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Kraft Foods Group Inc (KRFT) reported its results for the 4th quarter and full year of 2013 on February 13th, 2014. The company reported a 2.3% revenue growth for the fourth quarter but for the full year 2013 revenue declined 0.3%. After Kraft Foods Group separated from Mondelez International Inc (NASDAQ:MDLZ) at the end of 2012, the company's management seemed to have shifted their focus from revenue growth to profit maximization. As a result the company has become more efficient version in terms of costs. However, this quarter the enormous earnings are a result of a one-time gain related to market impacts on benefit plans. For the fourth quarter of 2013, Kraft Foods reported EPS of $1.54, $1.11 of which was related to the gain on pension plan. For the full year, EPS stood at $4.51 that implies a 26% higher EPS than what the company had estimated it would earn in 2013.

Margin Expansion

Through analysis we learned that the company is working steadily to expend its margins. As demonstrated by the figure below, Kraft Foods has managed to expand its gross margin q-o-q by 660 basis points during the fourth quarter of 2013. This expansion was mainly driven by a 2% rise in revenues accompanied by a 20% decline in cost of sales for the quarter. Moreover, net profit margin increased in the quarter by 8.88%. The operating margin increased from 5.8% in the 4th quarter of 2012 to 33% in the fourth quarter of 2013 and was instrumental to net profit margin expansion. A serious decline in selling, general, and administrative expenses also contributed to driving this level of net margins.

Source: yahoo finance

Shareholders' Return

Kraft Foods Group has transferred enormous returns to investors' wallets since its stock experienced a 13.97% price appreciation and outperformed its competitor General Mills (NYSE:GIS) whose price appreciation stood at 11.89% for the prior year. The company is currently offering a dividend yield of 3.91 with a dividend of $0.52. The company has also announced a $3 billion share buyback program that will enhance investors' confidence since this step of the company indicates the management has firm belief in its ability to continue attaining growth and positive results in the long run. Therefore the company is seeing value in its own stock and investors can expect enhanced returns from the company in the coming years out of price appreciation, continued dividends, and the share buyback program.

(click to enlarge)

Source: Y-Charts

The Road Ahead

Kraft Foods expect the first quarter of 2014 to be soft because of the weak US job market and reduced federal food stamp benefits. However, the company believes it is able to achieve long-term targets. The share buyback program is also evident of the fact that the company believes in itself and its future prospects. Kraft Foods has a well established brand portfolio and is also striving to enhance and promote high-margin brands in future. The company has some world-famous brands like Oscar Mayer, Velveeta, Philadelphia, Maxwell House, and Tang in its portfolio. It is admirable that the company has turned operating losses from its beverages segment into profits with a 100% y-o-y change this quarter.

Source: Fourth quarter earnings release

Since Kraft Foods generates 23% of its revenue from cheese sales this segment is the heart of the business. The future demand of cheese will definitely spur the company's top and bottom lines since the company serves North America that dominates the world cheese market both in terms of production and consumption. Overall cheese consumption will trend upwards due to the versatility and adaptability of cheese to recipes. The increasing rate of women at work and consumers switching from eating more food at home to partially or fully-prepared foods have also indirectly bolstered the cheese demand. One factor that favors the USA market is the acceptance of ethnic cooking like Italian and Mexican that use more cheese in their recipes. Moreover the collaboration of America's dairy producers with food service chains has also helped in further increasing demand for cheese in the region.

Recently the company announced a recall of 1.77 million pounds of Velveeta Pasta and ground beef products made by Truitt Brothers. This recall was initiated due to the exclusion of soy, an allergen from the ingredient list. This may cause the company to incur costs in the short term but in the long run the company will learn from its mistakes and because of the recall the consumers will trust the brand since the company has the guts to accept and remedy its mistakes.

Apart from that the company has set its long term growth algorithm where its operating income will grow by approximately 5% and that will in turn translate into EPS growth in the range of 5-9%. Free cash flow and return on invested capital stand as key metrics for the company and it is expected to show mid-single digit growth y-o-y. This scenario leads us to be optimistic about the company's future prospects.

Valuation

Since the company lacks a dividend history I will be using the multiples based valuation for the stock. Assigning more weights to the price-to-earnings and price-to-cash flows indicates their main contribution towards the value of a stock. Comparing the stock's fair value based on multiples with that of its current price dictates the conclusion that the stock is currently undervalued and has an upside potential of 4.91%. According to the multiples based valuation the stock has the potential to secure further price appreciation.

Source: Reuters & Morning star

Financial Analysis

Kraft Foods Group is offering a return on equity of 30.41 whereas the industry has set a benchmark of 13.87. In order to delve into the details we will use DuPont analysis. The DuPont analysis is a unique analytical tool that gives insight into the company's income statement and balance sheet.

Data Source: KRFT Earnings Releases

When studying the DuPont breakup for Kraft Foods it becomes visible that its ROE is mainly driven by its net profit margin and financial leverage. The company has managed to increase its net profit margins q-o-q thus providing a sustainable basis for its ROE. On the other hand, financial leverage contributes to a greater extent in generating this unsustainable level of ROE. High financial leverage implies that the company finances its assets heavily out of debt and not equity. However the good thing is that the company is striving to reduce its financial leverage and it has been reduced from 6.22 in Q1 of 2013 to 4.46 in the 4th quarter of 2013. Apart from the two, the contribution made by the asset turnover remained minimal that implies the asset management of the company is very disappointing and must be improved.

The company has lodged enormous debt levels on its balance sheet and that increases the company's financial risk. As shown in the graph below the q-o-q debt levels are rising considerably. However the CFO-to-debt ratio for the company in every quarter is rising steadily but is still far below the 50% threshold that implies that the company is over leveraged. Kraft Foods will find it difficult to raise more debt as its current debt levels are mounting. The company's management needs to reduce its debt by utilizing its cash flows in order to give the balance sheet a healthy look.

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Source: KRFT Earnings Releases

Glancing at the company's cash conversion ratios over the last four quarters we discover that the company's earnings are translated into a CFO that is a more robust measure of the company's earnings quality. A q-o-q rising trend in cash conversion implies that the company converts all of its earnings into cash flows and that is really efficient.

Final Takeaway

Kraft Foods Group is currently offering an attractive dividend yield and return on equity. It is also trading at a cheap price to earnings multiple of 17.15 compared to the industry's P/E of 23.3. Already some analysts have upgraded their price targets for the stock. Moreover one can expect even better results from the company once it completely undergoes restructuring. That will have a doubling effect on the company's key statistics. After restructuring, the company's profits will be bolstered as a result of cost savings and improved optimization of operations. The impact will also be imprinted on the company's strengthened cash flows with low capital expenditure requirement. This scenario makes me believe the stock is attractive for long-term investors. I would recommend holding this stock and welcoming Kraft's efforts that will translate into long term benefits for shareholders.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a Blackstone Equity Research research analyst. Blackstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Blackstone Equity Research has no business relationship with any company whose stock is mentioned in this article