Kraft Earnings Preview: Pricing, Cost Pressures Could Mute Earnings Growth
Kraft Foods Group ( KRFT ) 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 ~20.5%.
Our $55 price estimate for Kraft is about 5% below its current market price.
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 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.
- Dairy Products: 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 month 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 Beans: 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 coffee prices continued to remain high for the rest of the year, it could dent margins of the company's Beverages unit.
- Meat Products: 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 ( CME ) 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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