then what could be expected, management is
able to understate their depreciation expenses each year, which in turn would
allow them to overstate their income. After reviewing Kellogg’s 10-K there is no
evidence that management is extending the useful life of machinery any longer
than depreciation suggests.
Price Risk This is a policy that has a lot of flexibility. As stated in the industry
analysis Kellogg’s is part of many different countries all over the world. They
compete in a world market which means that they deal with many different
exchange rates. There is a large margin in how they deal with such rates and
how they account for them. In the disclosure of the 10-k there are many charts
and tables to explain how this is done which leads us to believe that they are
very conservative on their accounting of exchange rates. The idea of price risk
and exchange rates bring a lot of concern of aggressive accounting to the table,
but as stated in the business and industry analysis Kellogg’s thrives on its foreign
markets. If these exchange rates are not handled correctly they could provide a
potential red flag for future hedging and overvaluation of the company.
29
Accounting Strategy
Kellogg’s company, as already stated, follows US Generally Accepted
Accounting Principles, in accordance with the Financial Accounting Standards
Board, in its presentation of data. After close review of the financial statements it
is confirmed that Kellogg’s uses a very conservative accounting strategy. Its
competitors such as General Mills and Kraft share in this idea of conservative
accounting.
In the food production industry a lot of the same accounting principles are
used. Kraft and General Mills share in the idea of recognizing revenue. The
company recognizes revenue after delivery of products to its customers. Some of
the differences Kellogg’s might have from other competitors, in recognizing
revenue, is the actual price of recognition. They rely on local customer pricing
and promotional practices to account for the revenue at the point of delivery.
Relying on such things means that they cannot inflate prices to increase sales on
the income statement. The price is not company made but it is buyer made
meaning that the accounting of revenue is conservative.
Kraft and General Mills also share the straight-line depreciation of assets.
They are recorded at historical cost and depreciated over the life of the asset.
This shows that there is not much flexibility in the accounting of these assets,
since they are depreciated over time. This adds to the conservatism the industry
shares in its accounting practices.
Kellogg’s differs in accounting for liability of misbranded food. If products
are misbranded Kellogg’s recalls the items and incurs the cost of the consumer
loss. They also could suffer losses of consumer confidence in their products due
to the recall. As stated in the key accounting policies and accounting flexibility,
Kellogg’s keeps very low inventory which can reduce the mistake of misbranded
food. If such an event should occur it would be caught fast, due to little
inventory. In reviewing their disclosure Kellogg’s account for the liability if such a
30
loss were to occur. This makes their accounting economic ready and therefore,
conservative.
Though the companies are similar Kellogg’s has made some recent
changes in accounting policies. During 2006 a new policy was adopted. The
adoption was a “Share Based Payment”, SFAS No. 123 due to recognition of
compensation expense with employee stock options. This requires that “public
companies to measure the cost of employee services received in exchange for an
award of equity instruments based on the grant-date fair value and to recognize
this cost over the requisite service period” (Kellogg’s 10-K 2007). This conversion
has increased selling general and administrative expenses in 2006, which only
allows the accounting to be that much more conservative. By adopting a
principle that increases its expenses Kellogg’s is showing that its accounting
Strategy really shows the economic realty of the company.
In conclusion Kellogg’s accounting strategy is very conservative. The food
production industry in itself is a very conservatively accounted industry. Kellogg’s
shares in many principles with Kraft and General Mills but differs in its own way.
We can easily tie in the key accounting policies and accounting flexibility in the
determination of the conservative versus aggressive debate. After careful review
of the financial statements and policies it is concluded that Kellogg’s is the most
conservative of the three.
Quality of Disclosure
Similar to the choice of accounting strategies and flexibility, management
has the opportunity to choice the quality of disclosure. The quality of disclosure
can be as important as the financial statements in helping an analysis value a
company. Upon review of the financial statements in Kellogg’s latest 10-K, it is
adequate to say that their quality of disclosure is relatively high. Located in the
notes to the financials are numerous sections related to some of Kellogg’s most
important accounts and accounting policies. This high level of disclosure holds
31
true for most of the major players in the Packaged and Processed Goods
Industry such as Kraft and General Mills.
One of the most important practices implemented by Kellogg’s is the
degree of segmentation by geographical areas. Kellogg’s breaks down some of
its more important accounting figures into four distinctive areas, which are North
America, Latin America, Europe and Asia (Pacific). Kellogg’s segments its net
sales by these four major areas and also incorporates for foreign currency impact
of operating in different geographical areas around the world. By segmenting
their net sales and accounting for the foreign currency impacts an outside
analysis is able to see exactly how profitable a current section of the world is and
where there are areas for improvement. In addition to segmenting its company’s
net sales, Kellogg’s also segments its company operating profits by the same
four major geographical areas. This disclosure of operating profits if also
adjusted to account for the impacts of foreign currency adjustments. By
segmenting for its companies different geographical areas, in the accounting
areas of net sales and operating profit, Kellogg’s is able to give its financial
statements a high degree of disclosure, which in turn enable them to be more
effective to an outside analysis.
Disclosure of future and long term obligations can give a 10-K a high level
of disclosure that may be missing from those with little information concerning
company’s future obligations. There are three major areas in which Kellogg’s
discloses a high degree of information concerning future obligations, which
include pension, post employment and post retirement expenses. Although these
three areas may seem to be repetitive, they do cover three different types of
benefits and effect different types of people. Pension obligations refer to the
retirement options and benefits that are provided to Kellogg’s employees.
Kellogg’s goes to great lengths to describe and have the 10-K project an
accurate description of what its pension expenses are. They accomplish this by
having a detailed statement which includes all of the components that create the
pension expense.
32
Pension Expense (10-k reported)
(millions) 2006 2005 2004
Service cost $ 94.2 $ 80.2 $ 76.0 Interest cost 172.0 160.1 157.3 Expected return on plan assets (256.7 ) (229.0 ) (238.1 ) Amortization of unrecognized transition obligation — .3 .2 Amortization of unrecognized prior service cost 12.4 10.0 8.2 Recognized net loss 79.8 64.5 54.1 Curtailment and special termination benefits — net loss 16.7 1.6 12.2
Pension expense: Defined benefit plans 118.4 87.7 69.9 Defined contribution plans 18.7 31.9 14.4
Total $ 137.1 $ 119.6 $ 84.3 (taken from www.kellogg.com)
This chart, taken by Kellogg’s 10-K for 2007 demonstrates how they
account for pension expense, benefit plans and contribution plans. Post
employment expenses are created through the benefits owed to employees who
are no longer working for Kellogg’s due to numerous conditions, such as long-
term disability. In contrast a post retirement expense is the benefits owed to
former Kellogg’s employees that have met certain criteria such as age and
service to the company. Kellogg’s treats these expenses much as it did the
pension expenses, in that they report and highly disclose any relevant
information in their 10-K. By offering a high level of segmentation and breaking
down each different category of future obligation, an analysis can better
understand what future obligations that Kellogg’s will owe.
As shown through the previous examples, Kellogg’s has an extremely high
level and quality of disclosure. Management goes to great lengths to provide
adequate information that enables the 10-K to depict a true and accurate
description of the economic situation. Through the use of geographical
segmentation in net sales and operating profits, it is possible to see exactly
which areas are highly productive and which areas are beginning to show
improvements to the company. The disclosure of pension and retirement benefits
also gives the 10-K a high quality of disclosure. Due to the fact that these
benefits constitute a substantial portion of future obligations, it is important for
33
Kellogg’s to acknowledge and break these expenses down in order to create the
true picture. The high level of disclosure and segmentation that Kellogg’s shows;
ties itself directly to the fact that Kellogg’s also choices to use a conservative
approach to its accounting strategy. They believe it is better to depict the “true
and accurate” picture of the business, rather then deceive the public and attempt
to hide some of their less attractive business decisions.
34
Screening Ratio Analysis
Kraft Foods Inc.
2002 2003 2004 2005 2006 Net Sales/ Cash from Sales 0.9955 1.0084 1.0054 0.9954 n/a* Net Sales/ Net Accounts Receivable 9.5388 9.0525 9.0844 10.077 n/a* Net Sales/ Inventory 8.7886 9.1229 9.3322 10.2043 n/a* Sales/Assets 0.52 0.51 0.54 0.59 n/a* CFFO/OI 0.06 0.07 -0.02 -0.11 n/a* CFFO/NOA 0.06 0.05 -0.01 -0.07 n/a*
General Mills Net Sales/ Cash from Sales 1.23 1.22 0.9973 0.9979 1.003 Net Sales/ Net Accounts Receivable 10.72 10.96 10.96 10.87 10.81 NS/Inv 9.71 10.41 10.4139 10.84 10.03 Sales/ Assets 0.58 0.6 0.6001 0.62 0.63 CFFO/OI 0.163 -0.38 -0.08 0.1255 0.03 CFFO/NOA 0.039 -0.009 -0.0254 0.0804 0.02
Kellogg's Company Net Sales/ Cash from Sales 0.997 1.002 1.002 1.01 1.006Net Sales/ Net Accounts Receivable 11.21 11.67 12.38 11.58 11.54Net Sales/ Inventory 13.77 13.56 14.12 14.19 13.23 Sales/ Assets 0.813 0.861 0.91 0.962 1.018CFFO/OI -.088 0.111 0.035 -0.049 0.151CFFO/NOA -0.015 0.020 0.007 -0.010 0.032PENSION/SG&A 0.001 0.022 0.032 0.042 *ratios for Kraft 2006 are unavailable due to lack of financial information
35
Quantitative and Qualitative Analysis
The quantitative and qualitative analysis is the section where we break
down the company in two parts: revenue diagnostics and expense diagnostics.
These ratios help explain what is going on with the company itself as well as the
industry. The reason we look at these diagnostics is to see if there’s a
manipulation of income and if its revenue related or expense related.
Revenue Diagnostics 2002 2003 2004 2005 2006
Net Sales/ Cash from Sales 0.997 1.002 1.002 1.01 1.006Net Sales/ Net Accounts Receivable 11.21 11.67 12.38 11.58 11.54Net Sales/ Inventory 13.77 13.56 14.12 14.19 13.23
These three revenues Diagnostics help explain how revenue is being
generated and from what areas. The chart above is Kellogg’s revenue
diagnostics. We came to the conclusion that they are not only able to turn sales
into actual cash but they are able to turn sales back into inventory. This is good
for Kellogg’s but we look at how the industry compares in the section below.
Net Sales / Cash From Sales
00.20.40.60.8
11.21.4
2002 2003 2004 2005 2006Year
Rat
io
Kellogg'sGeneral MillsKraft
With Kellogg’s, General Mills, and Kraft all on top of the perfect ratio of
1.0 to 1.0 it proves that the ready to eat cereal industry is very stable. As this
number approaches 1.0, it tells that the company has been able to turn all of its
36
sales into actual cash for the company. These numbers are relatively close to 1.0
mainly due to the fact that all three companies sell to fairly established
companies and large supermarket stores, such as Wal-Mart, which in turn lowers
the uncollectible accounts for each company.
Net Sales / Net Accounts Receivable
02468
101214
2002 2003 2004 2005 2006Year
Rat
io
Kellogg's
General Mills
Kraft
Sales/ Net Accounts Receivable give an idea of how much of the
company’s sales generate into accounts receivable. In this case, the higher the
ratio the higher a companies total accounts receivable are. When a company has
a large accounts receivable it increases their liability that they may not be able to
collect all of that account. This ratio shows that Kellogg’s is an industry leader,
and has not been able to keep their accounts receivable all that low, thus
increasing their uncollectible accounts. Although all companies are close in
number Kellogg’s has a definite high accounts receivable number. This number
can be a bit misleading due to the fact that it is an industry strategy to keep a
low accounts receivable, insuring that past sales are converted in cash.
37
Net Sales / Inventory
02468
10121416
2002 2003 2004 2005 2006Year
Rat
io Kellogg'sGeneral MillsKraft
Sales/ Inventory ratio tells how the company can convert sales dollars into
inventory. Once again Kellogg’s is the leader in this area. This could be a good
and a bad thing at the same time. It could mean that Kellogg’s is easily able to
convert cash into inventory, but it could also mean they have excess inventory
on hand. Having excess inventory on hand could mean they are overstating their
assets and do not write off inventory as it should be written off. Once again the
industry stays around the same numbers, but Kellogg’s has a definite jump on
everyone else.
In conclusion the revenue ratios have not shown any significant problems
with income manipulation. Although Kellogg’s does lead the industry in most of
these ratios it might not be the best thing. They have not been able to keep their
accounts receivable as low as the rest of the industry which could pose a threat
in the future. All together though there weren’t any potential red flag’s that could
change the way their accounting policies and strategies appear in the future.
38
Expense Diagnostics 2002 2003 2004 2005 2006
Sales/ Assets 0.813 0.861 0.91 0.962 1.018CFFO/OI -0.088 0.111 0.035 -0.049 0.151CFFO/NOA -0.015 0.02 0.007 -0.01 0.032
The expense Diagnostics show how income is being shown through its
expenses. Looking at the chart above Kellogg’s does not seem to be overstating
any part of its company, considering the negative numbers. They seem to be
pretty stable with little decline or growth in any area. In the section below we
will look at Kellogg’s and the rest of the industry and see where their possible
distortions may occur.
Sales/Assets
00.20.40.60.8
11.2
2002 2003 2004 2005 2006Year
Rat
io
Kellogg'sGeneral MillsKraft
Asset Turnover helps show if the company is capitalizing its expenses. The
ratios of the entire industry are pretty stable, all increasing. We would only see
concern if this ratio started to decrease meaning that the assets were overstated
which would mean they are not capitalizing their expense when and where they
need to be capitalized. We see that Kellogg’s has an increasing ratio which
means their sales are increasing and so are their assets but it is occurring at a
steady rate showing now real concern. General Mills and Kraft are also increasing
39
showing that the food processing industry does a pretty good job of writing
obsolete items off and capitalizing their expenses.
Cash Flow from Operations / Net Operating Assets
-0.1
-0.05
0
0.05
0.1
2002 2003 2004 2005 2006Year
Rat
io
KelloggsGeneral MillsKraft
CFFO/NOA is a way to measure the return a company is receiving from its
operating assets, in terms of cash flow from operation. This ratio has a tendency
to be able to burry things such as long-term assets (PP&E). This ratio is intended
to bounce around slightly as it does throughout the industry not just Kellogg’s.
Kellogg’s is not investing a significant amount of their capital into operating
assets to create a greater cash flow from operations. Kraft on the other hand has
a quickly declining ratio which could mean that their cash flow significantly
decreased or they got rid of some of the operating assets (corporate garage
sale). This could not be a bad thing; it could mean they are getting rid of unused
machinery.
