How Valuable Is Kraft’s Grocery Business?

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, the division that primarily produces crackers, salted snacks, biscuits and nuts has been under pressure over the past few quarters due to heightened competition in certain categories. Here we provide an overview of the key value drivers and challenges to growth for Kraft’s grocery business.

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.

See Our Complete Analysis For Kraft Foods Group

Key Value Drivers

1. Growing Grocery Market

We expect the grocery market in the U.S. to grow at around 3-4% CAGR in the long run on growing consumer expenditure on food items and higher employment rates along with improving consumer confidence. According to the latest statistics released by the Bureau of Labor Statistics (BLS), average consumer expenditure on food items has increased by ~8% over the last 3 years. ^[1]

The consumer confidence index and non-farm employment growth have also been improving at a steady rate in the U.S. According to data compiled by Technomic, the consumer confidence index and employment growth for July 2013 at 80.3 and 1.7%, respectively, were a significant improvement over 2010 levels.

2. High Profit Margins

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 (a measure of profitability) 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.

Moreover, Kraft has also been able to expand its margins in the grocery business by ~300 basis points since 2010, according to our estimates. 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 the year these measures delivered net productivity of over 2.5% of cost of goods sold (COGS), which is the company’s long-term target. ^[2] We believe that a continued focus on productivity improvements and reducing overhead costs will help the company sustain its high profit margins from the grocery business.

3. Successful New Products

By our estimates, Kraft controls around 25% of the grocery market in the U.S., and realizes that the success of new products is the key to sustain its high market share in the long run. The company has delivered quite well on this agenda over the last couple of years. It launched Velveeta cheesy skillets in 2011, which captured 8% of the dry dinner mixes market within 3 months of its launch. ^[3] Revenues from the product were up more than 30% year-on-year during the first quarter and continued their double-digit growth during the second quarter as well. ^[4]

The fact that Velveeta cheesy skillets recorded double-digit growth throughout 2012 alongside Kraft’s widely popular mac and cheese brand suggests that the company has really been able to strike a chord with consumers in the dry dinner mixes category. 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.

Key Challenges to Growth

1. Stiff Competition

Kraft faces stiff competition from private label manufacturers that compete primarily on pricing. This competition has intensified due to weak economic conditions as consumers increasingly look for cost saving options and are attracted to the lower-priced brands. Price-based competition has impacted the performance of Kraft’s grocery division recently. Grocery sales, which declined by almost 4% y-o-y during the first six months of the year, have been a drag on the company’s overall performance. ^[2]

Kraft has been underperforming in the salad dressings category 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. Unilever also recently sold off its salad dressings business, Wish Bone, to Pinnacle Foods. ^[5]

Sales of Jell-O, 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. ^[6] 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 in order to boost sales. ^[3]

2. Cost Pressures

Volatile commodity costs remain the single biggest threat to the profitability of Kraft’s grocery business. The company uses commodities including dairy products, coffee beans, meat products, wheat, corn products, soybean and vegetable oils, nuts, sugar and other sweeteners as raw materials. According to the Bureau of Labor Statistics, the prices of milk have risen at a CAGR of 4%, beef prices have shot up at a CAGR of 6% while the prices of coffee and chicken have risen at a CAGR of 15% and 5% respectively, over the period of last three years. Not only this, the company is also expected to increase investments in innovation and promotional strategies for new products as it tries to maintain and advance its market share in the key categories. In 2012, the company’s advertisement costs were up by around 20% y-o-y. ^[2] This is expected to put additional downward pressure on margins going forward.

We currently have $61 price estimate for Kraft Foods Group, which is almost 10% above the current market price. Our estimate implies that the Grocery business is worth around $14 billion looking at the sum of the parts of its valuation.

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

1. Consumer Expenditures–2012, www.bls.gov [↩]
2. Company SEC Filings, sec.gov [↩] [↩] [↩]
3. Velveeta Boosts Sales with Cheesy Skillets, fooddigital.com [↩] [↩]
4. Q2 2013 Earnings Call Presentation, ir.kraftfoodsgroup.com [↩]
5. Salad Dressings Are Getting Squeezed, wsj.com [↩]
6. Kraft Launches Comeback Plan for Jell-O, adage.com [↩]