Soggy Kellogg Is a Bad Bet; Is Starbucks Too Strong?

Stock Exchange gives readers a chance to listen in as staff writers James Peltz and Michael Hiltzik debate the merits of individual stocks and other investments.

Kellogg Co. (K)

Jim: I guess we have a breakfast theme today, Mike, since we’re looking at Kellogg and Starbucks.

Mike: That’s right, a bowl of cold cereal and a cup of joe--it doesn’t get any better than this. Actually, Kellogg probably ranks among the Big Board’s leaders in terms of the catch phrases it’s given to the English language.

Jim: Such as?

Mike: “Snap, crackle and pop.” “They’re grrrreat!” “Two scoops.” Sadly, though, Kellogg itself is down to about a half-scoop these days.

Jim: Yeah, it’s pretty ugly in Battle Creek. Kellogg is still the nation’s largest maker of ready-to-eat cereal, and its big names include Kellogg’s Corn Flakes, Frosted Flakes and Rice Krispies.

Mike: But its share of the market has plummeted to about 32% today from 41% a decade ago.

Jim: And to me, the reason is pretty simple: Kellogg and other brand-name cereal makers went to the well once too often in terms of jacking up prices.

Mike: That’s right. Up to a couple of years ago, it was supermarket sticker shock. The price of a box of cold cereal got as high as $4 and $5 a box, and consumers rebelled.

Jim: Naturally. Shoppers got fed up with such high prices for what’s basically a staple product. They started buying cheaper, generic brands of cereal.

Mike: What’s often called bagged cereal.

Jim: Right--those less costly knockoffs produced by the likes of Quaker Oats Co. and Ralcorp Holdings Inc. Or they stopped buying cereal altogether. Those high prices, combined with the increasingly hurried lifestyles we all have, prompted more and more people to buy fruit bars or granola bars or other take-it-with-you snacks.

Mike: Not to mention the people who stopped buying cereal because they’re sensitive to what’s actually in a bowl of cereal.

Jim: True. And all these factors mean the whole cereal market is shrinking, making Kellogg’s problems even worse.

Mike: There’s a reason the cereal companies became master marketeers. Kellogg was selling either pure sugar or so-called nutritious cereals that tasted like new-and-improved forms of cardboard.

Jim: And they’re at it again. Last week, Kellogg announced its new “Ensemble” line of foods, including cold cereal, that have natural soluble fibers in them that purportedly help to lower your cholesterol. But this is all noise anyway. The central problem is, Kellogg hasn’t figured out how to stop the bleeding. They could wage an all-out price war to boost their market share ...

Mike: ... but then could kiss their profit margins goodbye.

Jim: And watch their stock take a beating. Or Kellogg can try to hold prices, but that means they’ll have to cut costs even further--especially since they have to keep spending a fortune advertising these brands--and I haven’t seen signs they’re going to do that. So where’s the light at the end of the tunnel? That’s why I can’t recommend this stock.

Mike: Me neither. Kellogg in the last couple of years has made lots of promises to investors that it’s going to turn this ship around but hasn’t delivered. So even if Kellogg comes up with a solution, there’s going to be skepticism built into this stock for quite a while.

Jim: That’s evident in the stock’s price. It’s now in the mid-30s, which is down 20% over the past 12 months. But that’s nothing. In the past five years, the Standard & Poor’s 500 has risen 137%. Care to guess Kellogg’s gain?

Mike: I’m sure it’s a soggy reflection of the S&P.;

Jim: It’s 9%. That’s pathetic for a company that has household brand names and leads its industry.

Starbucks Corp. (SBUX)

Jim: Can you explain to me, Mike, what Starbucks puts in its coffee that convinces people to keep coming back to pay $2 or more per cup? Is it nicotine? I read somewhere that the average Starbucks customer visits that place 15 to 17 times a month.

Mike: Is that all? Actually, there are a lot of numbers about this company that strain credulity, although I’m not saying they’re not true.

Jim: Nice double negative. But you’re right.

Mike: As for the stock, I’ve always been troubled by its price-to-earnings multiple, which usually seems to be out of sight. So you might be surprised to hear that I’ve come around.

