After identifying it as an interesting investment in yesterday’s post about Pepsi, I decided to crack open Kellogg Company’s annual report and see what was going on. What I found was a company that’s suffering from stagnant revenues, lower margins, and for some reason it had a ridiculously profitable 4th quarter in 2013. Check this out.

kellogg-profit-margins

Once you factor in that gigantically profitable quarter, the investment doesn’t look so sexy anymore. It’s also odd that the company’s 4th quarter was weak, unlike every other food company in North America. It’s also struggling with a shrinking of the cereal market in general, which is still a big part of its business even though it has diversified into different stuff like Nutrigrain bars, Rice Krispie snacks, and Pringles, which it acquired in 2012. And Eggos. Still plenty of terrible toaster waffles.

Undeterred, I kept reading. After all, many of Kellogg’s competitors are suffering from a lot of the same problems, yet they trade at a pretty significant premium in the price-to-earnings department. General Mills trades at 18 times earnings even after falling 10% over the last month, and it grew revenue all of 1% in 2013. Kellogg, meanwhile, has a P/E ratio of 11.75 times. I can endure a lot of uncertainty for an earnings multiple that’s almost 50% less than its nearest competitor. Maybe Pepsi could even throw it a bone and let it buy Quaker. (Note: there is a 0.0% chance of this happening)

Kellogg is doing a few other things right, including embarking on a pretty sizable cost cutting plan, and the other usual things, like paying out a rising dividend and buying back shares. We don’t care about a rising dividend, of course, but if it’s a side benefit to buying a business with significant upside, I’m there.

And then I discovered something that stopped me dead in my tracks. I finished the annual report, but don’t see myself investing in the name unless it gets so cheap I’m practically forced to. That won’t happen, unless consumer stocks somehow start to underperform, and dividend growth investors stop buying them.

This is what I read.

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…Okay. What’s the deal? Aren’t share buybacks supposed to be good?

Normally, they are. One of the reasons why I invested in Danier Leather is because the company is so aggressive in buying back shares. The company doesn’t really have a good use for its mountain of cash, so it’s using it to buy back shares that are trading at 63 cents on the dollar (although, admittedly, the company hasn’t brought back any lately).

In theory, even buying back shares of a company that trades at many times book value like Kellogg is supposed to be good. Less shares outstanding will boost earnings for existing shareholders because it increases their share in the company, all without triggering a taxable event.

And yet, when I checked the numbers, I found that the share count during 2013 decreased from 362 million shares outstanding to 358 million. What happened to the other 5 million shares?

The answer is simple. They were issued as bonuses.

The company’s top 6 execs were awarded stock bonuses worth more than $6 million. The CEO, John Bryant, took home the most, getting himself a cool $2.5 mil. The company’s chief growth officer got more than $1 million worth of bonus stock, even though he has a salary of $698k and DIDN’T ACTUALLY GROW THE G.D. COMPANY.

But wait. There’s more. The company’s top 6 managers also got stock options valued at more than $4.1 million. These can’t be exercised for a decade, but still, they exist, and they’re massive.

I dug a little deeper. Let’s talk a little about the company’s growth officer, Paul Norman. The company sent him abroad, presumably to manage the international business. Guess how much they paid him to move. $1.45 million. That’s on top of his stock options, his stock bonuses, and his $700,000 salary. All in all, Stormin’ Paul made $4.4 million to, I dunno, live in China. It’s a pretty good gig.

I’m as capitalist as they come, but I’m getting tired of this stuff. I don’t like the compensation, but I mostly don’t like the number of shares issued to management. At $60 per share, 5 million shares is $300 million in additional compensation, on top of salaries that look to be pretty competitive.

Kellogg make a profit of $1.8 billion in 2013 (which was about double 2012’s total). Is $300 million of it too much to give back to staff? I’m not sure I have the answer to that, but I’m sure most investors would rather have dividends or real share buybacks that are 15% higher than current levels. Too often, share buybacks are just a screen to partially cover stuff like this up. Keep this in mind when investing.

Tell everyone, yo!