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Summary

  • According to data gathered by NPD, approximately 25% adults today actively seek products with fewer preservatives and unnatural flavor.
  • The Bloomberg Protein Index increased 5% this year owing to the increase in prices of beef, pork, and ham.
  • The 95 year old Woburn plant will be closed down by the end of 2016 which is expected to reduce the overall operating costs of the company.

Kraft Foods Group Inc.'s (NASDAQ:KRFT) stock price has risen by 17% since its plunge in February of this year. The company claims that it has achieved an impressive household penetration rate of 98% in North America. However, the recently ended quarter's results reveal that the fact the company's sales are declining. The company is presently facing a lot of hurdles with constricted top-line growth, rising input costs, and an increasingly competitive environment. The following article highlights the recent quarter's results followed by factors that led to contraction in the profit margins and the efforts employed by the company to ease those pressures.

Financials

The aggregate top line of the company indicated a 3% YoY decline compared to the same quarter of the previous year. Rising per unit prices across major product classes offered by the company could be a plausible reason for this dip as price-sensitive customers moved on to cheaper alternatives offered by rival brands. The trend is expected to be present in the present quarter as well. The previous quarter's revenue dip overshadowed analysts' hopes for a meager rise in the company's top line. Even with said revenue plunge, Kraft Foods managed to enhance its earnings by 2.6% YoY by reducing its operating costs and working on its supply chain operations.

The company's debt to equity ratio is the most visible number in its financials wherein Kraft Foods' debt to equity ratio stalls at 188.39 compared to the industry average of 80.43.The company maintains a weak balance sheet compared to its peers which is apparent from its current and quick ratios of 1.46 and 0.92, respectively, compared to the industry averages of 1.75 and 1.34.The financial policy of the company led to an artificial inflation of its ROE figure which presently stands at 61 compared to the industry average of 13.78.However, Kraft Foods' gross, operating, and net profit margins exceed those of its peers.

The Price for Health Consciousness is on the Rise

As Americans become more health conscious the demand among food groups is heavily tilted towards protein-rich foods like eggs, lean meat, and pork as they are more advantageous for faster weight loss. According to data gathered by NPD, approximately 25% of adults today actively seek protein-rich products as opposed to those laced with preservatives and unnatural flavor. Reportedly, this percentage of healthy food mongers is at its highest since 2004.

With the demand for protein-rich foods on the rise and supply following a downward trend, the prices of these food items was bound to increase. The Bloomberg Protein Index has increased at a CAGR of 28% over the past five years; the index increased 5% this year owing to the increase in prices of beef, pork, and ham. In fact, the index is rising at double the pace compared to other food prices due to the heavier consumption of protein-rich foods among Americans. Besides the demand induced increase in price there are a few abnormal factors that led to a decline in the supply of certain products and took part in the price hike. The pork supply plunged as a Porcine Epidemic Diarrhea virus (PEDv) killed about 8 million piglets and reduced the supply of slaughter-ready pigs; beef prices hiked since cattle herds were negatively affected due to a long period of drought; the price of eggs and other dairy products also increased this year.

Besides the price increase in protein-rich foods, the company's coffee products are also stressed due to rising coffee costs owing to two major reasons. The first of those reasons is the drought in Brazil that is hurting its Arabica coffee crop. The second reason is the coffee rust disease in Central America that is hurting the overall coffee supply.

Beef, pork, and coffee are major ingredients for Kraft Foods. Rises in pricing across these product groups increased the overall COGS figure of the company. With the top line already following a downward trend, the rise in COGS led to a contraction of the company's margins. However, to soften the blow the company increased prices across 45% of its product portfolio, which led to a 5-12% increase in the prices of its cheese products and a 10% increase in Maxwell House and Yuban coffee brand prices.

The price increase might have been thought to soften the blow on margins but it might backfire since Kraft Foods is the first in the industry to actually raise prices due to rising raw material costs. Being the first the company is at risk to lose a bit of market share to its competitors since they are still offering quality products at lower prices. That being said, the company's overall volume sales might decline as a result of increasing product prices. With this decline in the overall volume sales of the company, an increase in advertising and marketing budgets shall be expected to follow.

Productivity and Supply Chain Improvements

In addition to increasing prices among 45% of its product portfolio, the company is also bringing forth improvements in production technology to slash its operating costs. The technological improvements are expected to benefit the company in the long term by reducing the company's per unit costs. Reduced per unit costs would further lead to gross margin expansion.

Presently, 28% of the company's production plants utilize Four Sigma Technology, which have increased the production yield by 40% compared to the regular production facilities of the company. Kraft Foods is upgrading its technology to Lean Six Sigma, which is expected to further enhance the company's production capacity. Enhanced production capacity would lead to better economies of scale, lower per unit costs and enhanced gross margins in return. The company is struggling towards this goal and is on course to shutting down older facilities that have become too costly to operate. The 95 year old Woburn plant will be closed down by the end of 2016. With these plans on course, operational costs are expected to follow a downward trend in the foreseeable future.

With regards to the supply chain, Kraft Foods is making strategic partnerships to minimize damaged goods and improve the overall production yield. One such strategic partnership led to an 80% improvement in the production of whole cashews by minimizing breakage during the transfer of cashews from the supplier to the company's manufacturing plants.

These efforts would lead to lower operating costs in the long run and would help the company expand its margins and earnings per share figure. However, it is important to remember that these efforts may not be immediately reflected in the bottom line. Their impact is more likely to become evident in a couple of years.

Shareholder Returns

The company distributes profits among its investors in the form of cash dividends and share repurchases. Recently the company announced a $0.525 per share dividend to be paid to the shareholders for this quarter. In addition to that the company's Board of Directors authorized a $3 billion share repurchase program towards the end of last year for further distribution of profits among the shareholders in an unrestricted manner. The company had repurchased $124 million worth of shares which reduced an aggregate number of 2.2 million common shares.

Valuation

The multiples-based valuation indicates approximately 6% upward potential in the stock price of the company. For my model, I have allotted varying weights to different price multiples based on their relationship to the company's financials. Since the P/E ratios and cash flows have a more direct relationship to the overall financial performance of the company they have been given a higher weight. On the other hand, the P/B and P/S ratios have been given lower weight since book value is an historical figure while revenues are a starting point to assess the financial performance of any company. Take a look at the following image to see the fair price the model suggests for Kraft Foods.

Source: Yahoo Finance; Morning star; Reuters

Concluding Remarks

Kraft Foods is a slow growth company in terms of both revenue and investor returns. The top line of the company is expected to grow within low to mid-single digits in the future owing to the fact that it leads its competitors in transferring rising input costs to consumers. However, this top-line weakness is expected to wear off in the future as the company increases its marketing and advertising expenses to regain volume sales.

Stable top-line growth coupled with stable dividend growth is expected to induce a slow but stable growth in the stock price. Moreover, where increasing dividends would contribute to dividend yield expansion, share repurchases would lead to further strengthening of shareholders' stance and per share earnings in the future. With these characteristics, I would recommend long term investment in the stock for investors who are not looking for high-growth risky alternatives.

Source: Kraft Foods - Impact Of Cost Management Decisions