The Best to You Each Morning

10/29/2008 11:00 am EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, and analyst Gregory Warren say Kellogg is in good shape and can boost dividends.

Kellogg (NYSE: K) continues to demonstrate why it differs from the growing list of underperformers in the packaged food industry, generating above-average sales and earnings growth through its sustained commitment to product innovation and efficient marketing behind its brands.

Despite concerns about rising costs of raw materials and fuel, as well as a protracted slowdown in the US economy, Kellogg continues to post solid top-line growth with just a minimal reduction in its operating profits.

While Kellogg may compete in only a few categories, its commitment to new products and marketing and its ability to leverage several brands across its product portfolio have allowed it to capture leading share in many of the categories where it competes.

In ready-to-eat cereal, which generates about half of Kellogg’s annual revenue, the company controls 33% of the market, both domestically and internationally. Kellogg also holds a leading share of the wholesome snack bar category, having leveraged the strength of cereal brands like Special K into market-leading products in this higher-growth segment.

Kellogg could not have done this without the direct-store-delivery system it picked up when it acquired Keebler in 2000. By knowing exactly what it wanted from the acquisition, Kellogg had far fewer issues with the integration and was able to use Keebler’s network to vault itself into a leading market share position in snack food.

About the only weak spot we can find in Kellogg’s portfolio has been its lack of exposure to higher-growth markets outside the US While the company does receive around 35% of its annual sales and profits from overseas, much of that has been concentrated in places like Western Europe, where the markets are more mature and growth is difficult to come by.

Kellogg recently unveiled plans to push further into emerging and developing markets, such as Eastern Europe, but there are concerns that the firm will face stiff competition. But given the success Kellogg has had gaining share from its rivals in many of the developed markets where it competes, we wouldn’t count it out just yet.

Kellogg employs a lot of financial leverage for a packaged-food firm, with debt making up more than 65% of total capitalization. The firm’s interest coverage ratio of 5.8x is more than adequate, however, as is a dividend payout ratio of 45%.

We don’t expect recent growth rates to continue, but given mid-single-digit gains for operating profit and share buybacks, we find Kellogg capable of raising its dividend at 7%—9% annually. Dividends have only been raised in each of the past four years, but we believe Kellogg is back on a sustainable track.

At our dividend buy price of $48.90, Kellogg would provide a steady 2.8% yield and the potential for average annual total returns of 10%—12%. (It closed Tuesday above $50—Editor.)

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