Kellogg's : Spin-off for the good?

Businesses are started with the objective of running them as a going concern. This accounting concept assumes that the business will have adequate resources to continue operations in the foreseeable future. However, when the business continues to run profitably (return on investment > cost of capital), it keeps generating free cash flows. These cash flows can be reinvested into the business for expansion and growth or returned back to the shareholders through dividends or buybacks.?

Now when the cash flow is reinvested and the business keeps growing, the expectations of the management? and stakeholders change. To keep the interests aligned, businesses often take restructuring decisions for sustainability of operations. In today’s newsletter, we are going to understand :

1. What is a spin-off?
2. Why does Kellogg's need a spin-off?
3. The way ahead
4. Valuation

What is a spin-off?

When an existing company divests a part of its business to form a new company, it’s called a spin-off. This new business, which is spun-off, will have a new name and will gain ownership of the assets, patents, and other intellectual property associated with the segment.

In a spin-off, existing shareholders will be awarded a 100% ownership interest in the form of a stock dividend. Further, shareholders may also be offered a discount to exchange shares of the parent company with shares of the new entity.?

A spin-off may occur for various reasons depending on the interests of the parties. Corporates have undertaken spin-offs to focus on businesses which seem to have long-term prospects. Additionally, the management team may also focus on streamlining operations and lower cost structures which means a company will spin off loss-making businesses or those with lower profit margins.

It is important to understand that businesses may be in different stages of a life cycle and the initial phase of the business cycle may be followed by?

• High debt which increases capital employed and has a return on investment
• Low market share and possibility of margin expansion?
• Operating leverage with more fixed costs?
• Under-utilization of capacity
• High spends on advertising expenses

While the odds are against the business in the short term, they do have a potential to outperform in the long run. However, the poor performance of the particular business may impact the returns to the shareholder.?

Why does Kellogg's need a spin-off?

To understand the rationale behind the spin-off, let’s first look at the revenue split across segments.

U.S., Canadian, and Caribbean cereal and plant-based business accounted for 20% of net sales in 2021.Products such as global snacking, international cereal, and noodles accounted for 80% of net sales last year.?

The spin-off is expected to create value for the shareholders and it is worth mentioning that the current conglomerate business structure is weighing down on the company’s snacking business and attracting lesser valuation compared to its peers.?

It is to be noted that North America sales decreased by 2.3 percent during FY21 while AMEA sales increased by 16 percent during the same period.

The way ahead

• North America Cereal Co., which includes the Company’s cereal business in the U.S., Canada, and Caribbean market
• Plant Co., a pure-play, plant-based foods company which includes the MorningStar Farms brand.?
• Global Snacking Co would focus on global snacking, international cereal and noodles, and North America frozen breakfast. The Kellogg Company’s three international regions - Europe, Latin America, and the Asia Pacific, Middle East, and Africa (AMEA) will remain almost entirely intact within this group.

Valuation

The company’s global snacking business (80% of FY21 revenue) could earn a higher valuation closer to its peer Mondelez International Inc. after separating from Kellogg’s North American cereal and plant-based foods units.?

Based on Mondelez’s valuation of 3.5x enterprise value on its 2021 sales, the remaining snacks business would be worth about $40 billion, ~$10 billion above current levels.

Ideally, a spin-off should create value for all the stakeholders involved. Kellogg’s emphasized it will generate a stable stream of revenue and improve profit margins as a stand-alone company in the next few years. According to Kellogg’s, the three companies will be able to better focus on strategic priorities, enabling efficient allocation of capital and resources.

Disclaimer - The views expressed in this article are of the author and do not represent the firm’s views.