Mondelez International: Should We Expect The Positive Trend To Continue?

Summary

Mondelez remains a compelling investment, as it navigates severe market challenges with aggressive cost management, focus on power brands, and selective white-space opportunities.

I remain confident that MDLZ will drive margins to leastwise 18% by 2018, led by production shift toward advantaged assets, focus on overhead reduction, and savings from shared services initiative.

Several white space opportunities should prove incremental for Mondelez.

Mondelez International Inc. (NASDAQ: MDLZ) is a snack company. The company manufactures and markets snack food and beverage products for consumers in approximately 165 countries around the world. The company operates through five segments: Latin America; Asia Pacific; Eastern Europe, Middle East, and Africa (EEMEA); Europe, and North America. Its portfolio includes over seven brands, including Nabisco, Oreo and LU biscuits; Cadbury, Cadbury Dairy Milk and Milka chocolates, and Trident gum, as well as over 50 brands. The company's brands span five product categories: biscuits (including cookies, crackers and salted snacks); chocolate; gum and candy; beverages (including coffee and powdered beverages), and cheese and grocery. The company's other brands include Oreo, Chips Ahoy!, Ritz, TUC/Club Social and belVita biscuits; Cadbury Dairy Milk, Milka and Lacta chocolate; Trident gum; Hall's candy, and Tang powdered beverages.

Source of picture: Mondelez International

I am increasing my EPS estimates after 3Q earnings. While Mondelez' global category growth has experienced a modest slowdown, higher EPS estimates reflect more aggressive overhead reduction. Overhead savings are also overcoming slower gross margin expansion due to higher input costs and stepped up trade spending.

MDLZ improved vol/mix by 60 basis points (improvement in three of its five business regions) despite continued challenging operating conditions in emerging markets (lowest growth rate since becoming a public company), deflationary pressures in developed markets (realized pricing in North America and Europe decelerated 150 basis points sequentially), and an 80-basis-point headwind from strategic revenue management actions. MDLZ's growth in key emerging markets of Brazil, China, and Russia (albeit two of the three are still declining) remained relatively stable to recent trends; however, MDLZ returned the chocolate category in Brazil to growth by narrowing the price gaps through tactical trade spending. In addition, MDLZ continued to narrow price gaps in Europe and benefited from lapping the heat wave in continental Europe a year ago while North America generated improved vol/mix from biscuits and growth in its Thins platform (i.e., launch of Chips Ahoy Thins). Second, MDLZ generated operating margins of 15.8% or a 220-basis-point improvement from a year ago, as a significant expansion of overhead reductions, a one-time VAT settlement in Latin America (30 basis points), and productivity gains more than offset greater investment in trade in Brazil and Europe to narrow pricing gaps with competitors. Notwithstanding sales growth challenges, MDLZ likely will generate productivity ahead of internal expectations as sustained vol/mix growth should be incremental to margin expansion from supply chain reinvention. In fact, in the three regions of vol/mix improvement, MDLZ posted 340, 230, and 230 basis point expansions in OI margin in Asia Pacific, Europe, and North America. Fourth, MDLZ increased its 2016 adjusted constant-currency EPS growth guidance to 25% (from double-digit growth) or adjusted EPS of approximately $1.96, reflecting:

  1. Approximately 1.6% organic growth (in-line with the YTD trend but lower than its previous guidance of approximately 2%);
  2. 15-16% OI margin (continued trend of greater SG&A savings over gross margin improvement in 4Q16);
  3. Interest expense of $600-625 million (no change from last quarter);
  4. Lower tax rate of approximately 20% (from "low 20s");
  5. A $0.09 FX penalty (up from $0.08 last quarter); and
  6. Increased share buybacks of $2.3 billion (from $2 billion). Notably, MDLZ opted to exclude gains and losses from mark-to-market impacts this quarter, which should result in a 30 basis point favorability to operating profit going forward.

MDLZ remains a compelling investment, as it navigates severe market challenges (e.g., recessionary conditions in several emerging markets, deflationary pricing pressures in developed markets) with aggressive cost management and prudent white-space opportunities.

I remain confident that MDLZ will drive margins to at least 18% by 2018, led by shifting a greater amount of production toward advantaged assets (production on four additional lines on its Salinas, Mexico plant; its Suzhou, China plant should continue ramping up over the next several quarters), continued reduction in overhead, and the realization of savings from its shared services initiative. In addition, lapping the large extent of SKU rationalization of lower margin products that started last year (cut from 74,000 SKUs in 2013 to 30,000 by 2015) should create increased visibility toward vol/mix improvement and the associated operating leverage. Finally, its revenue management initiatives, which are still in the relatively early stages of implementation, will focus on 10 major markets (greater focus on emerging markets) to better allocate trade dollars. Notably, MDLZ's recent agreements to divest legacy candy/gum plants and low-margin confectionery brands inherited in prior mergers across Europe should provide upside to MDLZ's 2018 margin targets.

Several key white-space opportunities should prove incremental for MDLZ; however, I believe that the launch of Milka and Oreo in the mainstream U.S. chocolate market and an increased push for Green & Black's distribution in the premium segment may prove challenging given more entrenched competition. First, I continue to believe that MDLZ's launch of Milka in China should prove similarly successful to its gum launch in the country ($200 million business within two years and China's chocolate and gum markets are similarly sized).

