Kraft Foods Group (NASDAQ:KRFT) is scheduled to announce its third quarter earnings on October 30. We will be closely watching the company’s top line performance in the grocery business where it lost market share during the first half of the year. We will also be focusing on the net impact of cost-savings from the ongoing productivity improvement program, and higher commodity and marketing costs on the company’s profitability.
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.
Our $61 price estimate for Kraft is about 10% above its current market price.
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Will Marketing Help Declining Grocery Sales?
By our estimates, Kraft’s grocery division makes up almost 40% of the company’s total 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 and Jell-O and Planters brands. 
However, Kraft faces stiff competition in the segment 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. The company has been under-performing 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. 
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.  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. 
Kraft’s Grocery sales, which declined by almost 4% y-o-y during the first six months of the year on heightened competition, have been a drag on the company’s overall performance.  We currently estimate Kraft’s grocery sales to decline by ~370 basis points for the full year, as we expect sequential growth in the division during the second half of the year as a result of increased marketing efforts. However, if the decline in grocery sales accelerates during the third quarter, there could be downside to our price estimate for the company.
Will Productivity Measures Offset Higher Costs?
Margin expansion has been the key to Kraft’s earnings growth over the last few quarters despite revenue pressures. 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 these measures delivered net productivity of over 2.5% of cost of goods sold (COGS), which is the company’s long term target. Continued focus on reducing overhead costs has also helped the company grow its profitability over the last few quarters. 
However, higher commodity costs are expected to put margins under pressure during the third quarter as the average producer price indices of dairy and meat products have been higher by almost 5% and 3% respectively. Moreover, increased marketing expenditure by the company to boost its grocery sales will also impact margins negatively. It will therefore be interesting to see if Kraft is able to sustain its higher margins during the third quarter.Notes: