Mondelez - High Quality Pays Off
Summary
- Owning some of the strongest snacking brands, Mondelez is an absolute leader in the category.
- Improvements in operating profitability would lead to future multiple expansion.
- Stake in JDE Peet's coffee business poses a significant threat to Nestle's hegemony in the space.
- Net working capital efficiencies in combination with lower future capital spend will provide yet another free cash flow tailwind.
Source: www.mondelezinternational.com
Investment thesis
Sometimes companies are priced at a premium and for a good reason. High return on invested capital backed by sustainable competitive advantages and strong management team with clear stewardship role is almost always a recipe a good investment. Mondelez (NASDAQ:MDLZ) has all the traits mentioned above on top of potential for a significant multiple repricing going forward.
I suggest you consider how you might have reacted if someone had suggested you invest in Coca-Cola or Colgate at, say, twice the market p/e in 1979. In rejecting that idea you would have missed the chance to make twice as much money as an investment in the market indices over that period.
MDLZ is a global leader in the snacking segment. Over the past decade the company has streamlined its brand portfolio by focusing on its leading market share in biscuits and chocolate. It owns many of global most popular brands within these categories, such as Oreo, Milka, Cadbury, Toblerone, Ritz, Belvita and many more.
Source: www.mondelezinternational.com
By leveraging these brands and simplifying its operating structure, MDLZ management has significantly increased its operating profitability over the past years while increasing its market share. This has resulted in a much higher Return on Equity and as a result significant multiple repricing upwards.
As it stands today, MDLZ is positioned for further profitability improvement while retaining its high free cash flow generation ability. At the same time its strong brands make the return on capital more resilient and give the company a significant bargaining power with retailers.
Business fundamentals as a driver
Source: Yahoo!Finance
Mondelez alongside Nestle have been the best performers over the past 5-year period within the peer group shown above.
The reason is that only MDLZ and Nestle managed to improve their Return on Equity by a significant amount since 2016.
* Adjusted for impairments and other one-off items
Source: author's calculations based on data from annual and quarterly reports
With asset turnover and leverage being relatively stable over the period, the two companies achieved higher ROE through improved operating profitability.
Source: author's calculations based on data from annual and quarterly reports
In spite of its strong performance, MDLZ operating margin of 14% still lags behind those of Nestle, General Mills and Kraft Heinz of around 17%. The company has further room to improve its profitability which will be one of the key drivers for its future multiple repricing.
What also sets MDLZ apart is that the company's higher and more consistent free cash flow growth over the past five years, especially when compared to its major peer - Nestle.
Source: author's calculations based on data from annual and quarterly reports
High free cash flow generation is another key characteristic of MDLZ, which at first glance appears to be overpriced based on its Free Cash Flow Yield.
Source: author's calculations based on data from annual and quarterly reports
However, MDLZ was also one of the highest priced companies on a free cash flow basis back in 2016 as well, when it traded at a much lower yield of only 2.5%. Fast forward to Q1 in 2020 and MDLZ has been one of the best performing stocks in the peer group registering the second highest free cash flow growth.
ROE and P/B multiple
Return on Equity is the most important driver of P/B multiples in the sector.
Source: author's calculations based on data from annual and quarterly reports & Yahoo!Finance
Although MDLZ's ROE improved significantly since 2016, the company has further room for improvement to catch up with the leaders.
If we compare the same graph with the 2016 period we could easily see why MDLZ and Nestle were the best performing stocks over the period. The multiple expansion of the two companies came as a result of their significant improvements in ROE.
Source: author's calculations based on data from annual and quarterly reports & Yahoo!Finance
Not only that, but as we could see the two companies achieved that without incorporating significant amounts of leverage, as Kellogg (K) and General Mills (GIS) are doing. Not surprisingly, this also results in a much lower financial risk for investors as interest coverage of MDLZ and Nestle is the highest in the group.
Source: author's calculations based on data from annual and quarterly reports
Why strong brands matter so much
MDLZ achieves a significant price premium through its leading brands and strong standing in biscuits, chocolate, candy & gum categories.
Source: Mondelez investor presentation
Mondelez leadership in these product categories was possible through the company's world most renowned brands such as Oreo, Milka, Cadbury, Toblerone, belVita and many more regional ones.
