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


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


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


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


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)


Inventory Turnover: Cost of goods sold/Inventory


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


48

Days Supply of Inventory: 365/holding period


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


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


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


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


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


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


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


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


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


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


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)


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


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


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’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


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


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


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


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%


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


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).


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.


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.


-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


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

whitney fogle: [email protected] sarah gardner...

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