40
Cash Flow from Operations / Operating Income
-0.5-0.4-0.3-0.2-0.1
00.10.2
2002 2003 2004 2005 2006Year
Rat
io
KelloggsGeneral MillsKraft
This ratio represents the amount of cash flow from operations which in
turn are explained by operating income. This ratio is intended to bounce around
as well, which it clearly does. Kellogg’s and Kraft stay somewhat steady while
General Mills shows a significant decline in 2003. This could mean that their cash
flow from their operations was not being converted into operating income. The
lower is the ratio, the better for the company. This shows that more money is
coming in from direct activities than investing for financing activities.
In conclusion the expense ratios have show many things about the
industry as well as Kellogg’s as a whole. We do not see any potential problems in
income manipulation within Kellogg’s however there are some other components
of the industry that showed significant drops or leaps in the expense ratios. This
could have an effect on how their accounting policies and strategies change in
the future.
Potential “Red Flags” With such a high management disclosure Kellogg’s keeps its readers
informed on what could become a risk in the future. These risks could lead to
potential “Red Flags” in future accounting practices. They include: foreign
exchange risk, interest rate risk, and price risk.
41
Foreign Exchange risk deals with the fluctuations of foreign currency with
effects third party cash flow. These fluctuations directly effect investments in
subsidiaries and cash flow related to reparation of those investments.
Foreign Currency translation Adjustments
(millions) 2006 2005
Foreign currency translation adjustments $ (409.5 ) $ (419.5) Cash flow hedges — unrealized net loss (32.6 ) (32.2) Minimum pension liability adjustments — (124.4) Postretirement and postemployment benefits:
Net experience loss (540.5 ) — Prior service cost (63.6 ) —
Total accumulated other comprehensive income (loss) $ (1,046.2 ) $ (576.1)
(Kellogg’s 10-k)
From the chart above you can see that Kellogg’s accurately accounts for foreign
currency risk, but the question is how accurate can you be? “Primary exposures
include the U.S. Dollar versus the British Pound, Euro, Australian Dollar,
Canadian Dollar, and Mexican Peso, and in the case of inter-subsidiary
transactions, the British Pound versus the Euro” (Kellogg’s 10-K 2007). In order
to stay on top of this issue Kellogg’s asses this risk based on past transactional
cash flow before entering new long-term contracts. This could have an effect on
accounting because assets globally might not be stated at the true economic
value, or it might be difficult to find the value due to currency differences. This
could become a potential “red flag” in the future.
Kellogg’s is also exposed to the realization of variation of interest rates in
the future. “Primary exposures include movements in U.S. Treasury rates,
London Interbank Offered Rates (LIBOR), and commercial paper rates” (Kellogg’s
10-K 2007). In order to keep this problem down to a minimum Kellogg’s uses
interest rate swaps and forward interest rate contracts to reduce interest rates
volatility. In swapping interest rates this allows Kellogg’s to attain the desired
variable versus fixed rate debt, based on current conditions. This could be a red
flag in the future depending on how Kellogg’s swaps their interest rates and how
much of an advantage they can take due to the swap. Also, this could be a red
42
flag depending on what interest rates do in the future and how Kellogg’s reacts
and accounts for them.
Price risk is also a factor that could lead to a potential “red flag.” Since the
industry is based on raw and packaging materials as well as well as fuel and
energy price fluctuations are going to affect the business. “Primary exposures
include corn, wheat, soybean oil, sugar, cocoa, paperboard, natural gas, and
diesel fuel” (Kellogg’s 10-K 2007). Kellogg’s has historically used a combination
of long-term contracts with suppliers, as discussed in the business analysis, and
exchange-traded future and options contracts to drive fluctuations down. The
“red flag” comes in when the costs go up to much to compensate for. How will
Kellogg’s account for such an expenditure. Also, in future accounting practices
how will Kellogg’s account for these option contracts with suppliers? These could
be possible “red flags” in how they display and disclose this information in the
future.
In conclusion Kellogg’s has many future potential “red flags” that could
affect their accounting strategy and policies. Many factors go into how Kellogg’s
discloses such “red flags” in future financial statements.
Conclusion Kellogg’s operates on a very conservative accounting basis. They have a
lot of margin (exchange rates, inventory, and equipment) to be aggressive with
their accounting but they choose not to be. They really tie their accounting
policies into their key success factors together with their trademark (goodwill)
estimates. That is a huge success factor industry wide and Kellogg’s does a
stellar job to make sure they portray the true economic value of their brand
names. There are some potential red flags that could pose future problems, but
as we can tell Kellogg’s does an outstanding job with setting their key accounting
policies, assessing the flexibility of each, choosing to be conservative and then
giving good disclosure of how they account for each part.
43
Ratio Analysis and Forecast Financials
Another method used to value a company is forecasting. This is done first
by formulating ratios which tell how to financially analyze the company. We ran
the ratios on Kellogg’s as well as the other competitors, General Mills and Kraft,
to see what trends we could find throughout the industry. The Food production
industry does not show many trends since food is always going to be in demand.
However we were able to tell certain things about the industry as a whole. After
preparing ratios throughout the industry we then forecasted out the financial
statements for Kellogg’s. We did this for each of the financial statements,
balance sheet, income statement, and statement of cash flows, over the next ten
years. The ratios were categorized in three different categories: Liquidity,
profitability, and capital structure we also added two extra ratios that we thought
showed a lot about the industry. These ratios were set up to show how Kellogg’s
faired in different aspects of the business.
Liquidity Ratios:
Liquidity is the ability for the company to pay back its short term
obligations. They are also a huge indicator on why and how the firm generates
cash flow. The liquidity of a firm can play a large role in how they operate as a
company and where their money is spent first.
Current Ratio: Current Assets/Current Liabilities
2002 2003 2004 2005 2006 Kellogg's 0.585 0.646 0.745 0.694 0.604 Kraft 1.040 1.033 1.071 0.935 0.788 General Mills 0.600 0.920 1.170 0.730 0.517 Average 0.742 0.866 0.995 0.786 0.636
As mentioned in the 10-K reports of the past two years Kellogg’s has
made leaps and bounds to make the company run more efficiently. As proven in
the current ratio, Kellogg’s has been able to use their assets more effectively in
44
congruence to their current liabilities. With their efforts to utilize what they have
over spending money on what they do not have Kellogg’s has shown one reason
they are the industry leader.
Current Ratio
0
0.5
1
1.5
2002 2003 2004 2005 2006
Year
Ratio
Kellogg'sKraftGeneral MillsAverage
As indicated above Kellogg’s current ratio does go slightly up showing a
favorable impact but then drops back down in later years. There is essentially
not much change over the five year span. Compared to the industry Kellogg’s
current ratio is slightly under industry competitors. This shows that Kellogg’s
cannot pay back its current liabilities as fast as other competitors. As a whole the
industry stays fairly close in the aspect that all current ratios are relatively close.
Quick Assets Ratio: Quick Assets/Current Liabilities
2002 2003 2004 2005 2006 Kellogg's 0.279 0.324 0.419 0.347 0.337 Kraft 0.465 0.494 0.421 0.424 0.392 General Mills 0.390 0.560 0.781 0.483 0.346 Average 0.378 0.459 0.540 0.418 0.358
The relationship between cash, securities, and accounts receivable versus
current liabilities are represented through the quick asset ratio. Just because
General Mills is on the top of the graph does not mean that they are the industry
leader. This is evidence that General Mills’ current liabilities are increasing faster
than the quick assets. Kellogg’s has stayed under the industry average. As the
number one company in the ready to eat cereal industry Kellogg’s has shown
45
that with the proper execution of asset management they are able to keep a
relatively steady ratio and stay under the industry average.
Quick Asset Ratio
00.20.40.60.8
1
2002 2003 2004 2005 2006
Year
Ratio
Kellogg'sKraftGeneral MillsAverage
Once again the industry as a whole does stay pretty close. General Mills
jumps ahead for awhile but the close competition between all three firms shows
that there is not much of a trend for the food production industry.
Account Receivable Turnover: Sales/Accounts Receivable
2002 2003 2004 2005 2006 Kellogg's 11.210 11.670 12.380 11.580 11.540 Kraft 9.386 9.053 9.084 10.078 8.880 General Mills 7.870 10.720 10.960 10.874 10.817 Average 9.489 10.481 10.808 10.844 10.412
Kellogg’s shows how they lead the industry in this ratio, because they are
the only company to stay above the industry average for the last five years.
They have continually received their money from customers faster than any
other company in the industry. This allows Kellogg’s to not have to assign large
amounts of money to allowance for doubtful accounts.
46
Account Receivable Turnover
0
5
10
15
2002 2003 2004 2005 2006
Year
Rat
io
Kellogg'sKraftGeneral MillsAverage
Days Supply of Receivable: 365/collection period
Days Supply of Receivables 2002 2003 2004 2005 2006 Kellogg's 32.5 31.276 29.48 31.59 31.63 Kraft 38.88 40.32 40.18 36.22 41.1 General Mills 46.37 34.04 33.3 33.56 33.74 Average 39.25 35.21 34.32 33.79 35.49
The ratio of day’s supply of receivables is essential in any liquidity
analysis. It shows how fast the company is able to collect on its receivables. A
decrease in receivable turnover is the most negative factor in the liquidity
analysis. It means it is taking longer for a company to collect on its accounts.
This could ultimately cause a large problem if the account receivable gets to high
and the company can no longer collect on account because they do not ever
receive the money. This might cause them to sell off some of their debt to
another company like retail merchants which then ultimately costs them their
rightful profit. As shown there is not much change in the industry on days
supply. Kellogg’s however is on top of the industry once again with the lowest
days supply meaning they collect faster than the rest of the industry. The food
production industry once again displays its stability with not much of a trend.
47
Days supploy of Receivables
01020304050
2002 2003 2004 2005 2006
Year
Rat
io (3
65/ h
oldi
ng
perio
d)
Kellogg'sKraftGeneral MillsAverage
Inventory Turnover: Cost of goods sold/Inventory
2002 2003 2004 2005 2006 Kellogg's 7.570 7.570 7.780 7.820 8.260 Kraft 5.164 5.543 5.884 6.534 6.258 General Mills 4.420 5.650 6.190 6.590 6.602 Average 5.718 6.254 6.618 6.981 7.040
Kellogg’s truly separates themselves in this category. Kellogg’s turns over
the inventory in their plants worldwide on average 1.3 times more than any
competitor. Kraft and General Mills are below the industry average in this
category. Since Kellogg’s money is not tied up in inventory for as long as their
competitors’ they are able to have a stronger better functioning “money merry-
go-round”.
Inventory Turnover
02468
10
2002 2003 2004 2005 2006
Year
Rat
io
Kellogg'sKraftGeneral MillsAverage
48
Days Supply of Inventory: 365/holding period
2002 2003 2004 2005 2006 Kellogg's 48.21 48.21 46.91 46.67 44.18 Kraft 70.68 65.84 62.03 55.86 58.33 General Mills 82.58 64.6 58.96 55.39 55.29 Average 67.16 59.55 55.97 52.64 52.6
Day’s supply of inventory represents how long it takes inventory to get in
one door and out another. This allows their assets not to be overstated and for
the idea of “food spoilage” not to be so common. The less inventory spoilage
then less write off’s that occur in the future. Kellogg’s is dominating the industry
in days supply with the lowest ratio. This shows that they really have an efficient
way of getting inventory in one door and out another. The industry as a whole
operates in a fairly close race. General Mills sits at the bottom of the industry
with the largest day’s supply of inventory.
Days Supply of Inventory
020406080
100
2002 2003 2004 2005 2006
Year
Rat
io (3
65/In
vent
ory
Turn
over
) Kellogg'sKraftGeneral MillsAverage
Working Capital Turnover: Sales/Working Capital
2002 2003 2004 2005 2006 Kellogg's -6.64 -9.01 -12.95 -10.53 -6.85 Kraft 101.9 115.96 49.95 -59.74 -15.48 General Mills -3.44 -39.65 24.17 -9.96 -3.92 Average 30.61 22.43 20.39 -26.74 -8.75
Working capital turnover is the ability of a dollar of working capital
(current assets minus current liabilities) to generate sales. A high working capital
49
turnover number is desirable because it shows that working capital is actually
generating sales. Kellogg’s has the lowest number of working capital turnover in
the industry portrayed in negative numbers. Kraft however is the industry leader
and then quickly falls in later years. The industry as a whole shows a very
negative number meaning that their working capital is not generating sales
dollars for them.
Working Capital Turnover
-100-50
050
100150
2002 2003 2004 2005 2006
Year
Rat
io
Kellogg'sKraftGeneral MillsAverage
Liquidity Conclusion
The overall liquidity of the industry refers to the ability of the cash
equivalents to meet its short term liabilities in a timely manner. The industry as a
whole does not portray much change throughout the liquidity ratios. This again
only supports the idea that the food production industry is stable and does not
operate on trends. Kellogg’s does however hold the industry standard in days
supply of inventory. They make sure that they have just enough resources on
hand to operate and not much more. This can be good or bad depending on how
you view the firm.
50
Liquidity Analysis 2002 2003 2004 2005 2006 Current Ratio 0.585 0.646 0.745 0.694 0.604 Quick Asset Ratio 0.279 0.324 0.419 0.347 0.337 Account Receivable Turnover 11.210 11.670 12.380 11.580 11.540 Days Supply of Receivables 32.5 31.276 29.48 31.59 31.63 Inventory Turnover 7.570 7.570 7.780 7.820 8.260 Days Supply of Inventory 48.21 48.21 46.91 46.67 44.18 Working Capital Turnover -6.64 -9.01 -12.95 -10.53 -6.85
Profitability Ratios:
The profitability analysis is set up to show the company’s profit margins.
These help show what is actually going on within the industry and who has the
best profits. This helps show who can minimize their costs then best to show the
greatest profit margin.
Gross Profit Margin: Gross Profit/Sales
Gross Profit Margin 2002 2003 2004 2005 2006 Kellogg's 45.00% 44.40% 44.90% 44.90% 44.20% Kraft 40.30% 39.20% 36.90% 35.90% 36.10% General Mills 41.35% 41.85% 40.52% 39.22% 40.15% Average 42.22% 41.82% 40.77% 40.01% 40.15%
Gross profit margin is calculated by dividing gross profit by sales. This
allows an analysis to determine how much of sales are related to gross profit.
Over the past 5 years, Kellogg’s gross profit margin has stayed consistently in
the 44.0% to 45.0 %. All companies throughout the industry have experienced a
slight drop from 2002 to 2006; however, Kellogg’s continues to maintain the
highest gross profit margin. This simply means that Kellogg’s is able to generate
more sales and keep their cost of goods sold lower, in order to establish a higher
51
gross profit. Overall, Kellogg’s gross profit margin has experienced a slightly
unfavorable drop over the past 5 years, however the drop has been less then
1% point. This can be considered a success as the other main competitors have
experienced drops of up to 4% points over the same span. The main reason for
Kellogg’s recent consistency in gross profit margin, is its continued growth of
both sales and gross profit, although sales has experienced slightly larger growth
which results in decrease in gross profit margin.