Having the highest market share in a given product category in combination with the world's strongest brands has a twofold effect on margins. Firstly, through higher bargaining power with retailers and secondly through an overall price premium for the products.
Moreover, MDLZ has focused on high margin product segments, such as confectionery, milk products & ice cream. Thus it has achieved one of the highest sector gross margins.
Source: author's calculations based on data from annual and quarterly reports
Having some the best cookie and chocolate brands also presents a huge opportunity for expanding into adjacent product categories, such as snacks, yogurt, ice cream, pastries etc.
Source: Mondelez investor presentation
Earlier this year the company completed another step into its expansion into these adjacencies with the acquisition of Give & Go, a leader in sweet baked goods.
"Our ambition is to lead the future of snacking by offering consumers a broad range of snacks in key growth channels and categories," says Mondelez exec said Glen Walter. "Give & Go’s leading position in the large and fast-growing in-store bakery channel gives us a unique opportunity to expand into new, on-trend consumer spaces," he adds.
Source: seekingalpha.com
The in-store bakery channel has been growing fast over the recent years and in this case both businesses could benefit from each other. On one hand Give & Go could leverage some of Mondelez strong snacking brands while at the same time it will also benefit from MDLZ distribution channels and already strong bargaining power with retailers.
Mondelez management has also been busy working within this area by offering Oreo and Milka branded ice creams through licensing. This represents a huge growth opportunity for the company to further expand into high margin new product categories.
Source: Mondelez investor presentation
MDLZ has been very successful in this field with its partnerships in the ice cream category in the U.S. and Europe for example, where it has been successfully competing against Nestle.
The company's global brands have been exceptionally strong across the globe with significant efforts going into adapting products to regional customers' tastes. In addition, MDLZ has a large number of local brands which it has reactivated and is planning on re-purposing through increased media spend.
I would roughly say about 45% of our portfolio is global brands, about 45% is local brands that we want to activate. And then about 10% is a brand that we do not want to activate and largely run there for cash. Of those local brands, those 45%, most of them have been activated; I wouldn’t say yet with the optimal media spend yet. So that’s where we want to increase it. But the ones that we have been able to increase media and reposition them and give them sort of a new purpose that has worked really well for us. So, one of the most striking examples would be Jubilee in Russia, which is a legacy biscuit brand, which was kind of dormant and we’ve revamped it, and it’s now showing double-digit growth and a strong market share increase. And we see that with a number of brands, LU in Europe, and we see that with a number of brands around the world.
Source: Link
In a nutshell, strong and streamlined brand portfolio is key for success. In the case of MDLZ, its leading global brands extract significant price premium and combined with leading market share position give the company a considerable bargaining power when dealing with large online and brick and mortar retailers. On top of that, expansion into adjacent product categories and a large portfolio of local brands presents a growth opportunity that many of MDLZ peers do not have. Last but not least, owning some of the strongest FMCG brands in the world is a sustainable competitive advantage that is extremely hard to replicate.
Why operating profitability will continue to be a driver
As we saw in the first section, operating profitability is key for future multiple expansion through higher ROE. MDLZ has managed to significantly improve its operating profitability from an average of around 10% in the first half of the decade to an average of around 14% in the second half.
Source: author's calculations based on data from Mondelez annual and quarterly reports
As we saw earlier, one of the reasons for that has been the company's industry leading gross margin achieved through some the strongest brands in the food industry.
On top of that MDLZ has been streamlining its business towards thee highest Return on Capital product segments - confectionery with its legacy brands, milk products & ice cream through licensing and coffee and beverages through its stake in JDE Peet's and Keurig Dr Pepper.
As we see from Nestle's segment breakdown, these segments have the highest return on capital.
Source: author's calculations based on data from Nestle annual report 2019
In the coffee and beverages space MDLZ has adopted a different strategy by spinning off its coffee business and combining it with JAB Holding's businesses. The combined entity JDE Peet's now has a large portfolio of strong coffee brands and with the resources available poses a significant threat to Nestle's coffee business which in turn resorted to a partnership with Starbucks.
Source: jabholco.com
With both JDE Peet's and KDP now publicly trading, investors have more visibility into Mondelez equity investments, while the increased cooperation with JAB Holdings seems to be the step in the right direction to tackle the hegemony of Nestle in the space.
