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Kraft Foods Group (NASDAQ:KRFT) had its rating upgraded by Morgan Stanley on 9th December 2013. The analysts at Morgan Stanley raised the company's stock price objective to $60 on the anticipation of the long term growth story ahead for the company. The stock currently trades at $53.73.

Many investors believe that the stock price was raised because the company will receive $2.76 billion from Starbucks (NASDAQ:SBUX) due to interest and legal fees. The company, when it was a part of Mondelez International INC. (NASDAQ:MDLZ), had an agreement with Starbucks which was violated by Starbucks as it ended the deal three years earlier. Due to a deal between Mondelez and Kraft Foods, all proceeds will be received by Mondelez and Kraft will receive none of the proceeds, so that's not the case.

I believe the price was raised due to the company's effective implementation of the ongoing programs which have helped it to improve its profits, despite negative sales growth.

Fundamental Snapshot

After beating analysts' expectations in its second quarter earnings report, Kraft Foods has disappointed them this time with its top line performance. Its sales are declining as the company is finding its independent way after its spin-off from Mondelez. During the third quarter of 2013, the company's net revenues decreased 4.2% YoY to $4.4 billion while missing analysts' estimates of $4.56 billion. The organic net revenues decreased 4.1%, due to lower net pricing and unfavorable volume/mix driven by customer inventory shifts associated with the spin-off. However, this was partially offset by base business growth.

All of the segments, except the cheese segment, posted lethargic results during this quarter. The cheese segment's revenues improved 0.9% as a result of higher pricing and sustained growth but organically the growth in this segment was flat, making the segment as unattractive as the others.

Although the revenues declined, the company succeeded in maintaining its organic revenue guidance, which it provided earlier for the full fiscal year 2013 report. It is projected that the organic revenues would be in line or slightly slower than the North American food and beverage industry's growth rate. Since the food and beverage industry is expected to experience a boost in the coming period, especially the snacks segment, we can expect that Kraft's revenue growth would also improve in line with that.

Now let us analyze the company's margins. Bearing the inflation impacts, company's cost of goods increased and caused its gross margin to decrease by around 38 basis points. However, it still managed to expand its YoY operating margin by aggressively reducing its selling, general and administrative expenses through its cost-cutting programs. These expenses, as a percentage of sales, were reduced by 3.45% compared to the third quarter of 2012. The operating margin expanded by 3.33%, which eventually improved the company's YoY net margin by 1.22%. Diluted per share earnings jumped $0.83 per share this quarter from $0.79 per share in last year's quarter reflecting an increase of 5%.

On account of better earnings this quarter and improving margins, the company has raised its full year earnings guidance to $3.58 per share from previous forecasts of $3.4 per share whereas the year-to-date per share earnings are $2.97.This would include the gains which the company received form its post-employment benefit plans.

The company has also raised its quarterly dividends to $0.525 per share reflecting an increase of 5% versus the prior rate of $0.5 per share. The company already had a dividend yield above the industry average. This increase in dividends would make the stock more attractive for the investors.

Free Cash Flows

Even though the company's per share earnings have increased, its per share operating cash flows have declined; mainly due to $586 million of pension contributions, $149 million of postretirement health care payments and cash paid for taxes and interest. Per share cash flows during the first nine months of 2013 fell to $1.88 from $3.49 per share in 2012.

The decrease in operating cash flows was partially offset by an improvement of the company's working capital which was driven by the favorable timing of the collection of receivables and lower inventory.

On the other hand, its capital expenditures in 2013 have increased compared to 2012 by $92 million, due to its current restructuring program. Management expects the 2013 capital expenditure to reach around $600 million compared to $440 million in full year 2012. The capex would be funded by operating cash flows.

The decline in operating cash flows and an increase in capital expenditure has considerably decreased the company's free cash flows from $3.01 per share in 2012 to the current level of $1.25 per share. Therefore, the company's management has maintained its target of $1.2 billion free cash flows in full year 2013.

Returns

Kraft's improved margins have enabled it to achieve higher returns on its equity and assets even with its smaller market share and negative revenue growth. The table below shows that in the first nine months of 2013 the company's returns on both its equity and total assets have increased compared to the same time period in 2012. This shows the successful and effective implementation of its ongoing cost cutting and restructuring programs.

Valuation

The company currently trades at a trailing price-to-earnings of 17.4, better than the industry, due to its positive earnings growth. The price-to-cash flow is also better than its industry peers even though Kraft Foods' operating cash flows declined in 2013 due to its current programs.

Source: Morningstar

The ratios indicate that Kraft foods is currently inexpensive and the stock price has the potential to go upside.

Conclusion

Kraft Foods has shown a mixed performance in 2013 as its earnings and returns have improved but its liquidity has declined due to lower operating and free cash flows. However, once the company completes its programs the capex will decline and operating cash flows will increase and result in an increase in the company's free cash flows. The effective implementation of these programs will also enable Kraft to further expand its margins and profits.

So, based on the fundamental and valuation analysis I would say that the price raise by Morgan Stanley is justified. I would recommend holding the stock.

Source: Kraft Foods - A Long-Term Buy