Gross Profit Margin
0.00%
25.00%
50.00%
75.00%
100.00%
2002 2003 2004 2005 2006
Year
Rat
io a
s a
perc
enta
ge
Kellogg'sKraftGeneral MillsAverage
Operating Expense Ratio: Operating Expenses/Sales
Operating Expense 2002 2003 2004 2005 2006 Kellogg's 26.80% 26.90% 27.40% 27.70% 28.10% Kraft 19.30% 20.10% 20.70% 20.90% 21.10% General Mills 26.04% 23.53% 22.07% 21.50% 23.01% Average 24.05% 23.51% 23.39% 23.37% 24.07%
Operating expense is calculated by dividing operating expense by sales.
This in turn gives the analysis an idea of how much of sales are tied up in
operating expenses. Much like the gross profit margin, Kellogg’s as well as its
competitors have been able to maintain a fairly consistent ratio. Kellogg’s does
have the most consistent operating expense ratio over the last 5 years; however
they have also had the highest ratio of the industry. This can be seen a negative
factor due to the fact that over time you would like to see this ratio drop,
implying that Kellogg’s was becoming more efficient in their operating expenses
52
(generating more sales per operating dollars). In terms of profitability, this
seems to be the one area that Kellogg’s has been an industry laggard. As
recently as 2006, Kellogg’s was 4% higher then the industry average. This
implies that for every dollar of sales, Kellogg’s has to spend $0.04 more then its
competitors.
Operating Expense Ratio
0.00%5.00%
10.00%15.00%20.00%25.00%30.00%
2002 2003 2004 2005 2006Year
Rat
io a
s a
perc
enta
ge Kellogg'sKraftGeneral MillsAverage
Net Profit Margin: Net Income/Sales
Net Profit Margin 2002 2003 2004 2005 2006 Kellogg's 8.70% 8.90% 9.30% 9.60% 9.20% Kraft 11.60% 11.40% 8.30% 7.70% 8.90% General Mills 5.76% 8.73% 9.53% 11.03% 9.36% Average 8.69% 9.68% 9.04% 9.44% 9.15%
Net profit margin is calculated by dividing net income by sales. This gives
an idea of how much of every sales dollar is retained and turned into net income.
A company would prefer to keep this ratio as high as possible, implying that they
are turning more percent of each sales dollar into net income. Kellogg’s has
again been able to keep an extremely consistent ratio ranging from 8.7% to
9.6% over the past 5 years. Kellogg’s has not been the model for the industry as
both Kraft and General Mills have shown a tendency to have their Net profit
margin experience major fluctuations recently. Kellogg’s net profit margin would
have to be classified as no change, although you could define it as unfavorable
due to the fact that it has shown no real increase over the past. This can be
53
looked at as a positive factor, due to the fact that an analysis can expect the
profitability ratios of Kellogg’s to be extremely consistent compared to that of
it’s competitors.
Net Profit Margin
0.00%
5.00%
10.00%
15.00%
2002 2003 2004 2005 2006
Year
Rat
io a
s a
perc
enta
ge
Kellogg'sKraftGeneral MillsAverage
Asset Turnover: Sales/Total Assets
Asset Turnover 2002 2003 2004 2005 2006 Kellogg's 0.813 0.869 0.891 0.962 1.018 Kraft 0.512 0.514 0.537 0.520 0.618 General Mills 0.481 0.576 0.600 0.623 0.639 Average 0.602 0.653 0.676 0.702 0.758
Asset turnover is calculated by dividing sales by total assets. This in turn
will tell an analyst how many dollars of sales are generated for every dollar of
assets on the balance sheet. This ratio can give insight into just how productive
a company’s assets are. The trend for the industry is to have an extremely low
asset turnover ratio, due in large part to the high investment in property, plant
and mainly equipment. The packaged and processed foods industry requires a
high investment in equipment that is used to produce the variety of products
that are made. Over the five year span, Kellogg’s has shown a slight increase in
the overall asset turnover, implying that their total assets are becoming more
productive and thus creating more sales for the company. This has held true for
54
all of the main competitors in the industry, due in large part to the increase in
total sales of the industry, while maintaining total assets at a consistent dollar
amount. The graph shows this overall increase in all companies asset turnover.
Asset Turnover
00.20.40.60.8
11.2
2002 2003 2004 2005 2006
Year
Rat
io
Kellogg'sKraftGeneral MillsAverage
Return on Assets: Net Income/Total Assets
Return on Assets 2002 2003 2004 2005 2006 Kellogg's 7.10% 7.80% 8.30% 9.30% 9.40% Kraft 5.94% 5.86% 4.45% 4.57% 5.51% General Mills 2.77% 5.03% 5.72% 6.86% 5.99% Average 5.27% 6.23% 6.16% 6.91% 6.97%
Return on assets is calculated by dividing net income by total assets. This
ratio shows how profitable a company is based on its total assets. This ratio is
comparable to asset turnover; however by using net income in the numerator,
you are able to see how much net income is generated per dollar of assets.
Kellogg’s, like much of its other profitability ratios, has established itself as an
industry leader in the return on assets category. They have also established a
consistent growth in their return on assets, implying that each dollar of assets is
generating more net income at year end. In Kellogg’s case, the growth in return
on assets can be directly linked to the consistent growth in net income over the
past 5 years. As mentioned before, Kellogg’s has continued to maintain a steady
dollar amount of total assets, which provides a consistent denominator for each
year’s calculation.
55
Return on Assets
0.00%2.00%4.00%6.00%8.00%
10.00%
2002 2003 2004 2005 2006
Year
Rat
io a
s a
perc
enta
ge Kellogg'sKraftGeneral MillsAverage
Return on Equity: Net Income/Equity
Return on Equity 2002 2003 2004 2005 2006 Kellogg's 0.81 0.545 0.39 0.43 0.48 Kraft 0.131 0.122 0.0891 0.0889 0.107 General Mills 0.1281 0.2196 0.201 0.2185 0.188 Average 0.356 0.296 0.227 0.246 0.258
Return on equity is calculated by dividing net income by total equity. This
ratio represents how much net income is earned based on the stockholders
investment into the company. Again, Kellogg’s has established itself as an
industry leader with a return on equity that noticeably higher then the industry
average. However this ratio can be misleading due to the fact that Kellogg’s has
experienced a consistent decline in the ratio over the past 5 years. The most
notable decline can be seen from year 2002 to 2003, when the ratio dropped
from .81 to .55. This drop in the ratio is directly related to a significant increase
in owner’s equity. Over the span of 2002 to 2003, owner’s equity rose from
$895.1 to $1,443.20, while the net income only rose from $720.9 to $787.1. This
significant increase in owner’s equity is the reason for such a drastic drop return
on equity. The graph below shows that it is an industry norm to have such a low
return on equity.
56
Return on Equity
00.20.40.60.8
1
2002 2003 2004 2005 2006
Year
Rat
io a
s a
perc
enta
ge Kellogg'sKraftGeneral MillsAverage
Overall Profitability
Overall profitability for Kellogg’s over the span of 2002 to 2006 would
have to be classified as slightly positive or no change. Kellogg’s has seen a
consistent growth in both sales and net income over this span of time, which has
lead to very little change in most of their profitability ratios. Another important
aspect of Kellogg’s overall profitability has been their ability to stay current and
often times exceed the same ratios of the industry.
The only major problem in terms of profitability has been operating
expense. This has been directly tied to Kellogg’s inability to lower their operating
expense per sales dollar. Although, they have been able to keep their sales
growing from year to year, they have experienced operating expenses growing
at a slightly larger rate. This in turn leads to a higher operating expense. The
trend over the 5 year span for the industry has been extremely stable, showing
little to no change from year to year. In order to move closer to the industry
Kellogg’s Industry Average Gross Profit Margin No change Slightly Negative Operating Expense Negative No change Net Profit Margin Slightly Positive Slightly Positive Asset Turnover Positive Slightly Positive Return on Assets Positive Slightly Positive Return on Equity Negative Negative
57
average and show a positive change in its operating expense, Kellogg’s needs to
find ways to decrease their overall operating expense or grow their sales at a
larger rate then their operating expenses.
Asset turnover and return on assets tend to be the most favorable ratios
for Kellogg’s. They have shown a consistent growth in both ratios over the 5 year
span. This shows that Kellogg’s assets have become more profitable as time
progresses. No both ratios, total assets is used as the denominator, causing the
possibility to raise both ratios by simply disinvesting in assets yet maintain the
same sales and net income from year to year. However, in Kellogg’s case, it has
been the constant growth in both sales and net income that leads to the better
ratios. The tendency of the industry has been to maintain a fairly consistent
dollar value of assets over this time span, while also showing growth in sales and
net income. Kellogg’s, however, has been able to have higher growth in these
two categories which leads to better ratios.
Profitability Analysis Profitability Analysis 2002 2003 2004 2005 2006 Gross Profit Margin 45.00% 44.40% 44.90% 44.90% 44.20% Operating Profit Ratio 26.80% 26.90% 27.40% 27.70% 28.10% Net Profit Margin 8.70% 8.90% 9.30% 9.60% 9.20% Asset Turnover 0.813 0.869 0.891 0.962 1.018 Return on Assets 7.10% 7.80% 8.30% 9.30% 9.40% Return on Equity 0.81 0.545 0.39 0.43 0.48
Capital Structure Ratios:
There are two primary ways for a company to grow, internal and external
financing activities. Internal financing is using retained earnings to help expand
their operations this is normally funded by operations the company currently
does. External financing comes from two different areas, debt and equity
financing. The company could choose to finance through debt meaning they
58
could issue bonds or obtain a loan. These transactions show up on the balance
sheet under liabilities normally specified as long term liabilities such as bonds or
notes payable. The first ratio discussed is the debt to equity ratio. This ratio
compares the company’s total liabilities to the company’s owner’s equity. It’s
ultimately a measure of how the much equity exists within the company
compared to each dollar of debt the company has incurred.
Debt to equity ratio: Total liabilities/Owners’ Equity
2002 2003 2004 2005 2006 Kellogg's 10.42 6.03 3.78 3.63 4.18 Kraft 1.21 1.078 1.004 0.947 0.946 General Mills 3.582 3.294 2.58 0.947 0.9462 Average 5.07 3.47 2.45 1.84 2.02
Kellogg’s debt to equity ratio average is 5.61. This means that for every
dollar of equity they have 5.61 dollars of debt financing. A decreasing trend in
these numbers shows that Kellogg’s is trying to reduce its liabilities compared to
its equity. Because of Kellogg’s large size they have the capacity to borrow
greater amounts of cash through loans. Kellogg’s has shown growth through the
years which does require some debt financing, but there is no reason to suspect
default in the future.
Debt to Equity Ratio
02468
1012
2002 2003 2004 2005 2006
Year
Rat
io
Kellogg'sKraftGeneral MillsAverage
The industry average shows a decrease in debt financing throughout the
years. Kellogg’s does support the highest ratio as compared to other companies.
This could be good or bad. Good because it is a very large company and can
59
obviously handle large debt financing. This could be bad because other
companies are surviving with less and less debt financing. They decreasing
number from 2002 to 2006 does show they are trying to reduce their liability
financing by increasing their shareholder’s equity and decreasing their long-term
debt. Kraft has the lowest ratio which shows that they do a lot of borrowing at a
low interest rate only helping them attain the lowest ratio. General Mills however
is closer to Kellogg’s showing that they borrow at close to the same rate.
Kellogg’s should focus on doing more internal financing to bring their interest
rates down and letting them borrow at a smaller rate bringing their ratio down.
Time interest Earned: NIBIT/Interest Expense
2002 2003 2004 2005 2006 Kellogg's 2.93 3.15 4.43 4.75 4.79 Kraft 7.22 8.81 6.92 7.47 8.87 General Mills 1.6 2.41 2.97 3.989 3.927 Average 3.917 4.79 4.77 5.403 5.86
Times interest is earned by dividing Operating Net Income by the Interest
Expense. This ratio is used to show how well the company can repay the interest
on their borrowed money. Kellogg’s ratio has increased showing that the ability
to repay has progressed do to higher operating net income.
Time interest earned
02468
10
2002 2003 2004 2005 2006
Year
Ratio
Kellogg'sKraftGeneral MillsAverage
Kraft is leading the group with the highest ratio to be able to pay back its
interest. General Mills on the other hand has the lowest ratio showing that its
60
operating net income is not quite as substation as the rest of the industry giving
them a harder time repaying interest expense. They industry as a whole does
portray an increasing ratio meaning that operating net income does continue to
increase for everyone showing that this industry is growing and will be able to
pay back interest expenses at a faster rate.
Debt Service Margin: Operating Cash Flow/Notes Payable (current)
2002 2003 2004 2005 2006 Kellogg's 2.37 3.65 1.73 1.02 1.11 Kraft 1.92 2.05 2.2 4.3 2.16 General Mills 0.25 2.03 2.5 5.72 1.178 Average 1.51 2.58 2.14 3.68 1.48
The debt service margin measures the company’s ability to pay back
current portion of its notes payable as a part of operating cash flow. This means
that the ratio shows the ability for the company to pay for its current portion of
long-term debt as a part of current operating activities. We found that there isn’t
much of a trend in this ratio; it really bounces around depending on the
companies operating activities during the year.
Debt Service Margin
0
2
4
6
8
2002 2003 2004 2005 2006
Year
Rat
io
Kellogg'sKraftGeneral MillsAverage
All companies hover around the industry average showing that operating
activities are remaining the same throughout the industry. Kellogg’s does fall
below the industry average in 2005 and 2006 showing that maybe their
61
operating activities did not generate as much cash flow as needed to payback
current portions of long term debt. General Mills on the other hand does show an
exceptional ability to generate cash flow from operating activities in 2005 and
2006. Kraft stayed along the industry average for the span of time, meaning that
they generate about as much cash flow needed to repay their current portion of
debt.
Capital Structure Analysis
2002 2003 2004 2005 2006 Debt to Equity Ratio 10.42 6.03 3.78 3.63 4.18 Times Interest Earned 2.93 3.15 4.43 4.75 4.79 Debt Service Margin 2.37 3.65 1.73 1.02 1.11
Other Important ratios:
There are a couple other ratios that we thought might be important to the
industry. The first one is property plant and equipment turnover. This is the most
important long-term asset in a firm’s balance sheet. This ratio shows the
efficiency of the property plant and equipment compared to the company’s sales.