As of end of March 2020, Mondelez owned 26.4% and 13.1% of Jacobs Douwe Egberts and Keuring Dr Pepper respectively.
Source: Mondelez quarterly report
Finally, MDLZ operating margin has been lower due to the company's very high advertising spend relative to revenue.
* Nestle not shown due to lack of data
Source: author's calculations based on data from annual and quarterly reports
This high level of advertising spend has allowed the company to build a global brand powerhouse and become an absolute leader in the snacking category. More importantly, by bringing its existing brands into adjacent product categories mentioned above, MDLZ will be able to capitalize on its master brand strategy and reduce its ad spend relative to revenue in the future.
Free Cash Flow generation
On top of all of the befits that strong brands and streamlined product portfolio bring, MDLZ also excels at free cash flow generation.
The company has significantly reduced its cash conversion cycle over the years and although it is likely to suffer in 2020 due to supply chain issues brought by the pandemic, the long-term drivers for reduced net working capital remain.
Source: author's calculations based on data from Mondelez annual and quarterly reports
MDLZ has a much more efficient inventory turnover than its peer Nestle, while receivables are also managed better. Payables on the other hand are much more dependent on size and are in line with MDLZ large size. This makes the company the best performer in terms of working capital utilization with the lowest cash conversion ratio (CCC).
*DSO - Days sales outstanding; DIO - Days inventory outstanding; DPO - Days payables outstanding;
Source: author's calculations based on data from annual and quarterly reports
In addition to efficient use of working capital, MDLZ has also been heavily reinvesting into its existing business. The high level of capital spend over the past years has significantly improved productivity and made possible for the company to now dial down the level of capital spend without compromising performance. Out of the reviewed peers, MDLZ has been spending the most on Capex relative to Depreciation & Amortization (D&A) expense.
Source: author's calculations based on data from annual and quarterly reports
A notable example of the high level of capital spend has been the improvement of the Cadbury business in the UK. According to MDLZ management, the operating costs of the UK factory were three times as high as MDLZ comparable operations in Germany, but the productivity gap has now been closed.
On a discounted free cash flow basis, the risk-reward ratio also appears to be positively skewed with a limited downside risk.
Using a beta of 0.76, equity risk premium and normalized risk-free rate of 6.0% and 3.0% respectively gives us a cost of equity of approximately 7.5%. With a free cash flow of $2.9bn over the last twelve months and a growth rate starting at 3.0%, which is the expected topline growth rate in 2020, the range of outcomes for MDLZ share price is as follows;
Source: author's calculations based on data from annual and quarterly reports
With MDLZ trading at around $52 a share there is a significant upside, if the company achieves a free cash flow growth rate of above 4% over the long-term.
As we saw so far this could be achieved easily due to:
- the company achieved organic top-line growth of 4% in 2019 which in spite of the pandemic appears to be an achievable target for 2020 as well;
- MDLZ is highly likely to further expand its operating profitability going forward which will have further positive effect on FCF;
- although in 2020 we might see a hiccup in NWC cash flow effect, the long-term drivers of NWC efficiency remain while lower capex will also provide a tailwind;
- the coffee business combination with JAB Holdings gives MDLZ exposure to high margin business with a significant growth opportunities;
Conclusion
Mondelez is one of the best-in-class food businesses, dominating the snacking category globally. Owning many of the strongest brands in the space is both a significant competitive advantage as well as a driver for future margin and market share expansion. Strong brands with a leading market share in their category also give a significant bargaining power with retailers which is crucial at times when online retailers are exerting more pressure on producers.
Improving profitability through further fixed cost optimization and expansion into high margin product categories will be the main driver of MDLZ future Return on Equity. If achieved, this would result in a higher multiple repricing which in combination with mid-singe digits organic growth makes a compelling long-term case.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
This article was written by
Vladimir Dimitrov, CFA studied at the London School of Economics and is a former strategy consultant where he learned how to properly value intangible assets when screening businesses for potential returns.
He is the leader of the investing group The Roundabout Investor where he teaches the process of evaluating roundabout investments; defined by potential high capital return, growth in free cash flow, safe dividends and conservative capital allocation. He offers weekly investment ideas, a model portfolio, a watchlist, macro outlooks, and sector deep dives. Learn more.Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MDLZ over 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.
Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
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