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Following the third quarter 2011 earnings, we have downgraded our recommendation on Kellogg, Inc. (K - Analyst Report) to Sell from Hold.

Kellogg posted weak third-quarter 2011 earnings of 80 cents per share, which lagged the Zacks Consensus Estimate by 10.1% and the prior-year earnings by 11%, on the back of economic slowdown, increased cost of goods sold, increased supply-chain costs and reinstatement of incentive compensation costs.

The cost of commodities, energy and fuel soared and peaked in the year, exceeding the expectations. Gross margins and operating margins also plummeted by 270 and 310 basis points, respectively, in the third quarter of 2011 due to mounting costs. Besides, the investments in the supply chain infrastructure across the U.S. added to the gross margin pressure, resulting in increased logistic costs, and reduced operating leverage.

Kellogg also expects gross margin to remain under pressure in fiscal 2011 and be down approximately 100 basis points compared to 2010. Kellogg has also narrowed its internal operating profit guidance to a range of down 2% to 4% for the year 2011 due to the impact of third quarter results and expected continued investments in supply chain during the remainder of the year.

Though the company has shown signs of improvement in the third quarter, particularly in the top-line growth, the results do not inspire in a challenging environment. Thus, the company has reaffirmed its 2011 internal sales guidance growth in the range of 4% to 5%. Earnings are also expected to remain flat for 2012.

In addition, Kellogg has a highly leveraged balance sheet, and is focused on continued reinvestment in the brands, as well as optimizing its business model and global organization. All these activities require huge cash investment. Though Kellogg has a strong cash-generating capability, but it is utilized to repurchase shares or pay dividends.

Additionally, Kellogg needs to finance the interest obligations on its long-term debts, which have increased at a 4-year CAGR (2006-2010) of 13%; whereas Kellogg had a total debt of approximately $5.3 billion and total equity of $2.3 billion, at the end of October 1, 2011.

Though the company has provided greater visibility in achieving its long-term profit growth targets with its continued spending on cost-reduction initiatives, we believe that intense competition from other established players and high debt load undermine the company’s future growth prospects.

Agreement of Analysts

For the current fiscal 2011, 16 out of 17 analysts covering the stock lowered their estimates over the past 30 days, while 15 out of the 19 analysts reduced their estimates for fiscal 2012. Thus, there are no positive catalysts to drive the stock.

Magnitude of Estimates Revisions

For fiscal 2011, the estimates plummeted from $3.48 to $3.38 over the past 30 days, while the analysts lowered their estimates from $3.78 to $3.57 in fiscal 2012.

Kellogg, which competes with General Mills, Inc. (GIS - Analyst Report) and Ralcorp Holdings Inc. , holds a Zacks #4 Rank, translating into a short-term Sell rating.

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