Property Plant and Equipment Turnover: Sales/Net PP&E
2002 2003 2004.00 2005 2006 Kellogg's 2.92 3.16 3.54 3.84 3.874 Kraft 2.02 1.92 1.95 2.05 2.01 General Mills 2.875 3.52 3.55 3.61 3.88 Average 2.61 2.87 3.01 3.17 3.25
This ratio allows us to explore a number of business questions. First does
the company use modern manufacturing techniques? This is shown through how
large or small the ratio is, showing the efficiency of the equipment as compared
to sales. The higher the ratio the more efficient the company’s equipment is.
62
Second if the ratios are changing what is the underlying business reason? Is
property plant and equipment of the company not as efficient as it needs to be?
Does the company need to invest in newer equipment? All of these questions can
be answered by the ratios. They show the efficiency of the property plant and
equipment and how the sales are generating as a result of their manufacturing
ability.
Plant Property and Equipment Turnover
012345
2002 2003 2004 2005 2006Year
Rat
io
Kellogg'sKraftGeneral MillsAverage
As shown in the graph the industry average has a pretty good return on
sales as a result of Plant Property and Equipment. It should be noted that Kraft
does have the lowest ratio average meaning that their manufacturing abilities are
not getting a very high return as a percentage of sales. Kellogg’s stays on top of
the industry especially in 2005 and 2006 meaning that maybe they’ve improved
some manufacturing technique. General Mills does stay close to Kellogg’s
showing that their manufacturing techniques are also as modern and up to par
as Kellogg’s.
EBIDA Margin: Earnings before interest, taxes, depreciation,
amortization/ sales
2002 2003 2004 2005 2006 Kellogg's 13.7% 13.3% 14.2% 14.0% 13.4% Kraft 17.4% 17.0% 12.2% 12.0% 13.1% General Mills 8.4% 12.5% 13.6% 16.1% 13.4% Average 13.2% 14.3% 13.3% 14.0% 13.3%
63
Some analysts prefer this ratio because they believe that it focuses on
“cash” operating items. This is because it excludes depreciation and amortization
expense, both being significant non cash operating expenses. This ratio indicates
the operating performance of the company because it reflects all operating
policies and eliminates the effects of debt policy.
EBITDA Margin
0.00%
5.00%
10.00%
15.00%
20.00%
2002 2003 2004 2005 2006
Year
Rat
io a
s a
perc
enta
ge
Kellogg'sKraftGeneral MillsAverage
Kellogg’s stays accurate with the industry average. This shows that their
operating performance is matched with their sales. Kraft and General mills
however bounce around quite a bit, showing that they don’t have quite as stable
operating performance as Kellogg’s. This is a good indicator of how well the
company is doing from year to year.
Forecast Financial Statement Methodology Income Statement with Kellogg’s Information In order to make an accurate forecast, we first search for trends over the
past five years of Kellogg’s financials. We project the net sales will increase 7%
growth from 2007-2017. We also took in consideration how the industry and our
competitors grow overtime to come up with a 7% growth. Recent growth of
Kellogg’s has being driven by acquisition of new brands to their product line such
64
as special K. So we think 7% growth rate will be a good measure of growth
taking in consideration any new acquisition and industry growth. For the
remainder of the income statement we used a five year average to complete our
forecast and used percentages to complete the bottom line.
Balance Sheet with Kellogg’s Information
The balance sheet forecast was done using almost the same method as
the income statement. We took the five year average and used those rates to
the entire ten year forecast. We took the average of current assets divided by
total assets; this number came to be 22.65%. Also we took the average of long
term assets divided by total assets; this number came to be 77.35%. The debt
and liabilities were calculated in the same manner, taking the five year average,
and then doing the ten year forecast. On the top line of the forecasted balance
sheet we put the asset turnover number for the past five years and then
forecasted it out. We then analyzed that compared to the growth in assets to
show the link between the income statement and balance sheet.
Statement of Cash flow with Kellogg’s Information
In order to forecast the items in the statement of cash flows we started
with the average of the previous five year data. Then we grew the number at the
same rate as net sales were grown, 7% for the ten year forecast. We tried to
find only major items which were depreciation and amortization, deferred income
taxes, pension and postretirement benefit plan contribution, and addition to
properties. These major items show trends and were meaningful to the overall
forecast. We were not able to forecast some items because they were too small
and did not show any trend.
Analysis and Forecast Conclusion
Now that we have forecasted out the all the financial statements for
Kellogg’s we believe they will continue to grow at a steady rate. The growth rate
65
was found to be 7.0% and we believe that it will not increase much more since
the industry is so stable. In an industry where there are not many trends its hard
to predict what the future holds, however it is easy to see that most companies
within the industry are steadily growing some faster than others. Unlike the
electronics industry, people will always need food, thus ensuring the demand for
food industry products.
One major weakness in our forecast is that we cannot predict what
seasons are going to be better for farming than others. As Kellogg’s continues to
use the same suppliers this does not change the effect of the weather. The food
industry highly relies on commodities and if there is nothing to grow it will be
harder to manufacture products. Also, most companies are pretty good at
predicting what people enjoy buying, but we cannot always predict how well a
specific item will sell. This could potentially be a weakness in our forecasting
abilities.
66
Balance Sheet
Asset Turnover 0.813 0.869 0.891 0.962 1.018
Asset Turnover = 1.1
$11,114.45
$11,892.46
$12,724.93
$13,615.68
$14,568.77
$15,588.59
$16,679.79
$17,847.37
$19,096.69
$20,433.46
$21,863.80
(millions, except share data) 2002 2003 2004 2005 2006 Assumptions 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
7.0% growth
Total current assets $1,763.40 $1,787.90 $2,121.80 $2,196.50 $2,427.00 $2,596.89 $2,778.67 $2,973.18 $3,181.30 $3,403.99 $3,642.27 $3,897.23 $4,170.04 $4,461.94 $4,774.28 $5,108.48
Long Term Assets $8,455.90 $8,354.80 $8,668.60 $8,378.00 $8,287.00 $8,867.09 $9,487.79 $10,151.93
$10,862.57
$11,622.95
$12,436.55
$13,307.11
$14,238.61
$15,235.31
$16,301.78
$17,442.91
Total assets $10,219.30
$10,142.70
$10,790.40
$10,574.50
$10,714.00
$11,463.98
$12,266.46
$13,125.11
$14,043.87
$15,026.94
$16,078.82
$17,204.34
$18,408.65
$19,697.25
$21,076.06
$22,551.38
Total current liabilities $3,014.90 $2,766.00 $2,846.00 $3,162.80 $4,020.20 $4,301.61 $4,602.73 $4,924.92 $5,269.66 $5,638.54 $6,033.24 $6,455.56 $6,907.45 $7,390.97 $7,908.34 $8,461.93
Long Term Liabilities $6,309.30 $5,933.50 $5,687.20 $5,128.00 $4,624.80 $4,948.54 $5,294.93 $5,665.58 $6,062.17 $6,486.52 $6,940.58 $7,426.42 $7,946.27 $8,502.51 $9,097.68 $9,734.52
Total Liabilities $9,324.20 $8,699.50 $8,533.20 $8,290.80 $8,645.00 $9,250.15 $9,897.66 $10,590.50
$11,331.83
$12,125.06
$12,973.81
$13,881.98
$14,853.72
$15,893.48
$17,006.02
$18,196.45
Owners Equity $895.10 $1,443.20 $2,257.20 $2,283.70 $2,069.00 $2,213.83 $2,368.80 $2,534.61 $2,712.04 $2,901.88 $3,105.01 $3,322.36 $3,554.93 $3,803.77 $4,070.04 $4,354.94 Total Liabilities and O.E
$10,219.30
$10,142.70
$10,790.40
$10,574.50
$10,714.00
$11,463.98
$12,266.46
$13,125.11
$14,043.87
$15,026.94
$16,078.82
$17,204.34
$18,408.65
$19,697.25
$21,076.06
$22,551.38
AS percentages
2002 2003 2004 2005 2006 Assumptions 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Total current assets 17.26% 17.63% 19.66% 20.77% 22.65% 7.0% growth 22.65% 22.65% 22.65% 22.65% 22.65% 22.65% 22.65% 22.65% 22.65% 22.65% 22.65%
Long Term Assets 82.74% 82.37% 80.34% 79.23% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35%
Total assets 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Total current liabilities 29.50% 27.27% 26.38% 29.91% 37.52% 30.12% 30.27% 31.27% 32.52% 32.64% 30.55% 31.04% 31.36% 31.45% 31.60% 31.62%
Long Term Liabilities 61.74% 58.50% 52.71% 48.49% 43.17% 52.92% 50.72% 48.12% 48.19% 48.93% 50.59% 49.99% 49.78% 49.31% 49.17% 49.50%
Total Liabilities 91.24% 85.77% 79.08% 78.40% 80.69% 83.04% 80.99% 79.39% 80.71% 81.57% 81.14% 81.03% 81.14% 80.76% 80.77% 81.12%
Owners Equity 8.76% 14.23% 20.92% 21.60% 19.31% 16.96% 19.01% 20.61% 19.29% 18.43% 18.86% 18.97% 18.86% 19.24% 19.23% 18.88% Total Liabilities and O.E. 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
67
Income Statement
millions of dollars 2002 2003 2004 2005 2006 Assumptions
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Net sales $ 8,304.10 $ 8,811.50 $ 9,613.90 $ 10,177.20 $ 10,906.70 7% growth
rate $
11,670.17 $ 12,487.08 $ 13,361.18 $ 14,296.46 $ 15,297.21 $ 16,368.02 $
17,513.78 $ 18,739.74 $ 20,051.52 $ 21,455.13 $ 22,956.99
Cost of goods sold $ 4,569.00 $ 4,898.90 $ 5,298.70 $ 5,611.60 $ 6,081.50 $ 6,507.21 $ 6,962.71 $ 7,450.10 $
7,971.61 $ 8,529.62 $ 9,126.69 $ 9,765.56 $ 10,449.15 $
11,180.59 $ 11,963.23 $ 12,800.66
SG&A expense $ 2,227.00 $ 2,368.50 $ 2,634.10 $ 2,815.30 $ 3,059.40 $ 3,273.56 $ 3,502.71 $ 3,747.90 $ 4,010.25 $ 4,290.97 $ 4,591.33 $ 4,912.73 $ 5,256.62 $ 5,624.58 $ 6,018.30 $ 6,439.58 $ 0.02 $ 0.09 $ 4.00 $
0.01
Operating profit $ 1,508.10 $ 1,544.10 $ 1,681.10
$ 1,750.30 $ 1,765.80 $ 1,889.41 $ 2,021.66 $ 2,163.18 $ 2,314.60 $ 2,476.63 $ 2,649.99 $ 2,835.49 $ 3,033.97 $ 3,246.35 $ 3,473.60 $ 3,716.75
$ (6.00) $ (20.00) $ (3.00) $ 2.30 Interest expense $ 391.20 $ 371.40 $ 308.60 $ 300.30 $ 307.40 $ 308.94 $ 310.48 $ 312.03 $ 313.59 $
315.16 $ 316.74 $ 318.32 $ 319.91 $
321.51 $ 323.12 $ 324.74
Other income (expense), net $ 27.40 $ (3.20) $ (6.60) $ (24.90) $ 13.20
Earnings before income taxes $ 1,144.30 $ 1,169.50 $ 1,365.90 $ 1,425.10 $ 1,471.60 $ 1,580.47 $ 1,711.18
$ 1,851.15
$ 2,001.01 $ 2,161.46 $ 2,333.25 $ 2,517.17
$ 2,714.06 $ 2,924.84 $ 3,150.48 $ 3,392.01
Income taxes $ 423.40 $ 382.40 $ 475.30 $ 444.70 $ 466.50 $ 491.02 $ 529.13 $ 568.62 $ 609.47 $ 651.64 $ 695.10 $ 739.77 $ 785.58 $ 832.44 $ 880.22 $ 928.79 Earnings (loss) from joint venture $ - $ - $
(1.00)
$ 9.00 $ 13.00 $ 10.00 $ 2.00 Net earnings (Loss) $ 720.90 $ 787.10 $ 890.60 $ 980.40 $ 1,004.10 $ 1,089.45 $ 1,182.05 $ 1,282.53 $
1,391.54 $ 1,509.82 $ 1,638.16 $ 1,777.40 $ 1,928.48 $ 2,092.40 $ 2,270.25 $ 2,463.23
percentage 2002 2003 2004 2005 2006 Assumptions
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Net sales 100.00% 100.00% 100.00% 100.00% 100.00% 7% growth
rate 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Cost of goods sold 55.02% 55.60% 55.11% 55.14% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% SG&A expense 26.82% 26.88% 27.40% 27.66% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05%
Operating profit 18.16% 17.52% 17.49% 17.20% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% Interest expense 4.71% 4.21% 3.21% 2.95% 2.82% 2.65% 2.49% 2.34% 2.19% 2.06% 1.94% 1.82% 1.71% 1.60% 1.51% 1.41% Other income (expense), net
Earnings before income taxes 13.78% 13.27% 14.21% 14.00% 13.49% 13.54% 13.70% 13.85% 14.00% 14.13% 14.25% 14.37% 14.48% 14.59% 14.68% 14.78% Income taxes 5.10% 4.34% 4.94% 4.37% 4.28% 4.21% 4.24% 4.26% 4.26% 4.26% 4.25% 4.22% 4.19% 4.15% 4.10% 4.05% Earnings (loss) from joint venture
Net earnings 8.68% 8.93% 9.26% 9.63% 9.21% 9.34% 9.47% 9.60% 9.73% 9.87% 10.01% 10.15% 10.29% 10.44% 10.58% 10.73%
68
Cash Flow Statement
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Operating activities Net earnings 720.90 787.10 890.60 980.40 1004.10 1029.20 1054.93 1081.31 1108.34 1136.05 1164.45 1193.56 1223.40 1253.98 1285.33 1317.47 Adjustments to reconcile net earnings to operating cash flows
Depreciation and amortization 349.90 372.80 410.00 391.80 352.70 359.75 366.95 374.29 381.77 389.41 397.20 405.14 413.24 421.51 429.94 438.54 Deferred income taxes 111.20 74.80 57.70 (59.20) (43.70) (44.57) (45.47) (46.37) (47.30) (48.25) (49.21) (50.20) (51.20) (52.23) (53.27) (54.34) Other (a) 67.00 76.10 104.50 199.30 235.20 239.90 244.70 249.60 254.59 259.68 264.87 270.17 275.57 281.09 286.71 292.44 Pension and other postretirement benefit plan contributions
(446.60)
(184.20)
(204.00)
(397.30) (99.30) (84.63) (87.58) (89.61) (91.75) (93.94) (96.18) (98.47) (100.81) (103.21) (105.67) (108.18)
Changes in operating assets and liabilities 197.50 44.40 (29.80) 28.30 (38.50) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00)
Net cash provided by operating activities 999.90 1171.0
0 1229.0
0 1143.3
0 1410.5
0 1459.6
6 1493.5
4 1529.2
0 1565.6
5 1602.9
5 1641.13 1680.21 1720.20 1761.14 1803.04 1845.93 Investing activities
Additions to properties (253.50
) (242.70
) (278.60
) (374.20
) (453.10
) (461.71
) (470.48
) (479.42
) (488.53
) (497.81
) (507.27) (516.91) (526.73) (536.74) (546.94) (557.33) Acquisitions of businesses (2.20) 14.00 0.00 (50.40) Property disposals 60.90 13.80 7.90 9.80 9.40 10.06 10.76 11.52 12.32 13.18 14.11 15.09 16.15 17.28 18.49 19.79 Investment in joint venture and other 6.00 0.40 0.30 (0.20) (1.70) 0.96 0.96 0.96 0.96 0.96 0.96 0.96 0.96 0.96 0.96 0.96
Net cash used in investing activities (188.8
0) (214.5
0) (270.4
0) (415.0
0) (445.4
0) (450.6
9) (458.7
6) (466.9
5) (475.2
5) (483.6
7) (492.20
) (500.85
) (509.62
) (518.50
) (527.48
) (536.58
) Financing activities Net increase of notes payable, with less than or equal to 90 days
(226.20)
208.50 388.30 360.20
(344.20)
Issuances of notes payable, with maturities greater then 90 days
354.90 67.00 142.30 42.60 1065.40
Reductions of notes payable, with maturities greater then 90 days
(221.10)
(375.60)
(141.70) (42.30)
(565.20)
Issuances of long-term debt 0.00 498.10 7.00 647.30 0.00
Reductions of long-term debt (439.30
) (956.00
) (682.20
) (1041.3
0) (84.70) Issuances of common stock 100.90 121.60 291.80 221.70 217.50
Common stock repurchases (101.00
) (90.00) (297.50
) (664.20
) (649.80
)
Cash dividends (412.60
) (412.40
) (417.60
) (435.20
) (449.90
) Other 0.00 (0.60) (6.70) 5.90 21.90
Net cash used in financing activities (944.4
0) (939.4
0) (716.3
0) (905.3
0) (789.0
0) (923.3
0) (918.7
6) (914.3
2) (956.9
0) (967.9
9) (1006.4
7) (1024.3
5) (1047.0
6) (1075.5
9) (1101.1
1) (1129.7
4)
Increase (decrease) in cash and cash equivalents (133.30
) 17.10 242.30 (177.00
) 176.10 85.67 116.02 147.94 133.50 151.29 142.46 155.00 163.53 167.05 174.44 179.61
Cash and cash equivalents at beginning of year 231.80 98.50 115.60 357.90 180.90 357.00 442.67 558.69 706.63 840.13 991.42 1133.88 1288.88 1452.41 1619.46 1793.90 Cash and cash equivalents at end of year 98.50 115.60 357.90 180.90 357.00 442.67 558.69 706.63 840.13 991.42 1133.88 1288.88 1452.41 1619.46 1793.90 1973.51
69
Valuations Analysis
The Valuations Analysis is the section where we value the company within
itself, and then as a part of the industry. There are five different models that
help us derive these conclusions. Each model shows something different about
the firm and whether it is overvalued and undervalued. We then use a sensitivity
analysis to help show what it would take to get the share price up to its observed
value today. This is done by altering the growth rates, cost of capital, and
weighted average cost of capital. The five models used to value the firm are as
follows: Method of Comparables, Discounted Dividends, Free Cash Flow, Residual
Income, and the Abnormal Earning Growth model. As described in the
paragraphs below some models are more accurate and some do not have a high
explanatory power.
