A Return to Basics at Kellogg

During much of the 1990s, Kellogg Co., the Battle Creek, Michigan-based food manufacturer, was an iconic U.S. business whose best days seemed to be behind it. With net sales then of more than $6 billion, it had increasingly lost the confidence, and even the interest, of Wall Street. Plagued by the realities of a mature market, rising costs and intense competition, the company’s brands were languishing and its profit margins were weak. New product launches proved largely to be forgettable failures. Kellogg developed a reputation for failing to live up to its own rosy projections. The stock suffered as did employee morale.

Those conditions might have stagnated or worsened for some time were it not for two important events that took place in 1999: the appointment as CEO of Carlos Gutierrez, a longtime company insider, and Kellogg’s first ever loss of market leadership to the industry’s perennial No. 2, General Mills Inc., later that year.

Under Gutierrez’s leadership, Kellogg embarked upon a process of corporate reinvention driven by a comprehensive focus on profitability. Like many companies sobered by recession, Kellogg had pursued profitability goals many times in the past but seemed to lack the management model and discipline to achieve them in a meaningful and sustained way. With impressive results during each of the past few years, however, Kellogg’s recent strategic turnaround seems to have had traction and has been at the core of the food giant’s recent revival.

To fully understand the magnitude of the Kellogg revival, it’s important to step back to the late 1990s and evaluate just how bad conditions had gotten for this century-old company. Financial journalists were bandying about such adjectives as “lethargic” and “insular” to describe the company, while making irresistible puns about “soggy profits.” Many Wall Street analysts had stopped tracking the company entirely.

One might conclude that the problem was that the company had a stodgy image during an era in which investors were captivated by dot-coms and other high fliers. But Kellogg’s difficulties were multiple and were well-entrenched within a corporation that largely had earned its lack of respect on the Street. Management had failed to deliver on a wide range of promises, especially its growth-oriented financial projections. With sales basically flat, gross profit margins slipped from 53.2% in 1996 to 52.1% in 1997 and 51.5% in 1998. Earnings per share (EPS) dropped from $1.53 to $1.35 during the same period.

Granted, the competitive environment at the time was difficult, especially with the emergence of premium-product private labels and the frequency of price wars. Retailer consolidation squeezed the industry’s overall sales potential, as did the slowdown in U.S. population growth.

But Kellogg undoubtedly made its own problems worse. Its advertising campaigns were weak, and the company’s product line seemed particularly vulnerable to generic competition. Meanwhile, innovation was stalled: With its top-selling product, Frosted Flakes, nearly 50 years old, the company went for long stretches without attempting to launch a major new product. Then when it did — with products like Heartwise and Fiberwise cereals and a cholesterol-fighting group of foods called Ensemble — results were spotty at best.

With a corporate crisis this serious, the board of directors might well have turned to an outsider, hoping to gain a fresh perspective on deep-seated strategic problems and the malaise afflicting the company. But their selection of Carlos Gutierrez, who had worked his way up the corporate ladder since joining Kellogg de Mexico as a sales representative in 1975, proved a wise decision.

“Being from the inside gives you the advantage of being able to observe what works and what doesn’t work,” Gutierrez recalled during a recent discussion. He had honed his perspective during years in charge of various international operations as well as the company’s cereal division. “I wasn’t the only one who had a sense that the company was off course. Throughout middle management, there were people who recognized that the company needed to make big changes.”

Years before stepping into the CEO’s post, Gutierrez had become convinced that the company’s problems were tied to a misguided set of financial priorities. “From 1991 through 1994, I ran the U.S. cereal business and it was very obvious — we were repeating the same thing over and over. We were chasing volume.” Indeed, Kellogg had a historical commitment to volume as the primary indicator of corporate success — as did most food companies and the Wall Street analysts who followed them.

John Renwick, a former food analyst from Morgan Stanley who now serves as Kellogg’s vice president of investor relations and corporate planning, explained that “during the 1980s, when inflation was high, food companies could raise prices a few times a year. So it made sense to strip out price and look at underlying volume.” Within the corporation, Renwick added, “people would say, ‘Volume is the best measure of our demand.’”

With a corporate culture directly tied to being the top volume mover in the cereal business, a number of short-sighted practices had flourished for years at Kellogg. The sales force focused on pushing the heaviest brands, regardless of their relative profitability or their susceptibility to generic competition. Meanwhile, the company became increasingly hooked on price discounts to prop up its market share, while attempting to offset this expense with cuts to the company’s advertising and innovation budgets. Brands suffered. It was a downward spiral. During the course of a year, the company’s stock fell by about 50%. Some company insiders tried to bury their heads in the sand. “It was very difficult to get people to acknowledge that tonnage wasn’t the most important measure,” recalls Renwick.

Says John Bryant, a former consultant who joined Kellogg during the late 1990s and now serves as its chief financial officer, “We were afraid we couldn’t give up on volume share because if we did we would start losing volume. But volume is a byproduct of good brand building. It shouldn’t be the overall focus,” he emphasized. “Sustainable growth and high-quality growth are more important objectives.”

The crisis came to a head soon after Gutierrez took office, when General Mills ousted Kellogg from industry leadership, in terms of dollar sales, for the U.S. cereal market. The new CEO took the opportunity to launch a number of strategic shifts, all aimed at transitioning the company into an organization that could set and achieve meaningful, sustainable, profit-oriented goals.

Anatomy of a Turnaround

To jump-start the process, Gutierrez made the largest acquisition in Kellogg’s history: the 2001 purchase of Keebler Foods Co., a successful cookie and snack-food manufacturer. This purchase helped push corporate revenues from about $6 billion in 2000 to $8.3 billion in 2002. More important, it broadened the company’s universe beyond the highly competitive, flat-growth world of breakfast cereals and provided new avenues through which to expand proven brands while boosting margins and earnings.

Around the same time, the company announced its commitment to a new business model, premised upon two related financial strategies. The first, known as “Volume to Value,” was described in Kellogg’s 2001 annual report as a “shift from a focus exclusively on volume to a focus on value growth,” measured in net sales. The new discipline demanded that volume, pricing, innovation, product mix and other business activities all be managed so as to achieve profitable revenue growth. The second strategy, termed “Managing for Cash,” aimed to strengthen the company’s cash flow, which had always been good but could be better still, Gutierrez believed.

Renwick emphasizes that both strategies are “virtuous cycles,” not linear transitions to a single end result. “Volume to Value” signaled a strategic shift toward “focusing on the underlying profitability of every sale we make,” Renwick explained. Adding value for consumers, rather than simply pushing volume through discounting and other tactics, would reduce the company’s vulnerability to generic competition. As less valuable products would be de-emphasized in the sales mix, volume might decrease, but that was a trade-off the management team believed was worth making to increase profitability.

The essence of “Managing for Cash” is to apply a continuous, disciplined approach to capital spending. The goal: Free up cash that could be used for everything from paying down the $4.7 billion worth of debt tied to the Keebler acquisition to buying back stock and various other investments that would further the company’s long-term profitable-growth objectives.

In addition, Kellogg’s new management team was committed to restoring realism to its financial forecasts. “Our new approach was based on an understanding of the business we’re in,” explains Bryant. “We’re a food company. If you look at the past three or four decades and see how the food business has evolved, while also looking at the effect inflation has had on results, it’s very clear that high single-digit earnings per share is what’s achievable.”

However, when Kellogg announced that it would pursue more realistic goals — low single-digit sales growth, mid single-digit operating profit growth and high single-digit EPS growth — Wall Street was less than impressed. The stock went down. “It was heresy,” Renwick commented, for a food company to aim for less than double-digit EPS growth, whether or not it could achieve it.

Looking back on that decision, however, he remains convinced that “changing this goal had a huge impact for us. Business units were now able to pursue realistic goals. We didn’t have to do self-defeating things in order to achieve exaggerated goals that could only be achieved a single time,” he noted, adding, “The mentality that’s needed to have ‘stretch targets,’ to stretch organizations in ways that are questionable, can be so destructive.”

As the vice president of investor relations, Renwick spent a good bit of his time trying to convince analysts and investors that Kellogg was worthy of consideration on its new terms. “As an ex-Wall Streeter, I knew we had to give them something, and that was going to be dependability. Food companies do not [achieve explosive growth] during a given year. Instead, they can achieve steady growth. I believe investors should buy food stocks as a dependable part of their portfolio — a source of steady growth and income.”

Four years later, many food companies have followed Kellogg’s lead, with Wall Street’s strong encouragement. But at the time, the new CEO’s effort to convince the outside world depended upon one thing and one thing only: results.

Realignment and Innovation

Traditionally, the company had not been structurally aligned in ways that could help employees understand and track both their own and their team’s impact on profitability. So, structural change became a high priority. In place of separate divisions organized around such disciplines as brand, supply chain and innovation, Kellogg now set in place fully integrated business units in which a brand’s sales staff, innovation team, marketers, managers and other relevant personnel were all focused on achieving the same realistic targets for net sales, cash flow and operating profits.

