Kraft Earnings: The Hurt Is Organic

DRAT! I wanted to pen a positive article for SA as I am by nature optimistic. I hoped that Kraft’s (KFT) Q4 results might let me expound the positive, wherein I’d discuss KFT’s stability: its brands’ shares, its cash flows and dividends. Kraft’s released Q4 helps me not much, so I will try to show you KFT’s bads, goods and uglies overall using this release.

The BAD: the Slaughter of the Shares

I have keen insight on Kraft, as I worked there 5 terrific years, 1991 to 1996: starting in Operations finance, to the US Cheese Division, up to North American HQ finance, and finally at Worldwide Food Strategy with our masters then, Philip Morris (MO).

While at NA HQ, I introduced the metrics of “organic revenue” and “organic income”; or maybe I lifted these from Nestle (NSRGY.PK), since I was doing competitor analysis. In any case, I still believe that “organic” metrics are the best way to analyze all behemoth packaged goods firms (and should be used by other non-cyclic industries as well).

Adjusting GAAP results back to “organic” drivers eliminates impacts of acquisitions, divestitures and forex. At Kraft, your giant divisions of billion-dollar brands are the story. Their cash flows support acquisitions, new products, big promotions, capex, and keep the lights on.

Below is Kraft’s “organic” revenue analysis for Q4 2008 (14 years later, they’re still doing it!). On the gold lines in this chart, North America and International show GAAP revenue increases of +0.4% and +14.6%, respectively. The “organics” show +2.4% for North America and +7.4% for International. So far, not bad…

Until you see the drivers of this organic “growth”. The column in blue, “Volumes”, was disastrous; North America and International shipped -5.4% and -4.4% less, respectively. “Mix” – the pink column, showing the mix of high-revenue products shipped versus lower-rev ones – was -1.4 pp unfavorable in North America, but favorable in International +1.3 pp.

“Price” is the green column, and this one is shocking. In North America, Price increases to customers drove revenue up +9.4 pp. Abroad, Price increases drove revenue +10.5 pp.

Some pricing was overdue, as KFT caught up its list prices to input costs for Milk/Dairy, Wheat, Meats and Soyoil (hence the pricing in Cheese, Meals, Snacks and Grocery); Dairy and Meats in particular react with a lag to higher energy costs as we had in mid-2008.

The issue pricing up certain categories is that private label substitutes are available; thus +14.3 pp Pricing in Cheese led to a -11.0 pp Volume decline in Cheese. So, too, did a +11.2 pp Price move in Snacks (Nabisco mostly) lead to a -8.2 pp Volume decline in Snacks. The most direct correlation was Grocery, where +7.9 pp Pricing resulted in -7.9 pp Volumes.

Now, from all of Kraft’s industry peers, we have heard that “stay-at-home” food consumption was strong in Q4, as the consumer avoided dining out.

What we see from Kraft’s results is that its Q4 pricing moves killed volumes… despite stay-at-home’s rising tide. This means that North American market shares were slaughtered across Kraft’s US portfolio.

This is the killer. Both at Cheese and at Strategy, we feared market share dips. We kept tight to our breast the lesson of General Motors (GM); Kraft then had 47% of US cheese, much like GM’s once dominant share in autos. A 44% share month in Cheese triggered red-flag alerts.

Why? A food brand’s worth comes from its (long-term) margins, and share. Margin will fluctuate – you can make up short-term margin losses by cutting Advertising & Promotion, Overhead, or just waiting for the input cost tide to turn.

Share is the big banana, the font of all goodness. Everything at which Kraft excels – marketing, operations, sales – is scaled for massive volumes. Massive volumes call for giant shares… 40%, 50% and up. “Philly” owned 80% of US cream cheese in my day.

The biggest risk to Kraft is Share decline. Share is horrible to lose. It is costly and tough to regain. The big trick to running Kraft always has been to pass higher costs onto the consumer, without inciting wholesale revolt. This must be done gently.

Kraft was not gentle in Q4. Consumers felt brutalized, and it shows. Investors reacted appropriately by sending KFT stock down - 9.15% on Wednesday.

The GOOD: Management, Costs, Cash and Brand

Kraft is now in the position of needing to regain Share. This is awful, as there are few “Promo Events” in Q1 and Q2, only Easter and Fourth of July stocking. Back-to-School, Thanksgiving and Christmas are the key sales/marketing pushes for Kraft, mindshare events that set up the whole next year… and Q3-Q4 is a long wait.

Management did a poor job of Q4 2008, but I wouldn’t bet against Irene Rosenfeld in the long-term. It’s also tough to bet on her, now. Still, in KFT’s conference with analysts found here, Rosenfeld did point to dairy costs declining “precipitously”. While hurting KFT’s top-line, this is great news for Cheese volumes, and may let Cheese regain share without too much operating margin impact.