Cost of Capital
In order to calculate the weighted cost of capital for Kellogg’s, the cost of
equity and cost of debt must be found. To calculate the cost of equity (KE)
regressions were run using Kellogg’s stock data for five different risk free rates,
10 year, 7 year, 5 year, 1 year and 3 month Treasury rates. After running the
regressions the highest adjusted R2 calculated was 0.0740 using the 3 month
Treasury rate. This corresponded to a very low Beta indicating that Kellogg’s
volatility compared to the rest of the market is very low, which means large
increases or decreases in the S&P 500 have less of an impact on Kellogg’s stock
price. This means that the capital asset pricing model cannot be used to
calculate KE in this case because all of Kellogg’s risk is firm specific.
70
3 mon. Treasury
Beta adj. R Squared Ke
72 months -0.0326 -0.0133 0.049970 60 months 0.0802 -0.0120 0.055609 48 months 0.4617 0.0740 0.074685 36 months 0.0463 -0.0282 0.053914 24 months 0.1053 -0.0393 0.056867
Using this formula will give a better estimate of KE than the capital asset
pricing model. It was calculated using Kellogg’s most current stock price of
$52.84, the Return on Equity ratio for 2006 of 0.48, and a growth rate of 0.09.
The estimated cost of equity comes to 12.84%.
ROE 0.48G 0.09 P 52.84B 5.202p/b 10.15763p/b-1 9.157632p/b-1*g 0.824187p/b-1*g+ROE 1.304187divide by p/b 0.128395
To calculate the cost of debt for Kellogg’s, the liabilities were taken as a
percentage of the total and multiplied by an estimated interest rate. The interest
rate used for notes payable and the rate used for long term debt was calculated
with information given in Kellogg’s 10-K. The other interest rates were estimated
using the current rate for short term commercial paper of 5.23%. The weighted
average cost of debt calculated is 5.454%.
71
$
Amount % of Total
Interest rate
Weighted rate%
Current Liabilities Current Maturities of long-term debt
723.30 0.0837 0.0523 0.00438
Notes Payable 1,268.00 0.1467 0.0530 0.00778Accounts Payable 910.40 0.1053 0.0523 0.00551Other Current Liabilities 1,118.50 0.1294 0.0523 0.00677 Total Current Liabilities 4,020.20 0.4650 Long Term Debt 3,053.00 0.3531 0.0583 0.02059Other Liabilities 1,571.80 0.1818 0.0523 0.00951 Total Liabilities 8,645.00 1.0000 Weighted average cost of debt
0.05454
Long Term Debt $
Amount % of Total
Interest Rate
Weighted Interest rate
6.6% U.S. Dollar Notes due 2011
1,496.20 0.3962 0.0660 0.0261
7.45% U.S. Dollar Debentures due 2031
1,087.80 0.2881 0.0745 0.0215
2.875% U.S. Dollar Notes due 2008
464.60 0.1230 0.02875 0.0035
Guaranteed floating rate Euro notes due 2007
722.10 0.1912 0.0375 0.0072
Other 5.60 0.0015 0.0523 0.0000 Less Current Maturities (723.30) Total Long Term Debt 3,053.0 0.0583
72
Weighted Average Cost of Capital
The weighted average cost of capital essentially predicts the cost of any
new capital a firm would want to acquire. Using the WACC formula:
WACCBT = (VD/VF)*KD + (VE/VF)*KE
WACCBT = (8,645/10,714)*(0.05454) + (2,069/10,714)*(0.1284)
WACCBT = 0.06881
WACCAT = (VD/VF)*KD(1-T) + (VE/VF)*KE
WACCAT = (8,645/10,714)*(0.05454)*(1- 0.35) + (2,069/10,714)*(0.1284)
WACCAT = 0.05339
Kellogg’s before tax and after tax weighted cost of capital is 6.881% and
5.339%. What this means is that Kellogg’s would have to pay an interest rate of
around 5.339%, after tax, on any new financing the company is involved in.
Method of Comparables
Method of comparables is the process of obtaining a share price based on
the industry average. This is done by take the industry average of each multiple,
excluding zeros and negatives and then applying them to the price per share
Kellogg’s has recorded for itself. This is not a very accurate valuation model
because it takes into account the industry and then averages and applies them
to Kellogg’s. Although this does show what is going on in the industry it is a bad
model for Kellogg’s company by itself. Depending on what is going on with other
companies it could skew the price one direction or another and not accurately
value Kellogg’s. As seen in the chart below the industry average for all multiples
is relatively accurate, no huge jumps in any certain category.
73
Industry Average (All Three) 2002 2003 2004 2005 2006PPS 44.29 42.45 43.75 45.19 48.11EPS 1.68 2.12 2.18 2.48 2.48DPS 0.89 0.92 0.98 0.86 1.2BPS 16.42 24.98 24.20 22.88 24.66EBITDA 2308.43 2560.17 2273.63 2452.03 2351.53FCF 1443.70 1535.00 1633.87 2308.10 2016.03EV 18592.35 18548.51 17807.28 16749.11 16467.61
This chart helps display the stability within the food processing industry.
This level of stability shows that these companies have little risk of going
bankrupt or defaulting on loans. This implies that they will be in business for an
extended amount of time.
Market/ Book General Mills 1.61 Industry Average 1.85Kraft 2.1 Kellogg's 19.78
Estimated Share Price 36.72
The market to book comparable uses the price per share at market value
and compares that to the book value of equity. We found this ratio by dividing
BPS into PPS for each company then averaging them together and multiplying
them by Kellogg’s BPS. The estimated share price came out to be $36.72 this
estimated share price makes Kellogg’s current price of $50.93 overvalued.
Price/Earnings General Mills 19.41 Industry Average 19.56Kraft 19.71 Kellogg's 2.53
Estimated Share Price 49.49
The price to earnings comparable uses price per share at market value
and compares it to the earnings per share. We found this ratio by dividing EPS
into PPS for each company then averaging them together and multiplying them
by Kellogg’s EPS. The estimated share price came out to be $49.49 which is
extremely close to $50.93. This shows the company is fairly valued compared to
74
how the market values it. It could be a good indicator that the company is fairly
valued.
Dividends/Price
General Mills 0.023 Industry Average 0.0245Kraft 0.026 Kellogg's 1.137
Estimated Share Price 45.96
The Dividends to price comparable uses dividends per share of the
company and compares them to the market value of the price per share. We
found this ratio by dividing price per share into dividends and then finding the
average of the two. We then backed into the ratio by dividing Kellogg’s dividends
by the industry average. The Estimated share price came out to be $45.96. The
current share price is $50.93 which shows that with this multiple Kellogg’s is
slightly overvalued.
P/EBITDA General Mills 0.037 Industry Average 0.023Kraft 0.009 Kellogg's 1471.6
Estimated Share Price 34.53
The price to EBITDA comparable uses price per share at market value and
compares it to the earnings before income taxes, depreciation and amortization.
We found this ratio by dividing EBITDA into PPS. Then, average the industry two,
and multiply the average by Kellogg’s EBITDA. The estimated share price came
out to be $34.53 which portrays Kellogg’s current price, $50.93 to be highly
overvalued.
P/FCF
General Mills 0.04 Industry Average 0.025Kraft 0.01 Kellogg's 965.1
Estimated Share Price 24.23
The price to FCF comparable uses the price per share at market value and
compares it to free cash flow. We found this ratio much like we found the
P/EBITDA ratio. Divide free cash flow into price and then find the average within
75
the industry. Then multiply that average by Kellogg’s free cash flow. The
estimated share price comes out to be $24.23 which extremely overvalues
Kellogg’s current price of $50.93. This shows that the P/FCF comparable is not
very reliable in telling us what is going on within the industry. Cash flow for each
company is different and to compare them all and try to value Kellogg’s does not
show a true value.
P.E.G. General Mills 19.41 Industry Average 19.56Kraft 19.71 Kellogg's 6%
Estimated Share Price 43.84
The Price Earnings Growth comparable compares the price to earnings
ratio to the earnings per share growth rate of Kellogg’s. To find this ratio we use
all of the P/E multiples and take the industry average, we then divided it by 1+
the growth rate for that year. We found the estimated share price to be $43.84
which slightly overvalues Kellogg’s current share price of $50.93.
P* Enterprise Value
General Mills 7.1 Industry Average 7.26 Kraft 7.42 Kellogg's 5.74
Estimated Share Price 41.71
The Enterprise value comparable compares the enterprise value of each
firm (Market value of equity + Liabilities – cash and cash equivalents) to the
EBITDA multiple. To find this ratio we used the enterprise value for each
competitor, we averaged them and multiplied that number by the Kellogg’s
enterprise value. We found the estimated share price to be $41.71 which makes
Kellogg’s current price of $50.93 overvalued.
76
Valuation Ratios: 2002 2003 2004 2005 2006 Conclusion P/B 21.56 24.33 53.87 42.04 $ 36.72 Over Valued P/E 54.37 38.74 44.10 43.74 $ 49.51 Fairly Valued D/P 60.21 51.93 45.12 58.31 $ 45.96 Over Valued P/EBITDA 50.26 26.50 28.85 27.19 $ 34.53 Over Valued P/FCF 31.84 43.26 30.02 12.09 $ 24.23 Over Valued PEG 54.45 38.83 44.21 43.84 $ 49.57 Fairly Valued P* (EV) 101.73 62.03 50.73 39.93 $ 41.71 Over Valued
In conclusion this chart shows that most of Kellogg’s multiples actually
over-value the company as compared to the current market price of $50.93. If
most of the ratios are showing undervalue compared to the price it’s a good
indicator that the firm is ultimately overvalued.
Intrinsic Valuation Methods:
Discounted Dividends
The discounted dividend valuation is another commonly used valuation
method. It involves discounting back expected future dividends to their present
value today, and also incorporating a terminal value to be added into equation to
give a final share value. The final formula involves the sum of the total future
dividends and the terminal value of the perpetuity added together to obtain the
share value. The final share value we obtained when using a cost of capital of
12.84% and using a terminal growth rate of 3%, was $12.30 compared to an
observed share price of $51.90. This would lead an analyst to believe that
Kellogg’s share price is extremely overvalued and the primary action would be to
sell the stock. Our sensitivity analysis shows that in order to achieve a share
price that is closer to the observed value we need to use a drastically lower cost
of capital. A 5% to 6% cost of capital begins to give us a share price that is
moving consistently towards the observed share price. A 3% dividend growth
rate was used based on the past history of Kellogg’s per share dividends. On
average, Kellogg’s dividends have grown at a 3% increase per year. We decided
that his was a reasonable assumptions to continue growing the per year
77
dividends at this rate. Of the six valuation models used, discounted dividends
have an extremely low reliability between the given value and the observed
share price. This is due to the high degree of variability between dividends and
the observed share price. While dividends seem to stay fairly stable for periods
of time, changing roughly every year and in some cases not for a few years,
while a company share price is constantly changing. This valuation model shows
that their may not be a direct tie from dividends to a shareholder and the price
that a company should be valued at.
