Expressing shock at declining margins due to higher costs is the corporate equivalent of wondering why you’re getting fat in spite of only eating Crunchy Nut Cornflakes for breakfast. The truth is that many supposedly healthy cereals are high in sugar and salt. Likewise, reinvesting hurts profits. The bigger question for investors, however, is whether spending money moves from a company’s waistline to its top-line.
That is exactly the issue at Kellogg. On Monday, only days before its scheduled first-quarter results, the world’s largest cereal maker by sales cut guidance for the full year. Revenues are only expected to increase 2-3 per cent in 2012 versus an average of 6 per cent annually over the past decade. Operating profits are forecast to fall 2-4 per cent. Having exceeded its average 44 per cent long-run gross margin as recently as two years ago, Kellogg’s profitability is looking soggy. Shares fell 5 per cent on the warning.
The company blamed those pesky Europeans for not eating enough Pop-Tarts, “weak volume growth in certain U.S. categories” and “the desire to invest in future growth”. As excuses go, the first is weak; and the second forgivable. But both should normalise over time. Investment is the key. Kellogg is upgrading its supply chain and production lines and is hiring and retraining staff. Capital expenditure as a percentage of revenues at 6.7 per cent in the fourth quarter is almost double the quarterly average for the past five years.
Will this investment help sales growth or is Kellogg spending just to stay at the table? Worse, is the money simply dissolving into the milk? Shareholders can only know by keeping a close eye on the top line. If revenues do not turn around fairly quickly, or if capex ratios do not normalize, investors may decide that they no longer wish to wake up everyday with Kellogg.