Kraft Food (KRFT) has been experiencing challenges since it was spun off from Kraft Food Inc. last year. The company, previously a part of bigger operations prior to separating, now focuses on selling packaged foods. Some of the popular brands that it includes are Velveeta Cheese and Maxwell Coffee. It now operates in six business segments that will help the company manage its portfolio more effectively and focus on building brand loyalty.
Around the time of the spin off the company saw its share value hike to 20%. However, volatility soon followed and was observed in the later half of 2013 although the price has remained around $52-$55. A look at the quarterly performance results could explain the shake in investors' confidence that might have contributed towards the volatility.
Operations After the Spin Off
On a quarterly basis, revenue has been falling significantly in all of the segments except cheese. Overall, net revenue or net organic revenue fell nearly by 4% to $4.4 billion. The price impact neared 1% while the product mix contributed the rest.
As you can see below, the decline in revenue mainly comes from the high inventory Kraft accumulated prior to the spin off. The higher spin related shipments in the previous year boosted the organic growth of company and caused an inflated figure in the past that of course is invalidated when compared with the current quarter. If we exclude the pricing, pruning and inventory effect, Kraft actually reported a 1% organic growth and the North American food and beverage industry saw a 0.5% volume decline in the third quarter. Kraft's performance was exceptional as it beat the industry by 100%.
Further, the company has been gaining market share in products that constitute more than 50% of the company's portfolio (2011:34%, 2012:40%). The company reported a 5% increase in its EPS to $0.83 this quarter. However, it includes gains from market-based impacts to post employment benefit plans of $0.18 and a negative $0.05 impact from changes in unrealized gains/losses from hedging activities. Excluding these events, the EPS is $0.7 this quarter marking an 11% decline from the previous year's figure.
The company is involved in a $650 million restructuring plan that began October last year. By September, the company incurred $554 million in costs which is expected to reach $600 million by the end of this year. Once the restructuring is complete we can expect the EPS to improve and the company to generate returns that are not dependent upon one-time events.
The US is recovering from one of the worst recessions in decades. The consumer confidence index has reached a 5 month high this December. This indicates that consumers may spend more next year. Personal spending increased by 0.5% in November and this figure was larger than anticipated. A pickup in employment, higher property values and stock-market gains are increasing household wealth and positive sentiment.
With positive macro variables the company is also working to improve itself internally. As the company invests in its brands and innovative new products (reported by its heavy marketing expenses), it is going to gain pricing power to drive margins higher offsetting the negative impacts of higher costs. This can already be seen from Kraft's new product revenue which was around 13% of total revenue in 2012 improving significantly from 6.5% in 2009.
Kraft holds a very high penetration rate in the American and Canadian markets. The 98% rate indicates its strong preference in the market. Moreover, the rising trend amongst young professionals for ready packed food means we can expect future growth. For example, let us consider the Cheese segment.
The cheese market has grown at a CAGR of nearly 3% since 2010. Kraft is the leader in the cheese industry and has enjoyed an approximately 27% share of the cheese market in 2010 and a 28% share of the cheese market in 2011. The lower sales in 2012 resulted in a 60 bps reduction in market share in 2012 to 27.4% and it has continued to remain at that level during this year as well. Assuming the share remains at this level in the future the company can increase margins through lowering expenses or increasing productivity and it seems that the company is already following that strategy. Operating income jumped by more than 7.5% to $171 million. The income improvement was due to increasing productivity and lower marketing as well as SGA expenses.
Kraft's cheese division's two popular brands, Philadelphia and Kraft Singles, each generate more than $500 million in sales and are very popular among consumers. With leading brands in the segment Kraft is set to benefit the most from the steady growth in the cheese market in the US and Canada. The different prices ranging from the expensive Kraft Deli Deluxe to the cheaper Velveeta (priced around $2) will allow Kraft gain a wider range of consumers in the market.
Similar to cheese, Kraft's other segment markets are also growing. These other segments include beverages, refrigerated meals and meals & desserts. Therefore, Kraft is not short of demand and it just has to continue to generate competitiveness from within. Through restructuring and improved marketing we can expect the company to generate more earnings from its present asset base and capture a greater market share.
We can quantify the upside potential of Kraft by using the multiple based valuation. I chose this model for Kraft's valuation because of the company's short dividend history which disqualifies it from the DDM.
As shown in the table above the company is undervalued based upon the price to earnings and price to cash flow multiples while on the basis of price to sales and price to book multiples the company is overvalued. I have assigned different weights to these multiples in order to compute the intrinsic value of the stock in the average case scenario. By assigning 45% weight to P/E, 10% to P/B, 10% to P/S and the remaining 35% weight to P/C, the intrinsic value of the stock is $61.31 which gives a capital return of 14.14% to investors.
Kraft also recently announced a $3 billion buyback program with an unspecified end date. Amongst the changes, the rationale behind the move is easy to understand. The company is confident it will start to improve once its restructuring strategy is implemented. Even though you might be late for the 52.5 cents dividend that is expected next month it is not too late to buy stocks in Kraft and benefit from its attractive portfolio and post-restructuring activities.