Rising Commodity Prices Could Limit Kraft Upside

Kraft Foods (NYSE:KFT) is the world’s second largest food and beverage company after competitor Nestlé (OTC:NSRGY). It also competes with PepsiCo (NYSE:PEP), General Mills (NYSE:GIS) and Kellogg (NYSE:K). Although the company manufactures both food and beverages, beverages account for only about 13% of our $35.64 price estimate for Kraft’s stock which is around 13% higher than the current market price.

We believe that Kraft’s beverages business could see market share gains as the economy improves and consumer spending on premium beverage products increases.  We’ve previously discussed how continuing economic recovery could lift Kraft’s stock value. (Kraft’s Beverage Share Can Improve With Economy)

Rising Commodity Prices Could Hamper Profit Margin Recovery

Beverages profit margin (measured by EBITDA margin) witnessed a decline from 21% in 2003 to 10% in 2008 before picking up again in 2009. Increasing expenses, rising prices of raw materials and not being able to pass on these rising costs to consumers have resulted in erosion of Kraft’s beverages profit margin. With large scale adoption of cost-cutting measures, we expect beverages EBITDA profit margin to increase going forward, reaching just under 15% by the end of our forecast period.

However, rising commodity costs could be a roadblock to this path, as commodity prices are expected to continue to increase into 2011. This would translate into higher input costs resulting in lower profit margins for Kraft. And, if Kraft tries to offset rising input costs with price increases, the price increase creates no real upside to company’s profitability. ^[1]

Market Share Estimates

Kraft’s share of the global beverage market increased from 13% in 2005 to 15% in 2008. This can be attributed to the shift of consumers from high calorie carbonated drinks to healthy and nutritious juice drinks. 2009 saw a decline in market share as an effect of the recessionary environment in the US. Going forward, as the economic environment improves, we expect Kraft to grow its market share and reach 14.5% by the end of the Trefis forecast period.

However, as a result of the increasing input costs, Kraft and other premium food manufacturers have already begun to raise prices. As a result, consumers can easily shift to less premium brands in the highly competitive beverages industry. Kraft already faces stiff competition from private label manufacturers. This competition has intensified during recessionary times and as consumers looking for cost savings are increasingly attracted to other brands that are lower-priced, and these brands are scaling up their operations in order to gain market share.

The issue of increasing commodity prices can have a two-fold impact on our forecasts, impacting: 1) our forecasts for beverages profit margin and 2) Kraft global market share in beverages, as discussed above.

If these two fall to around 12% and 13% respectively by the end of 2011 it would mean nearly 5%  downside to our price estimate for Kraft’s stock.

1. Tight Markets Seen for Coffee, Sugar, Cotton, WSJ, Jan 1, 2011 [↩]