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Kraft Foods (KRFT) offers the best in class cash return to its shareholders; with a dividend yield of 3.8% and a payout ratio of almost 75%. The company has lower margins in contrast to its peers, which offers it compelling long term margin expansion opportunities. Also, the company has solid brand recognition and a healthy brands portfolio. Moreover, KRFT is expected to enjoy high single digit earnings and 1-3% top line growth in upcoming years. The abovementioned factors make me bullish on the stock.

Financial Performance 3Q2013

The stock is up almost 16% YTD on the back of a healthy financial performance. KRFT reported an EPS of $0.83 for 3Q'13, up 5.1% YoY. However, adjusted EPS for the quarter was $0.65, missing analyst estimates of $0.69. Adjusted EPS for the third quarter was negatively affected by weak top-line results, higher interest expense and a higher tax rate. The company reported organic revenues of $4.4 billion, down 4.2% YoY. KRFT also experienced an organic revenue decline of 4.1% in 3Q'13, primarily because of lower sales volume and pricing; sales volume for the quarter declined by 3.1% mainly due to increased competition and reduced consumption. Also, due to soft consumer spending, the company was not able to increase prices, as pricing had an adverse impact of 1% on the top line result of KRFT in 3Q'13.

Key Stock Price Drivers

KRFT operates in a mature and highly competitive industry; therefore, it is not a top line growth story and earnings are likely to be driven by margin expansion. The company has a lower gross margin in comparison to its peers and remains a key earnings growth driver for KRFT. I believe KRFT is well positioned to benefit from cost saving initiatives, and will expand margins as it is committed towards its desire of being a low cost producer. The company indicated that cost reduction and productivity efficiency will be achieved through improvement in the supply chain, increased adoption of Lean Six Sigma practices, efficient management of labor costs and maintenance efficiency. KRFT has targeted to extract 4.5% of COGS savings in future to expand margins and fuel earnings growth. It is projected that through net productivity savings of 2.5%, the company can expand its EBIT by 5% if it reinvests 50% of the savings into its business. KRFT currently has a lower gross margin as compared to The Hershey Company (HSY), General Mills (GIS) and Kellogg (K), as shown in the chart below.


(Click to enlarge)

Source: Companies Reports and Calculations

As the company operates in a competitive industry and sales volumes are on the decline, advertisement spending remains key to building brand loyalty. The company has been increasing its advertisement spending to build consumer loyalty and strengthen its market share. KRFT has increased its advertisement spending as a percentage of sales to almost 4% in 2013, up from 2.9% in 2011 and 3.5% in 2012. Also, in the recent earnings release, the company's management indicated that in brand building efforts, it will further drive advertisement spending. As the company increases its advertisement spending, it will be able to build consumer loyalty and strengthen its market share, which will bode well for the company's future financial performance. Despite the recent increase in advertisement spending, the company's advertisement to sales ratio is still below its competitors, as shown in the chart below.


(Click to enlarge)

Source: Company Reports

KRFT owns a solid market share in several of its product categories. Also, the management is doing a good job in strengthening its product portfolio; The Cheese segment experienced an increase of 6% YTD in profits and Planters snack nuts business enjoyed an increase of volume share of 0.80% YTD. Also, despite the intense competition and soft economic conditions, the company has increased or maintained its market share in more than 50% of its product portfolio in 3Q'13, as compared to 34% and 40% in 2011 and 2012, respectively. The company's strong portfolio also bodes well for the future stock price performance.

The company offers the best in class cash return to its shareholders, as it offers a solid and above average dividend yield of 3.8%, with a payout ratio of 75%. I believe the company's healthy dividend yield limits near term stock price downside. The following table shows dividend yield comparisons between KRFT, K, GIS and HSY.

KRFT

K

GIS

HSY

Dividend Yield

3.8%

3%

3%

2%

Source: Yahoo Finance

Final Words

KRFT offers an attractive investment opportunity as it offers a high dividend yield of 3.8% and has the potential to expand its gross margin, which will fuel future earnings growth. The company's strong product portfolio and solid market share bode well for the company's financial performance.

Using the company's last three years average P/E of 17.75x and FY 2014 earnings per share estimate of $3.20, I calculate a price target of $57, which offers an expected price return of 7.5%.

FY 2014 EPS Estimate

Average P/E

Price Target

$3.2

17.75x

$57

Source: Investors Drawn To Kraft Foods Over High Dividend Yield, Potential To Expand Gross Margin