Higher Input Prices Will Restrain Kraft’s Margin Outlook

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).

The company manufactures both food and beverages, with beverages accounting for about 13% of our $35.64 price estimate for Kraft’s stock, a premium to market price. Chocolate, candy & gum constitute around 32% of our price estimate, with snacks adding 18% and grocery representing another 17%.

Rising commodity costs is again the focus for Kraft following its recent earnings release, a concern we’ve previously examined (see: Rising Commodity Prices can Limit Kraft Upside).

Net Revenue Improvement During Q4 2010…

The company’s Q4 2010 net revenues increased by 30%, with full year revenues increasing 27%. For Kraft’s North American operations, operating income declined by almost 6% despite a 12% increas in revenues. The company believes that this was largely due to “a steep increase in input costs that more than offset the benefits of higher pricing, lower overheads, favorable volume/mix and productivity”. A similar trend was observed in Kraft’s European operations. Rising commodity prices, in addition to weak consumer spending in developed markets, could be a sustained concern during 2011. ^[1]

… but Economic Hurdles Remain

Stagnant economic conditions are making it difficult for companies like Kraft to offset the rising input costs by raising prices. In a recent release, the Bureau of Labor Statistics states that the unemployment rate in the U.S. for January remained around 9%, a decline of only 0.4% from December. Although economists project improvement during 2011, the unemployment rate is expected to remain high relative to historic norms. ^{[2] [3]}

Kraft has lowered its earnings forecasts for 2011 and expects revenue growth to be driven more by higher prices than higher volumes. With the market for packaged food being very competitive, many consumers are expected to shift to cheaper alternatives. A significant number of Kraft’s products in the U.S. and Europe have already seen price increases, with further hikes planned for 2011. ^[4]

EBITDA Margin Outlook for Kraft’s Snacks Division

Historically, the EBITDA margin for Kraft’s snacks division has declined when commodity prices have increased. This metric increased in 2009, when commodity prices cooled off after sharp increases a year earlier. We expect the EBITDA margin for Kraft’s snacks division (which stood around 13.6% in 2009) to increase by about 1% during our forecast period. However, the current trends discussed above may present downside to our forecasts. If the EBITDA margin for Kraft’s snacks division falls to 11% in 2011 and then continues to decrease by another percentage point during our forecast period, it would imply downside of around 8% to our $35.64 price estimate for Kraft’s stock.

1. Kraft Foods Reports Strong 4Q Growth [↩]
2. Bureau of Labor Statistics: Employment Situation Summary [↩]
3. Euro rises as Fed’s Bernanke expects US unemployment rate remains high [↩]
4. Kraft cuts profit goal, commodities weigh [↩]