Meanwhile, the company redesigned its compensation strategy so that performance incentives would be primarily tied to an employee’s business unit, rather than to overall corporate results (as had previously been the case). With realistic targets in place, Gutierrez sought to create a culture in which meeting goals was essential. “Compensation became consequential,” Renwick explained. “It used to be, if you had a good year, you got 120% of your salary. In a bad year, you got 80%. Now it can be anywhere from zero to 200%.”

Winning the hearts and minds of employees took time. A new training program for salespeople spanned the course of a year, with input from executives and experts throughout the corporation. “Our sales force originally had been focused on volume. Now we effectively gave them all P&Ls,” explained CFO Bryant. “That helped them think about the cost of goods, the profitability of different products. Effectively, we enabled them to operate like small businesses.”

Meanwhile, the company’s traditional new-product launch documents were discarded; new ones would rigorously evaluate projected gross margins on per pound, per sale, per unit and other bases. Innovation teams were encouraged to piggyback value-added twists onto well-established brands, all in an effort to boost margins.

One early success was Special K Red Berries, a higher-priced product, which offered freeze-dried fruit mixed in with the cereal flakes. The “Volume to Value” payoff was clear: One box of red-berry cereal weighed only 12 ounces, less than half the weight of a box of Raisin Bran. But it provided a greater boost to net sales as well as higher per unit margins. Thanks to the Keebler acquisition, Kellogg’s innovation teams were able to explore profitable snack and cereal extensions of the company’s most valuable brands. In fact, Kellogg’s enhanced ability to innovate proved to be one of the greatest outcomes of the turnaround strategy. Special K Red Berries cereal helped beget Special K bars. Other profitable brand extensions include Pop-Tarts Yogurt Blasts, Kashi crackers and Eggo French Toaster Sticks.

“Investing in their brands and not being afraid to launch new products has really helped them,” according to Erin Ashley Smith, a securities analyst with Argus Research Corp., based in New York.

A Step-by-Step Strategic Rollout

The turnaround progressed along a focused, but graduated, course. In 2001, the company established as its first priority winning in the United States, specifically in the U.S. cereal market, because that was its original — as well as its biggest — business.“We said we would turn to international [markets] after we proved our models of ‘Volume to Value’ and ‘Managing for Cash,’” says Gutierrez. “We also wanted to be very cautious about how we would spend money and avoid the risk of spreading ourselves too thin.”

During 2002, the company focused on boosting its wholesome snacks business. Only then did Kellogg turn to its core international markets, which were, in order of size, the United Kingdom and Ireland, Mexico, Canada and Australia. One result of this focus on international markets was an 18% increase in net sales in Europe during 2003, or about 3% when adjusted for foreign currency translation. International markets should remain a high priority for the company moving forward.

There are plenty of challenges ahead. Cookie sales have been weak, not just for Keebler’s units but for the snack industry as a whole. And the popularity of low-carbohydrate diets certainly poses a continuing threat to any cereal manufacturer. But fortunately, some things haven’t changed at Kellogg. With its historical roots planted firmly in the health-food business, Kellogg’s revived advertising strategies have played up the nutritional and weight-control benefits of its products, whenever appropriate. An advertising promotion around the Special K diet, which recommends two cereal-based meals per day, has already proven a great success. Most recently, the innovation team launched a new, low-carbohydrate version of the company’s Special K powerhouse.

In all, new products launched within the last three years generated 15% of $8.8 billion in sales during 2003, according to Leonard Teitelbaum, global coordinator for food and agribusiness research at Merrill Lynch & Co. Kellogg’s new strategic focus has delivered results in a number of other important respects as well. With net sales up by 16.7% between 2001 and 2003, operating profits rose by 32%, from $1.17 billion to $1.54 billion. During the same period, earnings per share rose by over 65% on a diluted basis. Here’s sweet revenge for a company once described as lethargic: Its total shareholder return has outperformed its peer group, the S&P Packaged Food Index, during each of the past three years, most recently with a 15% return (compared with 5% for the industry). “Successful execution has differentiated Kellogg from its peers,” says Teitelbaum, “and allowed it to deliver on its promises”

“There were plenty of skeptics early on, [but] the results speak for themselves,” says Christine McCracken, vice president and analyst at FTN Midwest Research Corp. in Los Angeles. “When it comes to cost reductions, management of the balance sheet, the development of new products and growing categories profitably, Kellogg has surpassed everyone’s expectations.”