Jim: You’d recommend it? The caffeine has gone to your head. I’d avoid this stock, mainly because of that very P/E you mention.

Mike: Hear me out. Starbucks is an amazing company that still has a long way to go in fully developing its brand. Already it’s expanded its brand name in new and fascinating ways and, up to now, most of what it’s tried has worked.

Jim: Here are the basics: The company, led by Chief Executive Howard Schultz, went public at a split-adjusted $4.25 a share in ‘92, and the company and the stock have skyrocketed ever since, with the stock having soared tenfold since then. Starbucks now has around 1,930 outlets, including a couple hundred overseas, and they’re still hungry to expand.

Mike: Also unusual is that Starbucks is a chain that owns most of its properties. It’s not a franchiser.

Jim: Noted. Starbucks has proved it’s not a fad but a brand and operation that are successful and here to stay. Who would have guessed this would be a $1-billion-a-year business today? I’ve even seen surveys that show untold numbers of people have tried lattes and cappuccinos for the first time in their lives because of this joint.

Mike: Right, and now Starbucks is opening restaurants, selling its coffees in grocery stores, leveraging its brand even further. So what’s your problem with this stock?

Jim: Simply that it’s too expensive. Look, it’s true that Starbucks has always traded at a high P/E, and fairly so. It was a fast-growth company. But Starbucks isn’t a tiny operation with sky-high prospects anymore. So when I see that its P/E today is 51 times this year’s earnings, I see a very dangerous stock.

Mike: I hear you, and I agree that the day is going to come when Starbucks is going to hit the wall in terms of expansion.

Jim: Yes, and part of my problem with this stock is that we don’t know where the wall is!

Mike: But I believe the wall is a lot farther off than you think. There’s a lot of potential in Starbucks’ international expansion. Ditto its growth in supermarkets, and you also see it being sold at nearly every workplace.

Jim: Including our own.

Mike: Although I see that you still like to drink the rotgut out of our vending machines downstairs--a traditionalist as always. Anyway, you can now buy Starbucks ice cream or tea or fruit juice. Plenty of companies have tried this sort of line extension, and a lot have failed. But this seems to be a case where they’ve learned how to do things right.

Jim: I grant you they’ve achieved all this success with almost no long-term debt on the balance sheet.

Mike: It’s as solid as the Presbyterian Church.

Jim: But I’d even short the church at 51 times earnings. And we’ve seen evidence of why I’m right. Remember back in July, when Starbucks said earnings for its fiscal fourth quarter would be at the low end of expectations?

Mike: I do.

Jim: Then you recall that the stock plunged 14% that day alone. And Starbucks didn’t say it would miss the estimates, but simply hit the low end. That’s what happens when you have a fast-growth company with a stock trading that rich and investors who’ve come to expect 40%-plus growth. One slip, and look out below.

Mike: Yes, but the stock has come back nicely since then and now trades in the mid-40s. That’s still a gain of 40% for the past 12 months. Obviously, a stock with a high multiple like Starbucks is going to be volatile, but unlike Kellogg, these guys have delivered.

Jim: I will give them credit for rather consistent sales growth, which has been running 4% to 5% each month for stores open at least a year.

Mike: And give credit to Starbucks’ management. They’re very good at identifying their shortcomings and fixing them quickly.

Jim: For example?

Mike: They know one problem is that most of their business is done in the morning, as opposed to the afternoon or evening. But their average sale is higher in the afternoon and evening, so they’re trying to persuade customers to visit later in the day.

Jim: How?

Mike: By offering new products that they want at those hours, like flavored teas and coffee drinks.

Jim: I’ll give Schultz & Co. its due. After all, look how Starbucks has survived all the me-too coffeehouses out there. But whether it can have the same success on the grocery shelves or in the restaurant business is a huge unknown.

Mike: On the other hand, it’s been very successful in giving the brand the kind of cachet that gives customers confidence that they’re going to get quality for paying higher prices.

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Do you have a stock you would like to see discussed in this column? Michael Hiltzik can be reached at michael.hiltzik@latimes.com; James Peltz can be reached at james.peltz@latimes.com. Or write to either at Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.

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Kellogg, Monday: $35.00

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Starbucks, Monday: $46.38