3 Key Trends Impacting Our $61 Price Estimate for Kraft Foods Group

Kraft Foods Group (NASDAQ:KRFT) manufactures and markets packaged food products, including cheeses, convenient meals, beverages, 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 sales revenue of around $18 billion with a consolidated adjusted EBITDA margin of ~20.5%. We recently revised our price estimate for Kraft Foods Group to $61/share, which is almost 13.7x our 2014 full-year GAAP diluted EPS estimate for the company. Here, we discuss the 3 key trends impacting our valuation estimate for the company.

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Commodity Cost Pressures

Food commodity prices in the U.S., mainly dairy products, coffee beans, and meat products have been on fire this year. Raw milk prices 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 $22.6 per hundred pounds, up ~20% this year. ^[1]

On the other hand, 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 67% so far this year. ^[2]

In addition, prices of commodity meat products such as pork and beef have also been on an uptrend recently. Hog prices have been high due to a shortage in supply of slaughter-ready pigs because of the porcine epidemic diarrhea virus or PEDv, which 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 around 20% so far this year. ^[3]

Kraft uses large quantities of these commodities as raw materials. In order to tone down the impact of higher input costs on its operating margins, the company has either announced or implemented price increases across 45% of its product portfolio. During the latest earnings call, Kraft’s EVP and CFO, Teri List-Stoll mentioned that the company had increased prices of its cheese products by 5-12% in March. The company also plans to implement a 10% price hike across 50% of its Oscar Mayer cold cuts portfolio on May 25. Although Kraft has not raised its coffee prices so far this year, we expect that to follow in the next couple of months as well. ^[4]

Interestingly, in a vast majority of price increases announced and implemented so far, Kraft has been leading its competitors. This could potentially erode the company’s market share in some product categories. This is because some players in the industry are hedged in certain commodities, which partly insulates them from the impact of a sudden jump in prices of those commodities. So, a leading pricing measure generally erodes a company’s volume share, which is not always easy to regain and requires investments in advertising and marketing later on. Kraft’s CFO agrees that there would be some “dislocation” in market share in the short term, but it would be mostly offset by marketing and brand renovating activities that the company would be taking up simultaneously. ^[4]

The Rise Of Private Labels

The most prominent trend in the grocery segment has been the surge of private label brands over the past few years. It kicked in when the U.S. economy entered into a recession in 2009, forcing consumers with reduced spending capacity to opt for cheaper grocery brands. However, despite a significant recovery in the U.S. economy since 2009, the private label brands continue to attract consumers, resulting in intense price-based competition for national brands including those offered by Kraft.

The effect of this trend was visible in Kraft’s 2013 results. According to our estimates, the company’s grocery sales declined by ~3% y-o-y last year, led by salad dressings and gelatin desserts categories. ^[5] In the salad dressings category, Kraft suffered not only because of the stiff competition from private label brands but also due to the growing demand for labels that offer fresh, organic salad dressings. As a result of which Kraft’s budget brands got squeezed. The company ramped up advertising behind its salad dressing products this year and is seeing some improvement in sales. However, sales of Jell-O, a very popular brand in North America that is generally used as a synonym for gelatin desserts, continue to remain weak despite the ongoing marketing campaign that went on the air November last year. ^[4]

This could be partly attributed to the fact that the private labels have not only worked a lot on improving the quality of their products, but also on building their brand equity through investments in innovation, packaging and consumer engagement. Additionally, the lower-income consumers that have not bounced back as much as the ones in the higher income bracket, continue to remain cautious of their food budget. According to Nielsen, sales of private label brands have grown more than twice as fast over the past three years, compared to the national brands. ^[6]

This has put considerable pricing pressure on Kraft. According to our estimates, the company’s value share in the grocery market has declined by more than 180 basis points since 2010, at an average rate of around a 60 basis points per year. ^[5] If this rate were to continue in the long run, there could be around 10% downside to our price estimate for the company. However, we currently expect the decline in Kraft’s grocery market share to subside over the next couple of years as the pricing gap between private labels and national brands narrows and the company increases its marketing push behind the ailing brands. Currently, private labels are priced at around 20-25% lower than the national brands on an average. The price gap has already come down quite a bit over the past few years, as prices of the private label brands have increased at a much faster rate. ^[7]

Productivity Improvements

Kraft’s productivity drive has enabled it to mitigate the impact of commodity price inflation on its profitability over the last couple of years. The company has been effective in reducing its per unit costs by increasing 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%. ^[8]

Apart from Lean Six Sigma based enhancements, Kraft has also been focusing on a lot of other measures to reduce total operating costs. For example, in the procurement of cashews used for manufacturing Planters, the company has formed a strategic partnership to create a seamless supply chain from the producer to its plants, which would reduce the breakage of cashews by around 80% and increase the yield of whole cashews. It is working on a number of such cost cutting opportunities to reduce total operating costs. Although it might not reflect in its operating margins this year, due to sharply higher input costs, we believe that it would pay off in the long run as commodity prices cool down. ^[4]

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1. Asian Demand For Milk Shakes Up Market, wsj.com [↩]
2. Brazilian Drought Jolts Commodities’ Prices, wsj.com [↩]
3. Cattle Prices Jump To Record High, wsj.com [↩]
4. First Quarter Earnings Call, kraftfoodsgroup.com [↩] [↩] [↩] [↩]
5. Kraft Foods Group SEC Filings, sec.gov [↩] [↩]
6. Groceries Are Cleaning Up in Store-Brand Aisles, nytimes.com [↩]
7. Private Labels Borrow Brand Tactics To Grow Market Share, foodnavigator.com [↩]
8. Kraft Foods Group, Inc. to present at Consumer Analyst Group of New York Conference, kraftfoodsgroup.com [↩]