Sensitivity Analysis
0% 1% 2% 3% 4% 5% $ 30.04 $ 34.52 $ 42.60 $ 58.77 $ 107.27 6% $ 24.83 $ 27.41 $ 32.29 $ 39.18 $ 53.88 7% $ 20.77 $ 22.69 $ 25.36 $ 29.38 $ 36.77 8% $ 18.01 $ 19.32 $ 21.06 $ 23.50 $ 27.16 9% $ 15.88 $ 16.80 $ 17.99 $ 19.58 $ 21.81
10% $ 14.52 $ 15.21 $ 16.08 $ 17.19 $ 18.68 11% $ 13.13 $ 13.65 $ 14.28 $ 15.07 $ 16.09
The x-axis represents terminal growth rate while the y-axis represents the cost
of equity.
Discounted Free Cash Flow
The discount rate used in all Cash flow valuations is weighted average
cost of capital (WACC). In running our regression on the Kellogg’s financials we
found that WACC was .05339 or 5.339%. To find the discounted free cash flow
share price estimated we first subtracted (CFFO-CFFI) cash flow from investing
activities from cash flow from operating activities for all forecasted years. We
then found a present value factor of 1/(1+WACC)^t. We did this to discount the
cash flow back to 2006 dollars. We then choose a perpetuity of the cash flow
(1300) and discounted it back to 2006 dollars by multiply it times a present value
factor of .56 which we found by doing 1/(1+.05339)^11. We then added all the
present value of cash flows together to get a total present value of continuing
cash flows. We added this number to our present value of a perpetuity to get the
78
value of the firm. In order to get the estimated market value of equity we had to
subtract the book value of liabilities out. We then divided the estimated market
value of equity by the number of shares outstanding. This gave us our estimated
share price of $1.59 which is extremely undervalued compared to the current
share price of $51.90 (4/2/2007).
Sensitivity Analysis
0.05 0.085 0.09 0.15 0.25
0.06 -159.08 63.63 53.03 17.68 8.37
0.07 -79.54 106.05 79.54 19.89 8.84
0.08 -53.03 318.16 159.08 22.73 9.36
0.09 -39.77 -318.16 N/A 26.51 9.94
0.1 -31.82 -106.05 -159.08 31.82 10.61
0.11 -26.51 -63.63 -79.54 39.77 11.36
0.12 -22.73 -45.45 -53.03 53.03 12.24
We used a sensitivity analysis to see what value of WACC and growth rate
would get the estimated share price closest to the current share price. WACC is
on the x axis while growth rates are on the y axis. As found in the sensitivity
analysis a growth rate of 12% and a WACC of 15% gives us the closest number
to the current price of $51.90. This model is not a very good model to estimate
share price. Cash flow is a very high error volatile measure to use to forecast out
financials. This being true it is unrealistic to use it to predict a current share
price.
Residual Income
Another method used to value a company is by using the residual income
valuation model. This model attempts to directly tie forecasted equity to the
observed share price. The residual income model uses cost of capital and the
terminal growth rate used in the perpetuity, much like the discounted dividends
valuation. Again you take the sum of the forecasted earnings, added to the
terminal value of the perpetuity, but you also add in the company’s beginning
value of equity. When using a cost of capital of 12.84% and a terminal growth
79
rate of 3%, Kellogg’s share price was $18.16 versus the observed share price of
$51.90. This valuation method again shows that Kellogg’s share price is
extremely overvalued and should be sold. One reason for having such a low
intrinsic share price could be due to a cost of capital that is too high, since the
higher cost of capital the lower the intrinsic share price. This is shown through
our sensitivity analysis, as the cost of capital lowers, Kellogg’s intrinsic share
price begins to move closer to the observed share price. The sensitivity analysis
shows that a cost of capital ranging from 7% to 8%, depending on the terminal
growth rate used, gives an intrinsic value that is closest to the observed value.
Sensitivity Analysis
0% 1% 2% 3% 4% 7% 44.9 48.55 53.66 61.32 74.09 8% 36.88 39.13 42.12 46.31 52.6 9% 30.82 32.24 34.06 36.49 39.89
10% 25.5 26.38 27.49 28.91 30.81 11% 21.8 22.37 23.06 23.93 25.04 12% 18.83 19.19 19.62 20.15 20.81 13% 16.39 16.61 16.88 17.19 17.58
Of all the valuation methods used, residual income has the most reliability
and therefore gives an intrinsic value that is much more relevant then the
previous models discussed. One reason for residual income having such a high
level of explanatory power is because; it is directly tied to earnings which can be
forecasted out much easier then other values used in the previous models.
Abnormal Earning Growth
The AEG valuation model takes the companies forecasted earnings per
share and dividends per share along with KE to calculate an intrinsic value per
share. To get the AEG growth per year, the normal earnings (EPSt-1 * (1+KE)) is
subtracted from the cumulative dividend earnings (EPSt + Drip). In order to
create value, the abnormal earnings growth needs to be greater than or equal to
zero. When abnormal earnings growth is negative, it means the firm is
80
destroying value. Kellogg’s forecasted AEG numbers for the next 10 years are all
negative. The intrinsic value per share calculated with this model $18.60 which is
way below the observed share price of $51.90 on 4/02/2007. This may suggest
that Kellogg’s is overvalued. The sensitivity analysis below shows that Kellogg’s
would need to have a cost of equity of 6% and a negative growth rate of -0.05%
to get close to the observed share price.
Sensitivity Analysis
-0.01 -0.03 -0.05 -0.07 -0.09 0.04 69.82 77.93 82.44 85.30 87.29 0.05 57.03 61.38 63.99 65.73 66.97 0.06 47.76 49.99 51.61 52.72 53.55 0.07 40.11 41.69 42.75 43.50 44.07 0.08 34.39 35.42 36.13 36.65 37.05
Z-Score
The Altman Z-score is an original method that has been used by major
financial institutions and investment houses to evaluate the credit worthiness of
a company. The formula consists in assigning weights to items from the balance
sheet and the income statement. The Z-score formula is:
The highest weight of, 3.3 is given to EBIT/Total Assets, which is a
measure of how much operating income is being generated by total assets. The
lowest weight of, 0.6 is given to Market Value of Equity/Book Value of Liabilities,
⎥⎦⎤
⎢⎣⎡+
⎥⎦⎤
⎢⎣⎡+
⎥⎦⎤
⎢⎣⎡+
⎥⎦⎤
⎢⎣⎡+⎥⎦
⎤⎢⎣⎡=−
Assets TotalSales1.0
sLiabilitie of ValueBook Equity of ValueMarket 0.6
Assets TotalTaxes andInterest Before Earnings3.3
Assets TotalEarnings Retained1.4
Assets TotalCapital Working1.2scoreZ
81
this low number means that market factors are not determinant to get the
Altman Z-score. The Z-scores for Kellogg's is 1.84. This low number is indicative
that Kellogg's does not have a good credit score. A score ranging from 1.8 to 2.8
indicates a company with some credit problems; the problem with a low z-score
is that loans will have a higher interest premium. A number close or above 2.8
indicates a healthy credit score, and lower rates of obtaining money. Overall, the
credit rating of Kellogg's shows that they will have problems of attaining money
for loans and new acquisitions because of a higher interest rate.
Valuation Conclusion
After running various valuation models we have come to the conclusion
that Kellogg’s Company is over-valued. Method of comparables showed that five
out of the seven ratios proved over-valued for the share price while the other
two, though closer to the price, proved slightly over-valued. As for the intrinsic
valuations all four models showed the company to be significantly over valued.
The discounted dividends models proved an estimated share price of $11.94 or
$12.30 discounted up to April 2, 2007. The discounted cash flow model proved
an estimated share price of $1.59 or $1.61 discounted up to April 2, 2007. The
residual Income model proved an estimated share price of $18.16 or $17.62
discounted to April 2, 2007. The abnormal earnings growth model proved a
$17.62 or $18.16 discounted to April 2, 2007. The most reliable model out of all
of these is AEG which still showed low share price compared to today value. This
only proves that Kellogg’s is an overvalued company.
82
Appendix 1 – Screening Ratio
Kraft Foods Inc.
2002 2003 2004 2005 2006 Net Sales/ Cash from Sales 0.9955 1.0084 1.0054 0.9954 n/a* Net Sales/ Net Accounts Receivable 9.5388 9.0525 9.0844 10.077 n/a* Net Sales/ Inventory 8.7886 9.1229 9.3322 10.2043 n/a* Sales/Assets 0.52 0.51 0.54 0.59 n/a* CFFO/OI 0.06 0.07 -0.02 -0.11 n/a* CFFO/NOA 0.06 0.05 -0.01 -0.07 n/a*
General Mills Net Sales/ Cash from Sales 1.23 1.22 0.9973 0.9979 1.003 Net Sales/ Net Accounts Receivable 10.72 10.96 10.96 10.87 10.81 NS/Inv 9.71 10.41 10.4139 10.84 10.03 Sales/ Assets 0.58 0.6 0.6001 0.62 0.63 CFFO/OI 0.163 -0.38 -0.08 0.1255 0.03 CFFO/NOA 0.039 -0.009 -0.0254 0.0804 0.02
Kellogg's Company Net Sales/ Cash from Sales 0.997 1.002 1.002 1.01 1.006Net Sales/ Net Accounts Receivable 11.21 11.67 12.38 11.58 11.54Net Sales/ Inventory 13.77 13.56 14.12 14.19 13.23 Sales/ Assets 0.813 0.861 0.91 0.962 1.018CFFO/OI -0.088 0.111 0.035 -0.049 0.151CFFO/NOA -0.015 0.02 0.007 -0.01 0.032PENSION/SG&A 0.001 0.022 0.032 0.042 *ratios for 2006 for Kraft are unavailable due to lack of financial information
83
Appendix 2 – Core Financials
Current Ratio 2002 2003 2004 2005 2006 Net Profit Margin 2002 2003 2004 2005 2006
Kellogg's 0.585 0.646 0.745 0.694 0.604 Kellogg's 8.70% 8.90% 9.30% 9.60% 9.20% Kraft 1.040 1.033 1.071 0.935 0.788 Kraft 11.60% 11.40% 8.30% 7.70% 8.90% General Mills 0.600 0.920 1.170 0.730 0.517 General Mills 5.76% 8.73% 9.53% 11.03% 9.36% Average 0.742 0.866 0.995 0.786 0.636 Average 8.69% 9.68% 9.04% 9.44% 9.15%
Quick Asset 2002 2003 2004 2005 2006 Asset Turnover 2002 2003 2004 2005 2006
Kellogg's 0.279 0.324 0.419 0.347 0.337 Kellogg's 0.813 0.869 0.891 0.962 1.018 Kraft 0.465 0.494 0.421 0.424 0.392 Kraft 0.512 0.514 0.537 0.520 0.618 General Mills 0.390 0.560 0.781 0.483 0.346 General Mills 0.481 0.576 0.600 0.623 0.639 Average 0.378 0.459 0.540 0.418 0.358 Average 0.602 0.653 0.676 0.702 0.758
AR Turnover 2002 2003 2004 2005 2006 Return on Assets 2002 2003 2004 2005 2006
Kellogg's 11.210 11.670 12.380 11.580 11.540 Kellogg's 7.10% 7.80% 8.30% 9.30% 9.40% Kraft 9.386 9.053 9.084 10.078 8.880 Kraft 5.94% 5.86% 4.45% 4.57% 5.51% General Mills 7.870 10.720 10.960 10.874 10.817 General Mills 2.77% 5.03% 5.72% 6.86% 5.99% Average 9.489 10.481 10.808 10.844 10.412 Average 5.27% 6.23% 6.16% 6.91% 6.97% Inventory Turnover 2002 2003 2004 2005 2006
Return on Equity 2002 2003 2004 2005 2006
Kellogg's 7.570 7.570 7.780 7.820 8.260 Kellogg's 0.81 0.545 0.39 0.43 0.48 Kraft 5.164 5.543 5.884 6.534 6.258 Kraft 0.131 0.122 0.0891 0.0889 0.107 General Mills 4.420 5.650 6.190 6.590 6.602 General Mills 0.1281 0.2196 0.201 0.2185 0.188 Average 5.718 6.254 6.618 6.981 7.040 Average 0.3563667 0.295533 0.2267 0.2458 0.25833 Working Capital TO 2002 2003 2004 2005 2006 Debt to Equity 2002 2003 2004 2005 2006 Kellogg's -6.64 -9.01 -12.95 -10.53 -6.85 Kellogg's 10.42 6.03 3.78 3.63 4.18 Kraft 101.9 115.96 49.95 -59.74 -15.48 Kraft 1.21 1.078 1.004 0.947 0.946 General Mills -3.44 -39.65 24.17 -9.96 -3.92 General Mills 3.582 3.294 2.58 0.947 0.9462 Average 30.61 22.43 20.39 -26.74 -8.75 Average 5.07 3.47 2.45 1.84 2.02 Gross Profit Margin 2002 2003 2004 2005 2006
