Higher Commodity Costs To Weigh On Kraft’s Margins This Year

by Trefis Team
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Kraft Foods
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Margin expansion has been the key to Kraft Foods Group’s (NASDAQ:KRFT) 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.

We currently have $55 price estimate for Kraft, which is almost in line with its current market price.

Productivity Improvements

Kraft has been effective in reducing its per unit costs by increasing the 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 that we discuss below. [1]

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 $23.3 per hundred pounds, up ~29% 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. [2]
  • 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 70% 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. [3]
  • 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 36% so far this year. [4] On the other hand, beef prices continue to trend higher as a result of the severe drought in the U.S. in 2012, which reduced the nation’s cattle herd to its smallest size in six decades at the beginning of last year. Beef prices are expected to remain high over the next couple of years as it generally takes around 12-18 months for new calves, which take around 9 months to deliver, to become slaughter-ready. The price of front-month live cattle futures contract on the CME has increased by around 7% so far this year. [5]

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Notes:
  1. Kraft Foods Group, Inc. to present at Consumer Analyst Group of New York Conference, kraftfoodsgroup.com []
  2. Asian Demand For Milk Shakes Up Market, wsj.com []
  3. Brazilian Drought Jolts Commodities’ Prices, wsj.com []
  4. Cattle Prices Jump To Record High, wsj.com []
  5. Pricey Beef Is Set To Test Appetites, wsj.com []
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