Other input costs, both foodstuffs and energy, should drop as well. Passing on these savings may have the (brutalized) consumer return to Kraft brands… but if unemployment hits 10%, this may be a harder proposition than management thinks.

Another plus: Cash remains king at Kraft, as heritage from its Altria ownership. Management has done great in wringing productivity and divesting low-ROI brands. These impacts are not so visible in the P&L, but they gradually show up in Cash Flow. While KFT does not have a Cisco (CSCO)-like cash hoard (another heritage from Altria), the balance sheet is solid, and its dividend secure.

Finally, Kraft has Brand. Kraft has many valuable mega-brands, many of which could be lopped off and sold to domestic and foreign competitors with ease. So KFT stock is an attractive place for Warren Buffett and others to park and wait. Even in bad times, the mega-brand portfolio is a massive bulwark under the stock, so KFT can’t go much lower than $20.

The UGLY: International and Hedging

In my days, International was a regular disaster, with persistent volume and share losses due to the smart private label programs of European grocers, and Kraft’s premium pricing in the EU. Under Jim Kilts, International had a moment in the sun, but momentum faded.

Particularly in the EU, Kraft’s shares are 30% or less. So Kraft’s promotion efforts are treated poorly in the EU; unlike Nestle, with its “giant shares” there; and unlike Kraft North America, with its own “giant shares”. International is forever a challenge: the only prescriptive I can propose is to increase the visibility and accountability of International and its management, so as to throw light on the illnesses and cure them.

Kraft’s hedging ops is quite personal with me. In 1994-95, as a curious sort, I crafted my own initiative at HQ Strategy on Kraft hedging. My 50-year analysis showed that North America was, on average every year, + $50 million better off simply not hedging. The data were fairly “flat”; there were only four of 50 years where Kraft benefited from hedging.

I maintain that Kraft should never hedge. First, it has no asymmetric data advantage over the traders it bets against. Second, it’s not a core competency; nobody ever gets named CEO from the trading desk.

Finally – this was the coolest thing – in procuring disparate commodities at disparate times over the year, in over 90% of the years, Kraft’s commodity purchases acted as a portfolio with a “natural hedge”. So not only had we lost $50 million per year hedging, we expended all this effort against the God-given natural hedge that existed.

Dr. Rosenfeld, I am happy to discuss at your convenience. My pricing has gone up (and rather more than Q4 Cheese’s).

DISCLOSURE: No positions on Kraft or Nestle.

Comments

[jerobeam]

Thank you for this interesting article. I enjoyed reading it.

2009 Feb 05 11:41 AM

[stink726]

Good read; thanks for writing it.

2009 Feb 05 01:47 PM

[Caren]

Another great article Patrick. I agree with your keen insight.

2009 Feb 05 10:27 PM

[woodsey]

I now feel better about KFT.

2009 Feb 05 11:42 PM

[notsosmart]

they should go back & make some good cheese.

2009 Feb 06 02:29 PM

[Sugar Charlie]

What a GREAT piece, offering both caution and reassurance. My portfolio is always and in all markets heavily overweight consumer staples, and I hold Kraft, so this piece is welcome. First time I've seen this excellent website. The ads don't seem numerous enough to finance it. Does Seeking Alpha sell premium services? Thanks and best, Sugar Charlie..

2009 Feb 06 03:48 PM

[svosavvy]

Thanks author for the article, very informative

In your opinion, How do you feel a potential drop in soft commodities would affect kft? In other words cheap corn, soy , milk, etc... If the softs were to bottom out say this growing season. Would this help like in the instance of low oil helps the crack spread of refiners. Would low input costs and possibly a slowing to lower prices on kft's part help margins and revs? Crazy question ,but, I wonder if deflation and the potential for overproduction of soft commodities won't linger a bit in light of massive (inflationary) spending. Thanks

2009 Feb 07 09:50 PM

[Patrick Garot]

thanks for your comments. it's a balanced piece b/c Kraft is a balanced company. in times of strong economic growth, KFT marketers tend to rule. if economic difficulties persist, it is logical and desirable that the Sales function gain prominence.

svosavvy, great question. lower input costs are generally great for KFT. the big brands are managed for Share, Gross Margin % and $, Contribution Margin $ (gross margin less marketing/sales), and cash flows. (Sales dollars are an after-thought versus these; sales dollars often go down if input costs go down, unless volumes led by share recapture were so strong they countered a, say, 20% drop in costs and a 10% reduction in sales list prices.)

so holding percentage margins the same, and lowering input costs, means that Kraft can reduce prices. on-shelf, the consumer notices less "price gap" between private label and Kraft products (say, price gap down from 75 cents to 45 cents).

further, the consumer may feel richer in his other grocery purchases in a world of lowering costs, so "trading back up" to a Kraft/Nabisco brand for cookies, mayo or cheese is one of the first luxuries he pursues.

there can be negatives in lowering sales prices due to lower input costs (share moves back up gradually; in the meantime, lower $ in Gross Margin means less marketing A&P $ to spend if you're going to hold "Contribution Margin $").

but since Share is the big banana, and the greatest risk today, if input costs lower, it's time to reignite Field Sales, make smarter but lesser investment in advertising, and regain Share over the next 2 quarters. blame so-so profit results on "aggressive share recapture" and position the brands for Q3-Q4 events.

weird stock at a weird time, $25-27 range is fair value. in a bull run, $30 attainable. in a bear, $22 floor (unless a bad first-half that management doesn't guide appropriately; problem: it didn't guide well for this past Q4).

