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Higher Commodity Costs To Weigh On Kraft's Margins This Year

By: Trefis
Posted: 3/28/2014 1:54:00 PM
Referenced Stocks: KRFT;CME;HSH

Margin expansion has been the key to Kraft Foods Group's ( KRFT ) 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 prices.

We currently have $55 price estimate for Kraft , which is almost in line with its current market price.

Productivity Improvements

Kraft has been effective in reducing its per unit costs by increasing the 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 that we discuss below.

Soaring Commodity Prices

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.

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