In fact, MDLZ likely will benefit from several drivers, including:

  1. A well-placed online strategic partnership with Alibaba (NYSE:BABA) (10% of all snacks are purchased online in China, the highest of any country);
  2. Higher per capita consumption of chocolate compared to gum while still significantly trailing emerging and domestic markets like Brazil and the U.S.;
  3. The unique European milk chocolate brand appeal in Milka, which MDLZ will substantiate by importing milk directly from the Alps (it also helps that the Chinese have very little trust in locally produced dairy products);
  4. A well-timed entry in China, where Hershey (NYSE:HSY) -a direct competitor of the Milka brand, given both are positioned as milk chocolate- may struggle to allocate investment dollars toward expansion as it focuses on restructuring its recently acquired Shanghai Golden Monkey business.

Second, the repatriation of the Oreo, Ritz, and Premium biscuits equities should prove incremental in Japan as the country has per capita sweet and savory biscuit consumption that is slightly higher than the world average (+9%) while having higher per capita consumption in sweet biscuits than both the world (300%-plus) and U.S. average (+18%).

Third, while co-branding Milka with Oreo should help generate interest, I am somewhat more cautious on the incremental opportunity in the mature U.S. chocolate market, especially given the established nature of Hershey in the milk chocolate segment. The premium segment may prove just as challenging given that Lindt, Ghirardelli, and several craft chocolatiers make up a fairly fragmented market.

P/E/GROWTH RATIO:

The investor should examine the P/E (80.86) relative to the growth rate (59.99%), based on the average of the 3, 4 and 5 year historical eps growth rates, for a company. This is a quick way of determining the fairness of the price. In this particular case, the P/E/G ratio for MDLZ (1.35) is on the high side, but is acceptable if all the other tests are met.

SALES AND P/E RATIO:

For companies with sales greater than $1 billion, my methodology likes to see that the P/E ratio remain below 40. Large companies can have a difficult time maintaining a growth rate high enough to support a P/E above this threshold. MDLZ, whose sales are $26,517.0 million, needs to have a P/E below 40 to pass this criterion. MDLZ's P/E of (80.86) is not considered acceptable.

INVENTORY TO SALES:

When inventories increase faster than sales, it is a red flag. However an increase of up to 5% is considered bearable if all other ratios appear attractive. Inventory to sales for MDLZ was 10.16% last year, while for this year it is 8.80%. Since inventory to sales has decreased from last year by -1.36%, MDLZ passes this test.

EPS GROWTH RATE:

This methodology favors companies that have several years of fast earnings growth, as these companies have a proven formula for growth that in many cases can continue many more years. This methodology likes to see earnings growth in the range of 20% to 50%, as earnings growth over 50% may be unsustainable. The EPS growth rate for MDLZ is 60.0%, based on the average of the 3, 4 and 5 year historical eps growth rates, which is considered too fast.

TOTAL DEBT/EQUITY RATIO:

This methodology would consider the Debt/Equity ratio for MDLZ (62.18%) to be mediocre. If the Debt/Equity ratio is this high, the other ratios and financial statistics for MDLZ should be good enough to compensate.

FREE CASH FLOW:

The Free Cash Flow/Price ratio, though not a requirement, is considered a bonus if it is above 35%. A positive Cash Flow (the higher the better) separates a wonderfully reliable investment from a shaky one. This methodology prefers not to invest in companies that rely heavily on capital spending. This ratio for MDLZ (1.71%) is too low to add to the attractiveness of the stock. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.

NET CASH POSITION:

Another bonus for a company is having a Net Cash/Price ratio above 30%. I define net cash as cash and marketable securities minus long term debt. A high value for this ratio dramatically cuts down on the risk of the security. The Net Cash/Price ratio for MDLZ (-16.46%) is too low to add to the attractiveness of this company.

Despite gross margin coming in well below expectations and only 30 basis points ahead of last year, reflecting the negative impact of trade investment in certain markets that partially offset continued productivity. Regionally, improved OI margins in North America (+230 bps), Europe (+230 bps), Asia Pacific (+340 bps), and Latin America (+540 bps) more than offset OI margin contraction in EEMEA (-100 bps). The margin improvement included a 30-basis-point benefit ($35 million) from noncore items including VAT-related settlements (mainly in Latin America), gains from property sales, and costs related to its U.S. labor business continuity planning.

Upside Scenario $54.00

$54 assuming MDLZ were to generate earnings power of $2.35 and restore its modest premium to the U.S. packaged food group. MDLZ would capture higher earnings power from outpacing its operating margin target (at least 17%), gaining traction with its white-space opportunities, and benefiting from a recovery in the emerging markets and key global markets more quickly than expected.

Downside Scenario $38.00

$38 assuming MDLZ were to continue to face pressure in emerging markets, deflationary pressures in developed markets, and failing to deliver on its margin targets, while its white-space opportunities only translated into incremental costs without the respective returns. In this scenario, EPS may decrease next year, while its multiple would revert back to a discount to its peers.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.