On Feb 07 09:50 PM svosavvy wrote:

> Thanks author for the article, very informative
>
> In your opinion, How do you feel a potential drop in soft commodities
> would affect kft? In other words cheap corn, soy , milk, etc...
> If the softs were to bottom out say this growing season. Would this
> help like in the instance of low oil helps the crack spread of refiners.
> Would low input costs and possibly a slowing to lower prices on kft's
> part help margins and revs? Crazy question ,but, I wonder if deflation
> and the potential for overproduction of soft commodities won't linger
> a bit in light of massive (inflationary) spending. Thanks

2009 Feb 09 12:45 PM

[svosavvy]

Wow, thanks so much for your input

I am basically a crazy loon, all my friends want to buy gold for inflation. I on the other hand believe we will still be battling deflation for a little while. We are still battling deflation even after tarp 1, I think it will still be a strong factor after tarp 2. It is my crazy belief, maybe from growing up in an ag background, it is my concern that we will have some overzealous farmers this time around who look to the bloated prices of the past year to dictate their future targets. The best way I can sum up my feelings is by comparing to opec, basically I think opec isn't the only one with a discipline problem when it comes to production targets. I think a flood of supply spurred on by cheap energy will contribute to oversupply deflation vis lower feedstocks. If this can get kft back to earning increased share to rule the food world I see this as a long positive. Anyway it's just my crazy idea, sometimes I have to watch myself as I can get overly counter intuitive and shoot myself in the foot. Anyway kft in the low 20's was definitely already on my watch list, but, I like to hear others call floors too. Again thanks

2009 Feb 09 01:56 PM

[foglights]

Patrick,

I read your commentary with interest because I, too was a Kraft employee, having held senior management and strategy positions, albeit north of the border. If indeed, you were the architect of organic growth, I commend you. It was and is a key metric. You rightly observe that the growth numbers in Q4 were tough to say the least. Part of the issue in my view is that Kraft has not been successful in identifying and participating in categories and trends with staying power. Witness Nestle, who has the benefit and strength of having driven strategic investments in vibrant, consumer aligned categories. It's pretty hard to pull out consistently strong organic growth from mature to declining businesses...no matter how brilliant the merchandising in drive time periods. I wish I could be more bullish about the prognosis for the company and brands. I don't believe they'll be able to continue to line-extend and achieve superior sustained growth. There needs to be more fundamental change and this is certainly a tough environment in which to attempt such a feat.

2009 Feb 09 07:44 PM

[Patrick Garot]

foglights - sounds like we know some of the same people, and if you were senior vp anywhere worldwide, 1994-95, you may recall some of my "Peer Analysis" reports on GIS, K, NESZN, CAG, etc. from those days.
Nestle has always been a favorite of mine on how they redeploy capital into growth. They "seem to overpay" for acquisitions, but 3 years post-acq, you see payoff in their results. That said, I haven't gone into their balance sheet for years; should I for a future SA article, I will let you know what I find.
Agree with you on KFT's mature-to-declining categories. It's hard to move the needle without dramatic redeployments like Nestle, and KFT's balance sheet doesn't allow much of that.
But KFT still can grow its existing categories. So target +5% annual gains in category consumption, for instance, and maintain or grow Share. Act like the leader, and bruise a few knuckles telling consumers that cheese is better for you than a bag of Doritos.


On Feb 09 07:44 PM foglights wrote:

> Patrick,
>
> I read your commentary with interest because I, too was a Kraft employee,
> having held senior management and strategy positions, albeit north
> of the border. If indeed, you were the architect of organic growth,
> I commend you. It was and is a key metric. You rightly observe
> that the growth numbers in Q4 were tough to say the least. Part
> of the issue in my view is that Kraft has not been successful in
> identifying and participating in categories and trends with staying
> power. Witness Nestle, who has the benefit and strength of having
> driven strategic investments in vibrant, consumer aligned categories.
> It's pretty hard to pull out consistently strong organic growth from
> mature to declining businesses...no matter how brilliant the merchandising
> in drive time periods. I wish I could be more bullish about the
> prognosis for the company and brands. I don't believe they'll be
> able to continue to line-extend and achieve superior sustained growth.
> There needs to be more fundamental change and this is certainly a
> tough environment in which to attempt such a feat.

2009 Feb 10 12:49 PM