Times Interest Earned 2002 2003 2004 2005 2006
Kellogg's 45.00% 44.40% 44.90% 44.90% 44.20% Kellogg's 2.93 3.15 4.43 4.75 4.79 Kraft 40.30% 39.20% 36.90% 35.90% 36.10% Kraft 7.22 8.81 6.92 7.47 8.87 General Mills 41.35% 41.85% 40.52% 39.22% 40.15% General Mills 1.6 2.41 2.97 3.989 3.927 Average 42.22% 41.82% 40.77% 40.01% 40.15% Average 3.917 4.79 4.77 5.403 5.86 Operating Expense 2002 2003 2004 2005 2006
Debt Service Margin 2002 2003 2004 2005 2006
Kellogg's 26.80% 26.90% 27.40% 27.70% 28.10% Kellogg's 2.37 3.65 1.73 1.02 1.11 Kraft 19.30% 20.10% 20.70% 20.90% 21.10% Kraft 1.92 2.05 2.2 4.3 2.16 General Mills 26.04% 23.53% 22.07% 21.50% 23.01% General Mills 0.25 2.03 2.5 5.72 1.178 Average 24.05% 23.51% 23.39% 23.37% 24.07% Average 1.51 2.58 2.14 3.68 1.48 Days Supply of Inventory 2002 2003 2004 2005 2006
Days Supply of Receivables 2002 2003 2004 2005 2006
Kellogg's 48.21 48.21 46.91 46.67 44.18 Kellogg's 32.5 31.276 29.48 31.59 31.63 Kraft 70.68 65.84 62.03 55.86 58.33 Kraft 38.88 40.32 40.18 36.22 41.1 General Mills 82.58 64.6 58.96 55.39 55.29 General Mills 46.37 34.04 33.3 33.56 33.74 Average 67.16 59.55 55.97 52.64 52.6 Average 39.25 35.21 34.32 33.79 35.49 PP&E Turnover (new) 2002 2003 2004.00 2005 2006
EBITDA Margin 2002 2003 2004 2005 2006
Kellogg's 2.92 3.16 3.54 3.84 3.874 Kellogg's 13.7% 13.3% 14.2% 14.0% 13.4% Kraft 2.02 1.92 1.95 2.05 2.01 Kraft 17.4% 17.0% 12.2% 12.0% 13.1% General Mills 2.875 3.52 3.55 3.61 3.88 General Mills 8.4% 12.5% 13.6% 16.1% 13.4% Average 2.61 2.87 3.01 3.17 3.25 Average 13.2% 14.3% 13.3% 14.0% 13.3%
84
Appendix 3 – Liquidity, Profitability & Capital Structure
Liquidity Analysis 2002 2003 2004 2005 2006 Current Ratio 0.585 0.646 0.745 0.694 0.604 Quick Asset Ratio 0.279 0.324 0.419 0.347 0.337 Account Receivable Turnover 11.210 11.670 12.380 11.580 11.540
Days Supply of Receivables 32.5 31.276 29.48 31.59 31.63 Inventory Turnover 7.570 7.570 7.780 7.820 8.260
Days Supply of Inventory 48.21 48.21 46.91 46.67 44.18
Working Capital Turnover -6.64 -9.01 -12.95 -10.53 -6.85 Profitability Analysis 2002 2003 2004 2005 2006 Gross Profit Margin 45.00% 44.40% 44.90% 44.90% 44.20% Operating Expense Ratio 26.80% 26.90% 27.40% 27.70% 28.10% Net Profit Margin 8.70% 8.90% 9.30% 9.60% 9.20% Asset Turnover 0.813 0.869 0.891 0.962 1.018 Return on Assets 7.10% 7.80% 8.30% 9.30% 9.40% Return on Equity 0.81 0.545 0.39 0.43 0.48 Capital Structure Analysis 2002 2003 2004 2005 2006 Debt to Equity Ratio 10.42 6.03 3.78 3.63 4.18 Times Interest Earned 2.93 3.15 4.43 4.75 4.79 Debt Service Margin 2.37 3.65 1.73 1.02 1.11 Extra Two Important 2002 2003 2004 2005 2006
Property Plant and Equipment Turnover 2.92 3.16 3.54 3.84 3.874 EBITDA Margin 13.7% 13.3% 14.2% 14.0% 13.4%
85
Appendix 4 – Financial Forecast Balance Sheet
Asset Turnover 0.813 0.869 0.891 0.962 1.018
Asset Turnover = 1.1
$11,114.45
$11,892.46
$12,724.93
$13,615.68
$14,568.77
$15,588.59
$16,679.79
$17,847.37
$19,096.69
$20,433.46
$21,863.80
(millions, except share data) 2002 2003 2004 2005 2006 Assumptions 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
7.0% growth
Total current assets $1,763.40 $1,787.90 $2,121.80 $2,196.50 $2,427.00 $2,596.89 $2,778.67 $2,973.18 $3,181.30 $3,403.99 $3,642.27 $3,897.23 $4,170.04 $4,461.94 $4,774.28 $5,108.48
Long Term Assets $8,455.90 $8,354.80 $8,668.60 $8,378.00 $8,287.00 $8,867.09 $9,487.79 $10,151.93
$10,862.57
$11,622.95
$12,436.55
$13,307.11
$14,238.61
$15,235.31
$16,301.78
$17,442.91
Total assets $10,219.30
$10,142.70
$10,790.40
$10,574.50
$10,714.00
$11,463.98
$12,266.46
$13,125.11
$14,043.87
$15,026.94
$16,078.82
$17,204.34
$18,408.65
$19,697.25
$21,076.06
$22,551.38
Total current liabilities $3,014.90 $2,766.00 $2,846.00 $3,162.80 $4,020.20 $4,301.61 $4,602.73 $4,924.92 $5,269.66 $5,638.54 $6,033.24 $6,455.56 $6,907.45 $7,390.97 $7,908.34 $8,461.93
Long Term Liabilities $6,309.30 $5,933.50 $5,687.20 $5,128.00 $4,624.80 $4,948.54 $5,294.93 $5,665.58 $6,062.17 $6,486.52 $6,940.58 $7,426.42 $7,946.27 $8,502.51 $9,097.68 $9,734.52
Total Liabilities $9,324.20 $8,699.50 $8,533.20 $8,290.80 $8,645.00 $9,250.15 $9,897.66 $10,590.50
$11,331.83
$12,125.06
$12,973.81
$13,881.98
$14,853.72
$15,893.48
$17,006.02
$18,196.45
Owners Equity $895.10 $1,443.20 $2,257.20 $2,283.70 $2,069.00 $2,213.83 $2,368.80 $2,534.61 $2,712.04 $2,901.88 $3,105.01 $3,322.36 $3,554.93 $3,803.77 $4,070.04 $4,354.94 Total Liabilities and O.E
$10,219.30
$10,142.70
$10,790.40
$10,574.50
$10,714.00
$11,463.98
$12,266.46
$13,125.11
$14,043.87
$15,026.94
$16,078.82
$17,204.34
$18,408.65
$19,697.25
$21,076.06
$22,551.38
AS percentages
2002 2003 2004 2005 2006 Assumptions 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Total current assets 17.26% 17.63% 19.66% 20.77% 22.65% 7.0% growth 22.65% 22.65% 22.65% 22.65% 22.65% 22.65% 22.65% 22.65% 22.65% 22.65% 22.65%
Long Term Assets 82.74% 82.37% 80.34% 79.23% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35% 77.35%
Total assets 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Total current liabilities 29.50% 27.27% 26.38% 29.91% 37.52% 30.12% 30.27% 31.27% 32.52% 32.64% 30.55% 31.04% 31.36% 31.45% 31.60% 31.62%
Long Term Liabilities 61.74% 58.50% 52.71% 48.49% 43.17% 52.92% 50.72% 48.12% 48.19% 48.93% 50.59% 49.99% 49.78% 49.31% 49.17% 49.50%
Total Liabilities 91.24% 85.77% 79.08% 78.40% 80.69% 83.04% 80.99% 79.39% 80.71% 81.57% 81.14% 81.03% 81.14% 80.76% 80.77% 81.12%
Owners Equity 8.76% 14.23% 20.92% 21.60% 19.31% 16.96% 19.01% 20.61% 19.29% 18.43% 18.86% 18.97% 18.86% 19.24% 19.23% 18.88% Total Liabilities and O.E. 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
86
Income Statement
millions of dollars 2002 2003 2004 2005 2006 Assumptions
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Net sales $ 8,304.10 $ 8,811.50 $ 9,613.90 $ 10,177.20 $ 10,906.70 7% growth
rate $
11,670.17 $ 12,487.08 $ 13,361.18 $ 14,296.46 $ 15,297.21 $ 16,368.02 $
17,513.78 $ 18,739.74 $ 20,051.52 $ 21,455.13 $ 22,956.99
Cost of goods sold $ 4,569.00 $ 4,898.90 $ 5,298.70 $ 5,611.60 $ 6,081.50 $ 6,507.21 $ 6,962.71 $ 7,450.10 $
7,971.61 $ 8,529.62 $ 9,126.69 $ 9,765.56 $ 10,449.15 $
11,180.59 $ 11,963.23 $ 12,800.66
SG&A expense $ 2,227.00 $ 2,368.50 $ 2,634.10 $ 2,815.30 $ 3,059.40 $ 3,273.56 $ 3,502.71 $ 3,747.90 $ 4,010.25 $ 4,290.97 $ 4,591.33 $ 4,912.73 $ 5,256.62 $ 5,624.58 $ 6,018.30 $ 6,439.58 $ 0.02 $ 0.09 $ 4.00 $
0.01
Operating profit $ 1,508.10 $ 1,544.10 $ 1,681.10
$ 1,750.30 $ 1,765.80 $ 1,889.41 $ 2,021.66 $ 2,163.18 $ 2,314.60 $ 2,476.63 $ 2,649.99 $ 2,835.49 $ 3,033.97 $ 3,246.35 $ 3,473.60 $ 3,716.75
$ (6.00) $ (20.00) $ (3.00) $ 2.30 Interest expense $ 391.20 $ 371.40 $ 308.60 $ 300.30 $ 307.40 $ 308.94 $ 310.48 $ 312.03 $ 313.59 $
315.16 $ 316.74 $ 318.32 $ 319.91 $
321.51 $ 323.12 $ 324.74
Other income (expense), net $ 27.40 $ (3.20) $ (6.60) $ (24.90) $ 13.20
Earnings before income taxes $ 1,144.30 $ 1,169.50 $ 1,365.90 $ 1,425.10 $ 1,471.60 $ 1,580.47 $ 1,711.18
$ 1,851.15
$ 2,001.01 $ 2,161.46 $ 2,333.25 $ 2,517.17
$ 2,714.06 $ 2,924.84 $ 3,150.48 $ 3,392.01
Income taxes $ 423.40 $ 382.40 $ 475.30 $ 444.70 $ 466.50 $ 491.02 $ 529.13 $ 568.62 $ 609.47 $ 651.64 $ 695.10 $ 739.77 $ 785.58 $ 832.44 $ 880.22 $ 928.79 Earnings (loss) from joint venture $ - $ - $
(1.00)
$ 9.00 $ 13.00 $ 10.00 $ 2.00 Net earnings (Loss) $ 720.90 $ 787.10 $ 890.60 $ 980.40 $ 1,004.10 $ 1,089.45 $ 1,182.05 $ 1,282.53 $
1,391.54 $ 1,509.82 $ 1,638.16 $ 1,777.40 $ 1,928.48 $ 2,092.40 $ 2,270.25 $ 2,463.23
percentage 2002 2003 2004 2005 2006 Assumptions
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Net sales 100.00% 100.00% 100.00% 100.00% 100.00% 7% growth
rate 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Cost of goods sold 55.02% 55.60% 55.11% 55.14% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% 55.76% SG&A expense 26.82% 26.88% 27.40% 27.66% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05% 28.05%
Operating profit 18.16% 17.52% 17.49% 17.20% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% 16.19% Interest expense 4.71% 4.21% 3.21% 2.95% 2.82% 2.65% 2.49% 2.34% 2.19% 2.06% 1.94% 1.82% 1.71% 1.60% 1.51% 1.41% Other income (expense), net
Earnings before income taxes 13.78% 13.27% 14.21% 14.00% 13.49% 13.54% 13.70% 13.85% 14.00% 14.13% 14.25% 14.37% 14.48% 14.59% 14.68% 14.78% Income taxes 5.10% 4.34% 4.94% 4.37% 4.28% 4.21% 4.24% 4.26% 4.26% 4.26% 4.25% 4.22% 4.19% 4.15% 4.10% 4.05% Earnings (loss) from joint venture
Net earnings 8.68% 8.93% 9.26% 9.63% 9.21% 9.34% 9.47% 9.60% 9.73% 9.87% 10.01% 10.15% 10.29% 10.44% 10.58% 10.73%
87
Cash Flow Statement
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Operating activities Net earnings 720.90 787.10 890.60 980.40 1004.10 1029.20 1054.93 1081.31 1108.34 1136.05 1164.45 1193.56 1223.40 1253.98 1285.33 1317.47 Adjustments to reconcile net earnings to operating cash flows
Depreciation and amortization 349.90 372.80 410.00 391.80 352.70 359.75 366.95 374.29 381.77 389.41 397.20 405.14 413.24 421.51 429.94 438.54 Deferred income taxes 111.20 74.80 57.70 (59.20) (43.70) (44.57) (45.47) (46.37) (47.30) (48.25) (49.21) (50.20) (51.20) (52.23) (53.27) (54.34) Other (a) 67.00 76.10 104.50 199.30 235.20 239.90 244.70 249.60 254.59 259.68 264.87 270.17 275.57 281.09 286.71 292.44 Pension and other postretirement benefit plan contributions
(446.60)
(184.20)
(204.00)
(397.30) (99.30) (84.63) (87.58) (89.61) (91.75) (93.94) (96.18) (98.47) (100.81) (103.21) (105.67) (108.18)
Changes in operating assets and liabilities 197.50 44.40 (29.80) 28.30 (38.50) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00) (40.00)
Net cash provided by operating activities 999.90 1171.0
0 1229.0
0 1143.3
0 1410.5
0 1459.6
6 1493.5
4 1529.2
0 1565.6
5 1602.9
5 1641.13 1680.21 1720.20 1761.14 1803.04 1845.93 Investing activities
Additions to properties (253.50
) (242.70
) (278.60
) (374.20
) (453.10
) (461.71
) (470.48
) (479.42
) (488.53
) (497.81
) (507.27) (516.91) (526.73) (536.74) (546.94) (557.33) Acquisitions of businesses (2.20) 14.00 0.00 (50.40) Property disposals 60.90 13.80 7.90 9.80 9.40 10.06 10.76 11.52 12.32 13.18 14.11 15.09 16.15 17.28 18.49 19.79 Investment in joint venture and other 6.00 0.40 0.30 (0.20) (1.70) 0.96 0.96 0.96 0.96 0.96 0.96 0.96 0.96 0.96 0.96 0.96
Net cash used in investing activities (188.8
0) (214.5
0) (270.4
0) (415.0
0) (445.4
0) (450.6
9) (458.7
6) (466.9
5) (475.2
5) (483.6
7) (492.20
) (500.85
) (509.62
) (518.50
) (527.48
) (536.58
) Financing activities Net increase of notes payable, with less than or equal to 90 days
(226.20)
