Kraft Foods Group’s (NASDAQ:KRFT) 2013 fourth quarter and full-year earnings jumped on accounting gains due to market-based adjustments to the post employment benefit plan. The company earned $4.51 per diluted share for the full year compared to $2.75 per share in 2012. However, excluding the impact of accounting gains, EPS grew by just 3.3% y-o-y. 
Going forward, we expect Kraft to post modest revenue growth in 2014, as intense price-based competition in some of the Grocery product categories is expected to mostly offset pricing gains in the Cheese and Refrigerated Meals divisions. Additionally, we also expect company-wide adjusted EBITDA margins to remain relatively flat this year because of the offsetting impact of higher commodity prices in Beverages and Refrigerated Meals divisions, on the ongoing productivity and cost-savings program at the company.
We have updated our price estimate for Kraft to $56 per share based on the recent earnings release.
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Modest Revenue Growth
We believe that higher pricing would improve Kraft’s Cheese and Refrigerated Meals sales this year, as the company passes on increased commodity (dairy products and meat) costs to the consumers. However, heightened competition in the grocery segment is expected to mostly offset these gains.
The company’s organic net revenue declined marginally last year primarily due to the lackluster performance of its Enhancers and Snack Nuts division. In our analysis, we have combined this division with another reported division of the company, Meals and Desserts. The combined segment is referred to as the Grocery division. It includes our analysis of the company’s sales from products such as Cool Whip, Jell-O, Mac & Cheese, A1 steak sauce, and Planters nuts and peanut butter.
Kraft faces stiff competition in the grocery segment from private label manufacturers that compete primarily on pricing. This competition has intensified due to weak economic conditions over the past few years, as consumers increasingly look for cost saving options and are easily gravitated towards lower-priced brands. According to our estimates, the company’s grocery sales declined by ~3% y-o-y in 2013, led by salad dressings and gelatin desserts categories.
In the salad dressings category, Kraft has been under-performing not only because of the stiff competition from private label brands but also due to increasing demand for labels that offer fresh, organic salad dressings. As a result, budget brands offered by Kraft are getting squeezed. Similar circumstances prompted Unilever to sell off its salad dressings business, Wish Bone, to Pinnacle Foods last year.  During the fourth quarter earnings call, Kraft officials confirmed that sales in the category continue to remain weak and that there are no clear signs of improvement in the competitive environment as of now. 
On the other hand, sales of Jell-O, a very popular brand in North America that is generally used as a synonym for gelatin desserts, have also been declining over the past few quarters on not enough marketing push and tougher competition in the overall snacks category. While gelatin dessert mix sales remained almost flat, refrigerated pudding, mouse and gelatin sales fell ~20% over the last one year, according to IRI.  Kraft officials also confirmed that Jell-O sales continued to remain weak during the fourth quarter. However, they sounded confident of being able to revive the iconic brand this year on increased marketing push. 
Flat Margin Performance
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 100 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. In 2013, 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 partially offset productivity gains for the company this year. Wholesale prices of dairy and meat products rose over 3.5% y-o-y in 2013, which led to thinner margins in Kraft’s Cheese and Refrigerated Meals divisions as pricing gains did not fully offset the increase in costs.  This is because there is usually some lag between input cost inflation and pricing measures in the food and beverage industry, as commodity prices are highly volatile.
The U.S. Department of Agriculture expects wholesale dairy product prices to remain largely stable this year, which could improve operating margins of Kraft’s Cheese division as the company slowly passes on higher costs to the consumers. However, wholesale meat prices are expected to continue to rise this year as well. This along with intense competition from private label brands does not bode well for operating margins of the Refrigerated Meals division this year.
Apart from this, coffee prices have also been on a rise recently from their historically low levels last year. This is expected to weigh on the profitability of the Beverages division. Also, increased marketing expenditure by Kraft to boost its grocery sales is also expected to impact margins negatively. Therefore, margin expansion might not be an easy task for the company in 2014.Notes:
- Earnings Release, kraftfoodsgroup.com [↩]
- Salad Dressings Are Getting Squeezed, wsj.com [↩]
- Q4 2013 Earnings Call Presentation, kraftfoodsgroup.com [↩] [↩]
- Kraft Launches Comeback Plan for Jell-O, adage.com [↩]
- Company SEC Filings, sec.gov [↩]
- Changes in Producer Price Indexes, 2012 through 2014, ers.usda.gov [↩]