Realty Income(NYSE: O) did it, and so did International Business Machines(NYSE: IBM). So, on the surface, Kellogg(NYSE: K) isn't unique in my portfolio. But the difference with Kellogg is that the iconic food maker's good company/bad company spin-off is likely to lead to a major adjustment in both the business and the dividend policy. I'm thinking about selling the stock so I'm not left with a bad business and a reduced income stream.
Kellogg's cash cow
Kellogg is a food maker built upon a strong history in the cereal business. Essentially, cereal provided a reliable cash stream that was used to fund the expansion into other categories, like chips (Pringles) and crackers (Cheez-Its). Given the company's name and history, cereal was also considered somewhat sacred. How could a company built on a cereal foundation sell its cereal business?
Image source: Getty Images.
In fact, the reliable, though not growing, cereal business was one of the reasons why I bought the stock in the first place. It provided reliable cash flows and a strong foundation for the company's efforts in more growth-oriented lines of business, notably in snacks and emerging markets (the company has a material presence in Africa). But the company has decided to do what I believed to be unthinkable. It is spinning off its North American cereal business so it can focus more on growth.
The timing is actually good for this move. During the pandemic's height, the cereal business was upended by an employee strike and by a production plant closure (caused by a fire). So the division's performance was terrible and is now improving. Spinning it off today means that investors are looking at financial results that are heading temporarily higher because of the business' recovery. Longer-term, cereal is slow-growth, at best, given consumers' shift toward other breakfast options.
This is a good company/bad company split
That last fact is why Kellogg's move is so problematic for me. It is, ultimately, trying to separate out the slow-growth cereal business (the "bad business") so it can better highlight the growth in the rest of the company (the "good business"). It's a common move on Wall Street. Note that IBM spun off Kyndryl(NYSE: KD) not too long ago, and Realty Income spun off Orion Office(NYSE: ONL). Both were attempting to get out from under weaker operations. Not surprisingly, Orion and Kyndryl haven't been great performers since they were spun off.
I expect the same thing to happen with Kellogg's cereal spin-off. But there's a major difference. IBM and Realty Income didn't change their dividends after the spin-offs. As a shareholder, I got shares in a new business and my dividend stream remained unchanged. Given that Kellogg's North American cereal business is a large contributor to the top line, it seems likely that there will be a dividend reset to go along with the company's spin-off.
And the split won't be very clean, unlike with IBM and Realty Income. In fact, Kellogg will still sell the same cereal products outside the U.S. market after the split -- not to mention that Rice Krispy Treats is a key snack brand tied to a cereal brand that will be jettisoned in the U.S. market. In many ways, this break-up just doesn't make a lot of business sense.
More troubling, the North American cereal business doesn't have particularly attractive growth prospects (which is, of course, why it is being spun off). After the business bounces back from the strike and fire, slow growth is the best that can be expected. The only way to rev things up over the long term would be to acquire new businesses. That would, effectively, put the company in competition with its former parent, in addition to a host of other major consumer staples companies. But it won't be as large a company, so the spun-off North American cereal operations will be at a strategic disadvantage.
I'm not a happy camper
I bought Kellogg when it was struggling, partly because of the temporary disruption in the North American cereal business. I was fond of the historically strong core (cereal) and the long-term growth opportunity of the rest of the operation (particularly snacks and emerging markets). I was happy to wait for the cereal business to recover.
But with the company now spinning off the North American cereal business, I fear I'll be left holding a bad business that will struggle on its own, leading to a weak stock price. On top of that, I expect the company to adjust its dividend lower since the North American cereal business is a large operation.
So, as a shareholder, I risk getting a dividend cut and a bad business. I'm not convinced that owning the "good business" (which will be known as Kellanova) is worth being stuck with the bad business (which will retain the Kellogg name) and a lower dividend. I'm likely to sell the stock and put the money to work in other dividend stocks I own.
Another option would be to sell Kellogg stock now, wait for the spin-off to be completed, and buy Kellanova, the good company, with the proceeds. But given the odd business connections that will exist after the spin-off, I'm not sure that's worth the trouble, either.
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Reuben Gregg Brewer has positions in International Business Machines, Kellogg, Kyndryl, Orion Office REIT, and Realty Income. The Motley Fool recommends International Business Machines and Realty Income. The Motley Fool has a disclosure policy.
