Managing commodity costs and ensuring pricing while maintaining market share has preoccupied the Kraft Foods Group (NYSE: KRFT) management’s mind during the first half of this year. The third quarter is expected to be no different. In our analysis of Kraft’s second quarter earnings, we had taken note of the deleterious impact of the record high commodity costs on the company’s earnings (See Commodity Cost Pressures Weigh On Kraft’s Earnings). These commodity prices continue to soar, making us skeptical of improvements on this front in Kraft’s Q3 earnings. What we look forward to is assessing the impact of sales execution on gross margins.
Our valuation of Kraft Foods Group stands at $66 a share compared to a market price of ~$57.
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Record High Commodity Costs
Three commodity prices to watch out for here are milk, cheese and coffee. Milk prices hit a record high in September at $25.00 per unit for Class III milk futures. This more than 16% higher than the second quarter high of about $21.50. We have written earlier on the boost to the U.S. milk export due to demand from emerging economies, especially China.  The domestic consumption too had hit a record high 93.4 million metric tons of milk in the U.S. We have also identified that consumption of imported milk in China 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.
However, the export of milk from the U.S. has cooled down.  If the futures prices of milk is anything to go by, milk prices can be expected to decrease and reach $18 per unit in 2015. This is based on the price of the Class 3 milk futures quoted earlier as well.  However, there was no reprieve for Kraft from higher milk prices in Q3, and this is almost certain to affect the earnings badly. Looking at the price of cheese, after an initial decline in July, there has been an uptrend that has seen it go from $2.00 per unit to $2.40 this quarter. That represents a quarterly increase of 20%.  Combined with the increase in the price of milk, this will reduce the cheese division EBITDA margin if the price increases were not passed on completely to the consumers.
We have written earlier on the influence of coffee prices on Kraft (See How Will Coffee Prices Affect Kraft). Kraft Foods’ beverages division, which according to our estimates, constitutes 11.6% of the value of the stock price, has coffee as a major raw material. Coffee prices have shown a sustained increase for the most part of Q3, rising from $165 per unit to a high of $215, with a short-lived decline towards mid-September.  The high coffee prices are likely to have a negative effect on the profitability of this division and hence of the company’s Q3 earnings.
Mixed Results From Meat And Grain Prices
Pork and beef are two meat commodities whose prices affects Kraft’s profitability. They are major raw materials for Kraft’s refrigerated meals division, and are sold under the Oscar Mayer brand name. Oscar Mayer is the most popular frozen food brand of Kraft in the U.S. and Canada generating more than $500 million in annual sales. Pork prices took a roughly 28% drop from mid-July to early September. It has only been recovering gradually.  This can have a beneficial impact for this division’s EBITDA if prices to customers can be maintained. Beef, on the other hand has shown a significant and steady increase from $2.00 per pound to $2.70 in Q3. This 35% increase can work against the company, reducing the EBITDA margin for the refrigerated meals division. 
Yet another division whose profitability depends on commodity prices is the groceries division. Kraft’s Grocery division primarily produces crackers, salted snacks, biscuits and nuts. Cereal grains such as wheat are an important input to this division. Wheat prices declined about 20% this quarter, going from about $600 per unit to $480.  This cost saving may improve the EBITDA of this divsion.
Looking Forward To The Performance In Sales Execution
Preserving and enhancing market share in the presence of rising costs has proven challenging for Kraft in the first half of this year. Kraft foods overall market share in the first half of this year was 60%, but the Q2 contribution to this figure was less at only 50% market share in that quarter. The reduction in market share is believed to be on account of price increases in response to rising commodity costs. Half of its product portfolio saw price increase in Q2, and of these, 40% were double digit increases. This could lead to Kraft’s organic revenue growth trailing the industry.
Gross margin in the first half of the year suffered from over-promotion. As elaborated upon by the company’s CEO during their Q2 earnings call, this was due to a tendency to make up for temporary short-falls in gross revenue by aggressive price discounting to boost sales. This has led to under-performance on pricing net of commodity (PNOC) costs, thereby compromising on the preservation of a healthy gross margin. While the management had promised action on this front, it remains to be seen whether there has been any improvement in the promotional efficiency and optimization of couponing.
In the Q2 earnings call, the management had hinted at how the stacking up of discount coupons obtained through online promotional activity was leading to the consumers getting more discounts than the company would ideally give. There was also mention of taking a long-term view and favoring product and process innovation to drive sales, rather than resorting to price discounting. 
Given the significant and unfavorable change in commodity prices, we believe it will prove difficult for the company to defend its gross margins. The promotions and discounts are unlikely to have been reduced significantly, given the cost pressures. The only silver lining for the company is an improvement in the consumer purchases in Q3, which grew 2%, up from 1.5% in Q2.  However, even this was disappointing considering the expectation was for 2.1%. For Kraft Foods, Bloomberg Businessweek has an analysts consensus estimate of $0.75 earnings per share (EPS) for Q3 2014.
View Interactive Institutional Research (Powered by Trefis):Notes:
- Latest Price And Chart For Class 3 Milk [↩]
- See Higher Commodity costs to Weigh On Kraft’s Margin [↩]
- U.S. Exporters Face Rougher Sailing In August [↩]
- U.S. Milk Prices Hit Record High [↩]
- Cheese Cash Settled October 2014 Future [↩]
- Latest Price And Chart For Coffee [↩]
- CME Lean Hog Index [↩]
- Beef Monthly Price [↩]
- Latest Price And Chart For Wheat [↩]
- Kraft Foods Company Q2 Earnings Call Transcript [↩]
- Consumers Spending More [↩]