208.50 388.30 360.20
(344.20)
Issuances of notes payable, with maturities greater then 90 days
354.90 67.00 142.30 42.60 1065.40
Reductions of notes payable, with maturities greater then 90 days
(221.10)
(375.60)
(141.70) (42.30)
(565.20)
Issuances of long-term debt 0.00 498.10 7.00 647.30 0.00
Reductions of long-term debt (439.30
) (956.00
) (682.20
) (1041.3
0) (84.70) Issuances of common stock 100.90 121.60 291.80 221.70 217.50
Common stock repurchases (101.00
) (90.00) (297.50
) (664.20
) (649.80
)
Cash dividends (412.60
) (412.40
) (417.60
) (435.20
) (449.90
) Other 0.00 (0.60) (6.70) 5.90 21.90
Net cash used in financing activities (944.4
0) (939.4
0) (716.3
0) (905.3
0) (789.0
0) (923.3
0) (918.7
6) (914.3
2) (956.9
0) (967.9
9) (1006.4
7) (1024.3
5) (1047.0
6) (1075.5
9) (1101.1
1) (1129.7
4)
Increase (decrease) in cash and cash equivalents (133.30
) 17.10 242.30 (177.00
) 176.10 85.67 116.02 147.94 133.50 151.29 142.46 155.00 163.53 167.05 174.44 179.61
Cash and cash equivalents at beginning of year 231.80 98.50 115.60 357.90 180.90 357.00 442.67 558.69 706.63 840.13 991.42 1133.88 1288.88 1452.41 1619.46 1793.90 Cash and cash equivalents at end of year 98.50 115.60 357.90 180.90 357.00 442.67 558.69 706.63 840.13 991.42 1133.88 1288.88 1452.41 1619.46 1793.90 1973.51
88
Appendix 5 – Cost of Capital
10 yr. Treasury
Beta adj. R
squared Ke 72 months -0.0349 -0.0131 0.045455 60 months 0.0753 -0.0126 0.050965 48 months 0.4564 0.0712 0.070018 36 months 0.0324 -0.0288 0.048820 24 months 0.1063 -0.0391 0.052515 7 yr. Treasury
Beta adj. R
Squared Ke 72 months -0.3483 -0.0131 0.029685 60 months 0.0755 -0.1260 0.050875 48 months 0.4568 0.0715 0.069940 36 months 0.0343 -0.0287 0.048813 24 months 0.1064 -0.0391 0.052422 5 yr. Treasury
Beta adj. R
Squared Ke 72 months -0.0347 -0.0131 0.045363 60 months 0.0758 -0.0126 0.050892 48 months 0.4569 0.0718 0.069947 36 months 0.0363 -0.0287 0.048913 24 months 0.1061 -0.0392 0.052406 1 yr. Treasury
Beta adj. R
Squared Ke 72 months -0.0332 -0.0132 0.048842 60 months 0.0790 -0.0122 0.054449 48 months 0.4596 0.0734 0.073480 36 months 0.0448 -0.0283 0.052742 24 months 0.1052 -0.0393 0.055759 3 mon. Treasury
Beta adj. R
Squared Ke 72 months -0.0326 -0.0133 0.049970 60 months 0.0802 -0.0120 0.055609 48 months 0.4617 0.0740 0.074685 36 months 0.0463 -0.0282 0.053914 24 months 0.1053 -0.0393 0.056867
89
ROE 0.48g 0.09 p 52.84b 5.202p/b 10.15763p/b-1 9.157632p/b-1*g 0.824187p/b-1*g+ROE 1.304187divide by p/b 0.128395
WACCBT = (VD/VF)*KD + (VE/VF)*KE
WACCBT = (8,645/10,714)*(0.05454) + (2,069/10,714)*(0.1284)
WACCBT = 0.06881
WACCAT = (VD/VF)*KD(1-T) + (VE/VF)*KE
WACCAT = (8,645/10,714)*(0.05454)*(1- 0.35) + (2,069/10,714)*(0.1284)
WACCAT = 0.05339
90
Appendix 6 – Method of Comparables
Observed Share Price (12/31/06): $ 50.93 Observed Share Price (4/2/07) : $ 51.90 Kellogg's (K) 2002 2003 2004 2005 2006 2007PPS 36.06 38.29 45.24 46.39 48.43 51.86 EPS 1.77 1.93 2.16 2.38 2.53 EPS growth 8% 9% 11% 10% 6% DPS 1.01 1.01 1.01 1.06 1.137 BPS 8.623 13.9 27.74 21.83 19.78 EBITDA 1144.3 1169.5 1365.9 1425.1 1471.6 FCF 811.11 922 958.6 728.3 965.1 EV 9407.32 8758.6 8339.6 8320.64 8449.03 General Mills (GIS) 2002 2003 2004 2005 2006 2007PPS 52.86 49.66 49.96 53.54 59.23 59.04 EPS 1.38 2.49 2.82 3.34 3.05 EPS growth 15% 80% 13% 18% -8% DPS 1.1 1.1 1.17 0.64 1.38 BPS 25.72 44.53 27.33 29.1 36.76 EBITDA 667 1316 1509 1815 1567 FCF 852 613 991 2207 1479 EV 12027.82 13288.04 12691.44 11335.3 11130.85 Kraft (KFT) 2002 2003 2004 2005 2006 2007PPS 43.95 39.4 36.06 35.65 36.67 36.26 EPS 1.9 1.95 1.56 1.72 1.86 EPS growth 3% 2.60% -20% 10% 8.10% DPS 0.56 0.66 0.77 0.87 0.96 BPS 14.92 16.52 17.54 17.72 17.45 P/E ratio 20 16 23 18 19 EBITDA 5114 5195 3946 4116 4016 FCF 2668 3070 2952 3989 3604 EV 34341.9 33598.9 32390.8 30591.4 29822.95 Industry Average (All Three) 2002 2003 2004 2005 2006 2007PPS 44.29 42.45 43.75 45.19 48.11 49.05 EPS 1.68 2.12 2.18 2.48 2.48 DPS 0.89 0.92 0.98 0.86 1.2 BPS 16.42 24.98 24.20 22.88 24.66 EBITDA 2308.43 2560.17 2273.63 2452.03 2351.53 FCF 1443.70 1535.00 1633.87 2308.10 2016.03 EV 18592.35 18548.51 17807.28 16749.11 16467.61 Valuation Ratios: 2002 2003 2004 2005 2006 Conclusion P/B 21.56 24.33 53.87 42.04 $ 36.72 Over Valued P/E 54.37 38.74 44.10 43.74 $ 49.51 Fairly Valued D/P 60.21 51.93 45.12 58.31 $ 45.96 Over Valued P/EBITDA 50.26 26.50 28.85 27.19 $ 34.53 Over Valued P/FCF 31.84 43.26 30.02 12.09 $ 24.23 Over Valued PEG 54.45 38.83 44.21 43.84 $ 49.57 Fairly Valued P* (EV) 101.73 62.03 50.73 39.93 $ 41.71 Over Valued
91
Appendix 7 – Valuation Models
Discount Dividends Cost of Capital (Ke) 0.13 Terminal Growth Rate 0.03 Dividend Growth Rate 0.03 0 1 2 3 4 5 6 7 8 9 10 Perpetuity 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 DPS (Dividend/ Share) 1.14 1.17 1.21 1.25 1.28 1.32 1.36 1.40 1.44 1.49 1.53 16.06 PV Factor 0.89 0.79 0.70 0.62 0.55 0.48 0.43 0.38 0.34 0.30 0.30 Discounted Dividend 1.04 0.95 0.87 0.79 0.72 0.66 0.60 0.55 0.50 0.46 4.80 Terminal Value Calculation Terminal Dividend / (Ke - g)
1.58/ (0.1284-0.03) Sensitivity Analysis
16.06 Terminal Growth Rate 0.00 0.01 0.02 0.03 0.04 Intrinsic Value of Future Dividends 0.05 30.04 34.52 42.60 58.77 107.27 Total PV of Future Dividends 7.14 0.06 24.83 27.41 32.29 39.18 53.88 PV of Terminal Dividend 4.80 Ke 0.07 20.77 22.69 25.36 29.38 36.77 Intrinsic Value of Future Dividends 11.94 0.08 18.01 19.32 21.06 23.50 27.16 Intrinsic Value of Future Dividends (4/2/07) 12.30 0.09 15.88 16.80 17.99 19.58 21.81 Observed Value 4/2/07 51.90 0.10 14.52 15.21 16.08 17.19 18.68 0.11 13.13 13.65 14.28 15.07 16.09
92
Discounted Cash Flow
Kellogg's Free Cash Flow Valuation WACC 0.05339 Ke 0.1284 Growth Rate 0.03
1 2 3 4 5 6 7 8 9 10
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Terminal
Cash from Operations 1,459.66 1,493.54 1,529.20 1,565.65 1,602.95 1,641.13 1,680.21 1,720.20 1,761.14 1,803.04
Cash from Investments 450.69 458.76 466.95 475.25 483.67 492.20 500.85 509.62 518.50 527.48
Free Cash Flow 1,008.97 1,034.78 1,062.25 1,090.40 1,119.28 1,148.93 1,179.36 1,210.58 1,242.64 1,275.56 1,300.00
PV Factor 0.95 0.90 0.86 0.81 0.77 0.73 0.69 0.66 0.63 0.59 0.56
PV of free cash flows 957.83 932.54 908.78 885.58 862.96 840.93 819.45 798.51 778.11 758.24
Total PV of Annual Cash Flow 8542.95
Continuing Terminal Value PV of Terminal Value Perpetuity 733.60
Value of Firm 9276.55
BV of Liabilities 8645 Sensitivity Analysis Estimated Market Value of Equity 631.55 WACC
Number of Shares 397 0.05 0.085 0.09 0.15 0.25
Estimated Price Per Share 1.59 Growth Rate 0.06 -159.08 63.63 53.03 17.68 8.37
Estimated Share Price (4/2/07) 1.61 0.07 -79.54 106.05 79.54 19.89 8.84
0.08 -53.03 318.16 159.08 22.73 9.36
Observed Share Price 50.93 0.09 -39.77 -318.16 N/A 26.51 9.94 Observed Share Price (4/2/07) 51.90 0.1 -31.82 -106.05 -159.08 31.82 10.61
0.11 -26.51 -63.63 -79.54 39.77 11.36
0.12 -22.73 -45.45 -53.03 53.03 12.24
93
Residual Income
Cost of Capital (Ke) 12.84% Terminal Growth Rate 3.00% Actual 1 2 3 4 5 6 7 8 9 10 Terminal 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Perpetuity EPS (Earning per Share) 2.53 2.71 2.90 3.10 3.32 3.55 3.80 4.06 4.35 4.65 4.98 DPS (Dividends per Share) 1.14 1.17 1.21 1.25 1.28 1.32 1.36 1.40 1.44 1.49 1.53 BPS (Book Value Equity per Share) 5.21 6.74 8.43 10.29 12.32 14.55 16.98 19.64 22.54 25.71 29.15 Residual Income Model Forecasted Net Income 2.71 2.90 3.10 3.32 3.55 3.80 4.06 4.35 4.65 4.98 Normal Income 0.87 1.08 1.32 1.58 1.87 2.18 2.52 2.89 3.30 3.74 Annual Forecast Residual Income 1.84 1.81 1.78 1.73 1.68 1.62 1.54 1.45 1.35 1.23 1.27 12.87 PV Factor 0.8862 0.7854 0.6960 0.6168 0.5466 0.4844 0.4293 0.3804 0.3372 0.2988 0.2988 PV of Residual Income 1.63 1.42 1.24 1.07 0.92 0.78 0.66 0.55 0.46 0.37 3.85 Terminal Value of Perpetuity Terminal Value/ Ke - g 12.87 Sensitivity Analysis Intrinsic Value of Equity Percent of Value Terminal Growth Rate Beginning Value of Equity 5.21 28.7% 0% 1% 2% 3% 4% PV of Total Residual Income 9.10 50.1% 7% 44.9 48.55 53.66 61.32 74.09 PV of Terminal Perpetuity 3.85 21.2% 8% 36.88 39.13 42.12 46.31 52.6 Intrinsic Value of Equity 18.16 Ke 9% 30.82 32.24 34.06 36.49 39.89 Intrinsic Value of Equity (4/2/07) 17.62 10% 25.5 26.38 27.49 28.91 30.81 Observed Value of Equity (4/2/07) 51.90 11% 21.8 22.37 23.06 23.93 25.04 12% 18.83 19.19 19.62 20.15 20.81 13% 16.39 16.61 16.88 17.19 17.58
94
Abnormal Earnings Growth Model
1 2 3 4 5 6 7 8 9 Perp
Forecast Years
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
EPS 2.71 2.90 3.10 3.32 3.55 3.80 4.06 4.35 4.65 4.98
DPS 1.17 1.21 1.25 1.28 1.32 1.36 1.40 1.44 1.49 1.53
DPS invested at 12.84% (Drip) 0.15 0.16 0.16 0.16 0.17 0.17 0.18 0.18 0.19
Cum-Divident Earnings 3.05 3.26 3.48 3.71 3.97 4.23 4.53 4.83 5.17
Normal Earnings 3.06 3.27 3.50 3.75 4.01 4.29 4.58 4.91 5.25
Abnormal Earning Growth (AEG) -0.01 -0.02 -0.02 -0.03 -0.04 -0.05 -0.05 -0.07 -0.08 -0.08
PV Factor 0.8862 0.7854 0.6960 0.6168 0.5466 0.4844 0.4293 0.3804 0.3372
PV of AEG -0.01 -0.01 -0.01 -0.02 -0.02 -0.03 -0.02 -0.03 -0.03
Core EPS 2.71
Total PV of AEG -0.17
Continuing (Terminal) Value -0.81
PV of Terminal Value -0.27
Total PV of AEG -0.45
Total Average EPS Perp (t+1) 2.26
Capitalization Rate (perpetuity) 0.1284
Sensitivity Analysis
Intrinsic Value Per Share 17.62 g
Intrinsic Value Per Share 4/2/07 18.16 -0.01 -0.03 -0.05 -0.07 -0.09
0.04 69.82 77.93 82.44 85.30 87.29
Observed Share Price 4/2/07 51.90 0.05 57.03 61.38 63.99 65.73 66.97
Ke 0.06 47.76 49.99 51.61 52.72 53.55
0.07 40.11 41.69 42.75 43.50 44.07
Ke 0.1284 0.08 34.39 35.42 36.13 36.65 37.05
g 0.03
95
Appendix 8 – Z-Score
DATA FOR Z-SCORE 2006 2005 2004 2003 2002 Working Capital -1593.20 -966.30 -724.20 -968.80 -1251.50 Retained Earnings 3630.40 3266.10 2701.30 2247.70 1873.00 EBIT 1471.60 1425.10 1365.90 1169.50 1144.30 Sales 10906.70 10177.20 9613.90 8811.50 8,304.10 M.V. Equity 994.93 966.89 872.91 784.13 702.55 B.V Liabilities 8645.00 8290.80 8533.20 8699.50 9324.20 Total Assets 10714.00 10574.50 10790.40 10230.80 10219.30 Current Assets 2427.00 2196.50 2121.80 1797.20 1763.40 Current Liabilities 4020.20 3162.80 2846.00 2766.00 3014.90 Price per share 2.50 2.36 2.14 1.92 1.73 # Shares Outstanding 397.97 409.70 407.90 408.40 406.10 Factor 1.2 1.4 3.3 0.6 1.0 TOTAL Z-SCORE 2006 -0.18 0.47 0.45 0.07 1.02 1.84 Z-SCORE 2005 -0.11 0.15 0.44 0.07 0.96 1.51 Z-SCORE 2004 -0.08 0.35 0.42 0.06 0.89 1.64 Z-SCORE 2003 -0.11 0.31 0.38 0.05 0.86 1.49 Z-SCORE 2002 -0.15 0.26 0.37 0.05 0.81 1.34
96
References
1. Kellogg’s Website: www.kelloggs.com
2. General Mills Website: www.Generalmills.com
3. Kraft Website: www.kraft.com
4. Yahoo Finance: www.finance.yahoo.com
5. Palepu, Healy, Bernard, Business Analysis & Valuation (Ohio:
South-Western, Thompson, 3rd Edition 2004)
6. Kellogg’s Company 2007 10-k
7. St. Louis Federal Reserve:
http://www.stls.frb.org/default.cfm