Kraft Foods Group (
) is scheduled to announce its 2014 first quarter earnings on May
1. We expect increased price-based competition in the grocery
segment and higher commodity prices to weigh on the company's
earnings growth. However, cost savings from productivity
initiatives could partially offset the impact of increased pricing
pressure and higher input costs.
Kraft Foods Group manufactures and markets packaged food
products, including beverages, cheeses, convenient meals and
various grocery products. The company primarily deals in the North
American markets with the majority of its sales coming from the
U.S. and Canada. It generates annual sales revenue of around
$18 billion with a consolidated adjusted EBITDA margin of
Our $55 price estimate for Kraft
is about 5% below its current market price.
See Our Complete Analysis For Kraft Foods
The surge of private label brands has been the most
prominent trend in the grocery segment over the past few years. It
kicked in when the U.S. economy entered into a recession in 2009,
forcing consumers with reduced spending capacity to opt for cheaper
grocery brands. However, despite a significant recovery in the U.S.
economy since 2009, the private label brands continue to attract
consumers, resulting in intense price-based competition for
national brands, including those offered by Kraft.
This could be partly attributed to the fact that the private
labels have not only worked a lot on improving the quality of their
products, but also on building their brand equity through
investments in innovation, packaging and consumer engagement.
Additionally, the lower-income consumers that have not bounced back
as much as the ones in the higher income bracket, continue to
remain cautious of their food budget. According to Nielsen, sales
of private label brands have grown more than twice as fast over the
past three years, compared to the national brands.
This has put considerable pricing pressure on Kraft's grocery
sales revenue. According to our estimates, the company's value
share in the grocery market has declined by more than 180 basis
points since 2010, at an average rate of around a 60 basis points
per year. We expect the trend to manifest itself in Kraft's
first quarter results as well. However, the decline in Kraft's
grocery market share should subside in the long run as the pricing
gap between private labels and national brands narrows, and the
company increases its marketing push behind its ailing brands.
Currently, private labels are priced at around 20-25% lower than
the national brands on an average. The price gap has already come
down a bit over the past few years, as prices of the private label
brands have increased at a much faster rate.
Higher Input Costs
Margin expansion has been the key to Kraft's earnings
growth over the last couple of years, as revenues have remained
largely flat since 2011. According to our estimates, the company's
consolidated adjusted EBITDA margin stood at 20.4% in 2013, up more
than 80 basis points from where it was in 2011. This could be
largely attributed to the company's ongoing productivity
improvement program. However, we believe that Kraft could find it
difficult to sustain its margins this year due to soaring commodity
According to Kraft's latest annual SEC filing, the company uses
large quantities of commodities which primarily include dairy
products, coffee beans, and meat products such as beef and pork as
raw materials. The prices of all these essential commodities have
been high this year, which could mean thinner margins for the
company since pricing measures are generally a last resort for
retail food and beverage companies. This is primarily because of
competitive reasons because some players in the industry are hedged
in certain commodities, which partly insulates them from the impact
of a sudden jump in commodity prices. So, a leading pricing measure
could erode volume share of a company in the market, which is not
always easy to regain and requires investments in advertising and
marketing later on. Below, we take a closer look at what's
driving certain commodity prices higher this year.
Prices of raw milk and other dairy products in the U.S. have
risen sharply over the past few months due to increasing export
demand from the fast-growing Asian markets, especially China.
According to the U.S. Dairy Export Council, exports of dairy
products from the U.S. grew by 19% y-o-y last year. Most of the
increase in export demand came from China where the consumption
of imported milk has risen sharply since a 2008 incident in which
adulteration of domestically produced milk was found to be the
reason behind the death of six children. The price of current
class III milk futures contract
has risen to around $24.3 per hundred pounds, up ~34% this year.
If milk prices continue to remain this high for the rest of the
year, Kraft's Cheese margins could potentially take a hit.
Coffee prices have also been steep this year as one of the worst
droughts in the history of Brazil has hit the country's coffee
plantations, leading to a downward revision in production
forecasts. Brazil is the world's largest producer and exporter of
coffee. It contributed more than 35% to the global coffee
production last year. Prices of Arabica coffee futures have
increased around 67% so far this year. During the fourth quarter
earnings conference call, Kraft's management agreed that if
continued to remain high for the rest of the year, it could dent
margins of the company's Beverages unit.
Prices of commodity meat products such as pork and beef have also
risen sharply this year. Hog prices have been high due to a
shortage in supply of slaughter-ready pigs because of the porcine
epidemic diarrhea virus or PEDv, that has killed millions of
piglets since last spring. The virus that was discovered in
the U.S. hog herd in May last year, causes diarrhea, vomiting and
dehydration in hogs but poses no health risks to humans according
to swine veterinarians. The price of front-month lean
hog futures contract on the Chicago Mercantile Exchange (
) has increased by more than 22% so far this year.
Kraft has been effective in reducing its per unit costs by
increasing production capacity through Lean Six Sigma based
enhancements of its manufacturing processes. During the recent
CAGNY presentation, Kraft CEO, Anthony Vernon, said that 28% of the
company's manufacturing facilities were now operating on
four-sigma, which yields 40% increase in productivity. This implies
an improvement of over 10% in the company's production capacity
since it launched this program. As a result, Kraft delivered net
productivity of around 3.3% of cost of goods sold (COGS) last year,
which was ~80 basis points higher than the company's long term
target of 2.5%. Kraft's productivity drive has enabled it to
mitigate the impact of commodity price inflation on its
profitability over the last couple of years. However, this might
not be an easy year for the company to replicate the same success
due to sharply higher input costs as discussed above.
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