Kraft’s Sustained Weakness In Its Grocery Business Can Hamper Growth

The grocery segment is the most profitable business for Kraft Foods Group (NASDAQ:KRFT) and also generates the highest revenues for the company. According to our estimates, the division makes up ~40% of the company’s total value. However, it has been under pressure over the past few quarters due to heightened competition in certain categories and lighter marketing push behind some brands.

Salad dressings and refrigerated gelatin desserts are the main trouble points for Kraft right now. While the former category is seeing increased private label penetration, the latter has suffered primarily due to reduced marketing investments. The expectation that the company’s ongoing productivity improvement and overhead cost cutting plans will mostly offset margin pressures from lower prices and higher marketing costs is included in our $61 price estimate for Kraft. We also expect growing new product revenues to partially offset the current weakness in salad dressings category. However, the sustained decline in salad dressings sales and a tepid response to the company’s new marketing initiatives will magnify the downward risk to our estimates.

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 revenues topping $18 billion and has guided for adjusted earnings per share target of $2.78 for 2013. ^[1]

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Grocery Troubles

By our estimates, Kraft’s grocery division makes up almost 40% of the company’s value while it contributes just about 25% to its consolidated revenues. This is because Kraft earns healthy margins on the sale of its grocery line of products. The division’s adjusted EBITDA at over 30% is over one and a half times the company’s consolidated figure of ~20%. Higher margins are a result of some very popular grocery brands operated by the company, such as its namesake Mac and Cheese, Jell-O and Planters.

However, the performance of Kraft’s grocery division has been lackluster recently due to market share declines in dressings and dessert categories. Grocery sales, which have declined by almost 4% y-o-y during the first six months of the year, have been a drag on the company’s top line performance. Kraft attributed heightened competition in the salad dressings category and lack of marketing push for its Jell-O brand as the key reasons behind this decline in revenues. ^[2]

Kraft’s underperformance in the salad dressings category is primarily due to stiff competition from private label brands on one hand and increasing demand for labels that offer fresh, organic salad dressings on the other hand. As a result, budget brands offered by Kraft are getting squeezed. Even Unilever recently sold off its salad dressings business, Wish Bone, to Pinnacle Foods. ^[3]

Jell-O sales, a very popular brand in North America that is generally used as a synonym for gelatin desserts, have also declined over the past few quarters on not enough marketing push and tougher competition in the snacks category. While gelatin dessert mix sales have remained almost flat, refrigerated pudding, mouse and gelatin sales fell ~20% over the last one year, according to IRI. ^[4]

Solutions At Work

Kraft has increased its focus on marketing investments in order to bring the grocery business back on track. The company’s CEO mentioned during the second quarter earnings call that two-third of the division’s brands are going to be on air during the third quarter. Its Jell-O and Planters advertisements have already started airing. ^[5] The company is also banking on new product innovation. While its Velveeta cheesy skillets continue to perform well, Kraft also launched Recipe Makers in the convenient dinner category recently. Recipe Makers is a line of meal starters that comes with two sauces, which can be easily added to fresh ingredients to complete the meal.

Moreover, the company also decided to split its largest division into two for enhanced focus on development and marketing of similar products. Jell-O, Cool Whip, Velveeta dinners and Kraft Mac & Cheese, and a few other brands will be a part of a new meals and desserts division, while the enhancers and nuts division will include Planters, A-1 and Kraft and Good Seasons salad dressings. Although this is more of a structural change, it will definitely help the company in deploying more focused marketing strategies for products that fall under similar categories.

Potential Downside

We currently expect Kraft’s grocery market share to decline by ~100 basis points in the long run as revenue growth from new products is expected to partially offset the decline in salad dressing sales. Moreover, higher marketing investment is also expected to boost the sales of its popular grocery brands such as Planters and Jell-O.

We also expect margin pressures due to lower prices and higher marketing costs to be mostly offset by the company’s ongoing productivity and overhead cost reduction plans. According to our estimates, the company’s adjusted EBITDA margins have expanded by almost 250 basis points since 2010. Most of these profitability gains have come from productivity enhancements in supply chain and manufacturing processes based on Lean Six Sigma principles. During the first six months of this year, these measures delivered net productivity of over 2.5% of cost of goods sold (COGS), which is the company’s long-term target. As a result, the company’s gross margins were down by just 30 basis points despite lower selling prices due to promotional offers and higher input commodity costs, especially in the cheese division. Continued focus on reducing overhead costs will also help the company grow its profitability.

However, sustained pricing pressures amid weakness in the salad dressings business and tepid consumer response to new marketing measures pose substantial downward risk to our estimates, as they might result in lower market share and thinner margins in the long run. If we assume that Kraft’s Grocery market share as well as EBITDA margins will both decline by ~200 basis points in the long run, it implies ~10% downside to our current $61 price estimate for the company.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. Kraft Foods Group Reports Second Quarter 2013 Results, ir.kraftfoodsgroup.com [↩]
2. Q2 2013 Earnings Call Presentation, ir.kraftfoodsgroup.com [↩]
3. Salad Dressings Are Getting Squeezed, wsj.com [↩]
4. Kraft Launches Comeback Plan for Jell-O, adage.com [↩]
5. Mr. Peanut Takes to the Airwaves to Show the “Power of the Peanut”, finance.yahoo.com [↩]