Kraft Foods Group (NASDAQ:KRFT) is scheduled to announce its 2014 second quarter earnings on July 30. We expect increased price-based competition in the grocery segment and higher commodity prices to weigh on the company’s earnings growth. However, cost savings from productivity initiatives and pricing actions in cheese, coffee and refrigerated meat categories could partially offset the impact of higher input costs on its margins.
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 sales revenue of around $18 billion with a consolidated adjusted EBITDA margin of ~20.5%.
We currently have a $61/share price estimate for Kraft Foods Group, which is almost 13.7x our 2014 full-year GAAP diluted EPS estimate for the company.
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Higher Commodity Costs
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 $21.5 per hundred pounds, up almost 15% this year. 
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 more than 60% so far this year. 
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 27% so far this year. 
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 this year. During the first quarter 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 this year. The company also implemented a 10% price hike across 50% of its Oscar Mayer cold cuts portfolio on May 25.  Early last month, Kraft also raised prices for its Maxwell House and Yuban roast and ground coffee brands by around 10% on an average. 
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 she believes it would be mostly offset by marketing and brand renovating activities that the company would be taking up simultaneously. 
Lower Grocery Sales
We believe that higher net pricing would improve Kraft’s cheese, coffee, and refrigerated meals sales revenue during the second quarter since the company has passed on some of the increase in commodity costs on these products to end consumers. However, heightened price-based competition in the grocery segment is expected to partially offset these gains.
The company’s organic net revenue declined by 2.4% y-o-y during the first quarter, primarily because of the lackluster performance of its Enhancers and Snack Nuts and Meals & Desserts divisions. In our analysis, we have combined these two divisions together. 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 organic net revenue from grocery sales declined by around 6.4% y-o-y during the first quarter of this year. We are expecting a similar performance from the division during the second quarter as well. (See: Price-Based Competition In The Grocery Segment Weighs On Kraft)Notes: