NEW YORK — Equity research firm TD Cowen, a division of TD Securities, has initiated coverage of WK Kellogg Co as “market perform,” noting that while the company’s spin-off from Kellanova gives it the opportunity to regain market share in breakfast cereal there is still concern that years of underinvestment “may have impaired the company’s brands and hampered its ability to engineer a turnaround in a declining category.”

TD Cowen’s “market perform” rating means the newly formed company’s stock is expected to have a total return that falls between the parameters of an “outperform” (i.e., a stock expected to achieve a total positive return of at least 15% over the next 12 months) and an “underperform” (i.e., a stock expected to achieve a total negative return of at least 10% over the next 12 months).

In the report, TD Cowen identified several factors driving its “market perform” rating.

First, the research firm said the US cereal category is in “structural decline.”

“Management themselves acknowledge that US breakfast cereal is a structurally declining category,” TD Cowen said. “Our tracking data indicates a -2.7% CAGR for category volume over the past four years despite structural benefits to food-at-home from the pandemic. The shift in consumer preferences to higher protein, less sugary breakfast foods has played a significant role in these trends. Category growth has decelerated to 1.6% over the past four weeks with volume down 5.6% and will likely worsen in 2024.”

Along with a declining US cereal category, TD Cowen mentioned that WK Kellogg’s market share has been declining for several years. And while WK Kellogg management believes it can get market share back to where it was before a fire and labor strike at its manufacturing facilities in 2021, TD Cowen analysts are not as optimistic.

“We note that the company’s market share had been slipping for several years before the fire/strike occurred and probably would have ended up where it is today (29% compared to 32% in 2019) even if the manufacturing disruption had not occurred,” TD Cowen said. “Management describes its top brands as ‘The Big Six,’ but none of them have the market power of the must-have brands of their competitors (Cheerios and Honey Bunches of Oats). The company’s adult-oriented Special K and Kashi brands in particular have failed to adapt to changing consumer preferences.”

A third reason for caution identified by TD Cowen relates to EBITDA margins. WK Kellogg has set a mid-teens EBITDA margin goal by 2026, a goal that is in line with other competitors in the food category. But according to TD Cowen, the goal represents nearly 600 basis points of expansion from the company’s starting point in 2023.

“This sounds hard to do in a category where volume is sharply declining and competitors probably need to discount their prices more aggressively to stabilize it,” TD Cowen said. “If so, then Kellogg will need to follow and push back its margin targets.”

TD Cowen has established an $11 share price target for WK Kellogg based on EV/EBITDA multiple of 6.5x against its forward 12-month EBITDA estimate. The research firm said the best-case scenario includes “higher-than-expected market share gains in cereal and/or better-than-expected category performance vs. company estimates of down (low single digits)” as well as “faster-than-expected margin recovery and improved velocity from consolidated sales force.” The downside scenario, meanwhile, could feature an “increased promotional environment leading to price rollbacks on key brands” and “higher-than-expected costs from the spin-off resulting in depressed margins.”