Kraft Foods Group (KRFT) reported a mixed set of numbers for the third quarter, as revenues slipped lower while the company was able to sustain higher profitability. Revenues declined primarily due to lower pricing and tough year-on-year comparisons. On the other hand, gains from a couple of changes in actuarial assumptions of post retirement benefit plan helped the company post ~15% growth in operating income. 
However, excluding the impact of market-based adjustments to post employment benefit plan, the company’s operating margins came under pressure from lower selling prices and higher commodity costs. Going forward, we expect Kraft’s revenue growth to remain subdued on growing price-based competition in some categories.
Kraft Foods Group manufactures and markets packaged food products, including beverages, cheeses, convenient meals and various grocery products. The company primarily deals in the North American markets, with the majority of its sales coming from the U.S. and Canada. It generates annual revenues topping $18 billion and has guided for earnings per share (EPS) target of $3.58 for 2013.
We have updated our price estimate for Kraft to $56 based on the third quarter earnings announcement.
Grocery Sales Continue To Remain Under Pressure
Kraft reported lower sales across all segments due to tough y-o-y comparisons, as the company shipped higher volume on account of “safety stock” during the previous year quarter, ahead of its spin-off from Mondelez International. The company-wide decline in sales volume due to uneven comparisons was ~3%. However, Kraft’s grocery products sales volume declined at almost double the rate due to heightened competition in the desserts and salad dressings categories.
The Grocery division in our model for Kraft represents our valuation estimate of the company’s operations in Meals & Desserts and Enhancers & Snack Nuts categories. Continued strong performance of Velveeta dinners and Kraft Mac & Cheese within the meals and desserts category was more than offset by Jell-O desserts sales, which continued to remain weak despite the recent launch of a new marketing campaign. However, the company officials remain confident of reviving the iconic brand on the back of increased marketing over the next few quarters. 
In the enhancer and snack nuts category, Kraft’s sales declined by more than 10% y-o-y, primarily due to stiff price-based competition in salad dressings from private label brands on one hand and growing demand for labels that offer fresh, organic salad dressings on the other hand. Moreover, pricing measures with insistence on profitable growth and lack of marketing efforts has squeezed the demand for budget brands offered by Kraft. We therefore expect the company’s market share in the category to continue to decline over the next few quarters.
Pricing, Cost Pressures Offsetting Productivity Measures
Margin expansion has been the key to Kraft’s earnings growth over the last few quarters despite revenue pressures. According to our estimates, the company’s adjusted EBITDA margins have expanded by almost 250 basis points since 2010. Most of these profitability gains have come from productivity enhancements in the supply chain and manufacturing processes based on Lean Six Sigma principles. Continued focus on delivering net productivity of over 2.5% of cost of goods sold (COGS) in the long term and reducing overhead costs has allowed the company to deliver healthy profits, despite significant pricing pressures in some categories.
However, commodity costs are expected to put margins under pressure going forward as higher feed grain costs due to severe drought conditions last year, have led to inflation in meat and dairy products this year. During the third quarter, average producer price indices of dairy and meat products were higher by almost 5% and 3% respectively. Moreover, increased marketing expenditure by the company to boost its grocery sales amid rising price-based competition will also impact margins negatively.
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