- Kraft continues to maintain strong brand recognition but failure to innovate new products and categories has dragged down growth and profitability.
- Weakness in key revenue segments such as Beverages, approximately 15% of sales, and Refrigerated Meals, 18% of sales suggests current valuation is expensive.
- Based on my Levered Returns model, an entry point of $45 would require approximately 20%-25% decline based on the stock price of $60.63 as of July 6th.
Approximately 98% of American households are said to have at least one Kraft (NASDAQ:KRFT) product in their pantry. This speaks to how Kraft has historically dominated manufacturing and marketing of food and beverage products in the US and Canada. In the US, based on dollar share in 2013, Kraft held the number one or two branded market share position in 16 of its top 17 product categories. Its product categories span across meal occasions, both at home and in food-service locations.
Yet for the last two years, Kraft has posted negative sales growth, -1.6% and -0.3% in fiscal year (FY) 2012 and 2013, respectively. The trend is especially troubling since the general economic environment has been steadily improving, with consumer confidence up 10% since 2011 (Source: FRED). To better understand the drag on sales, I analyzed the company's operating segments and forecasted revenue growth accordingly using the Levered Returns segment analysis model:
Kraft's operating segments in order of revenue contribution are as follows:
Cheese segment (22% of Revenue) sells cheeses under various brand names including Philadelphia cream cheese; Kraft and Deli Deluxe processed cheese slices; Velveeta and Cheez Whiz. In the most recent quarter the company posted 2.0% growth over the same quarter in the prior year. Management attributed growth to "commodity-driven pricing". I project a growth rate around 1.5% to 2.5% which is reasonable for this revenue segment going forward.
Refrigerated Meals segment (18% of Revenue) under the Oscar Mayer brand sells cold cuts, hot dogs, and bacon; Lunchables lunch combinations; Claussen pickles; and Boca soy-based meat alternatives. The segment has 25 brands with annual net revenues between $100 million and $1 billion each. Despite dominance in the category, the segment in its most recent quarter declined -0.1% due to unfavorable volume/mix from the Easter shift and retail customer inventory reductions offset by higher shipments of lunch combinations. I believe the segment's flat sales in the recent quarter are consistent with the long-term outlook for the company. A growth rate around 0.5% to 1.5% is reasonable for this revenue segment.
Beverages segment (15% of Revenue) includes brands such as Maxwell House coffees; Tassimo hot beverage system (under license); Capri Sun (under license), Kool- Aid, Crystal Light, and Country Time powdered beverages. The Beverages segment continued to struggle during the first quarter of 2014 posting a -5.3% decline in the latest quarter. Management explained the poor performance resulted from lower pricing. Lower net pricing resulted from lower commodity cost-driven pricing actions in coffee and increased promotions in ready-to-drink beverages. Given the -9.1% decline in the segment FY 2012 and -1.4% decline in FY 2013, I'm assuming a rate of -5.0% for the full year FY 2014 and -2.5% for FY 2015, and 0.0% thereafter.
Meals & Desserts segment (13% of Revenue) products include macaroni and cheese dinners, Velveeta shells and cheese dinners, JELL- O products, Cool Whip whipped topping and Taco Bell Home Originals (under license) meal. In the most recent quarter, the company posted a -7.8% decline. Management attributed the decline to unfavorable volume/mix. I think a rate of -2.5% in FY 2014 and 0% thereafter is reasonable for this revenue segment.
Enhancers & Snack Nuts segment (12% of Revenue) includes brands like Planters nuts, Kraft Mayo, Miracle Whip, Kraft and Good Seasons salad dressings, A.1. steak sauce, Grey Poupon premium mustards and other products. The company posted -5.5% growth in the latest quarter. Management explained the poor performance resulted primarily from unfavorable volume/mix and lower net pricing. Given lower pricing trends may linger going forward, I've assumed a rate of -2.5% in FY 2014 and 0% thereafter.
Canada (11% of Revenue) offerings include Kraft peanut butter and Nabob coffee, as well as a range of products bearing brand names similar to those marketed in the U.S. In the most recent quarter, the company posted a -11.4% decline primarily due to unfavorable foreign currency. I've assumed Canada's revenues remain flat at 0.0% throughout the projection period as a result of the current headwinds facing this market.
Other Businesses segment (10% of Revenue) includes the company's Food-service and Exports businesses which sell primarily branded products like Philadelphia cream cheese, A.1. steak sauce, and a broad array of Kraft sauces. First quarter results came in at a -1.4% decline resulting from organic causes. I imagine this segment will deliver growth between -1.5% to 0.0% going forward.
Based on the build-up by revenue segment, I'm projecting total revenue growth to come in around -1.0% for FY 2014, 0.1% for FY 2015, and 0.6% for FY 2016.
DCF Analysis and Assumptions
I've input my revenue forecast into the Levered Returns DCF model and the results were as follows:
Other Key Assumptions in the Model
Profitability: Kraft operating income margins for the last five years have averaged 17.3% but have ranged from 15% to 21%. Analysts are expecting the company to deliver margins around 19.5%-20.0% for FY 2014 and FY 2015. I believe these estimates are fair given the numerous cost reduction initiatives the company is undergoing including realigning its U.S. sales organization, consolidating management centers, and streamlining corporate and business unit organizations. The company's also investing in efficiencies that can be realized at its production facilities. These initiatives provide sufficient support for projecting margin expansion over the next three years.
Capital Expenditure: Capital expenditures as a percent of revenue from 2010 to 2012 averaged 2.4%. The company invested 3.1% of revenue in capital expenditures to realize production efficiencies in 2013. I believe going forward capital expenditures around 2.7% provides a reasonable estimate for the company's requirements.
Discount Rate: I've assumed a 9.0% weighted average cost of capital "WACC" for Kraft. You can see my full build-up and play with my assumptions here: LR WACC build-up.
While Kraft remains a dominant player in the branded food products category, I believe the stock is expensive at $60.63, its July 6th, 2014 closing price. Until the company can manage to reinvigorate its innovation engine, I believe the company will continue delivering dismal top-line performance and mediocre profitability. I would only be interested in jumping into this stock at a price around $45 which would require a pullback of around 20% to 25%. I would love to hear your thoughts on my model and your conclusions from the Levered Returns DCF model in the comments.