Kraft Earnings Preview: Modest Revenue Growth, Thicker Margins Expected

Kraft Foods Group (NASDAQ:KRFT) is scheduled to announce its 2013 fourth quarter and full-year earnings on February 13. We expect the company’s earnings growth to be primarily driven by thicker operating margins amid modest revenue growth. Sales are expected to come under pressure from increased price-based competition, especially in the grocery segment. However, cost savings from productivity initiatives are expected to more than offset higher commodity prices, resulting in better operating margins for the company.

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 diluted earnings per share target of $3.58 for 2013.

Our $57 price estimate for Kraft is about 10% above its current market price.

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Lower Grocery Sales To Weigh On Top Line Growth

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. ^[1]

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 and increasing demand for labels that offer fresh, organic salad dressings. As a result, budget brands offered by Kraft are getting squeezed. Unilever also sold its salad dressings business, Wish Bone, to Pinnacle Foods last year. ^[2]

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. ^[3]

Because of weakness in salad dressings, gelatin desserts and other product categories, Kraft’s grocery sales declined by more than 5% y-o-y during the first nine months of 2013. However, we expect grocery sales to do slightly better during the fourth quarter as a result of increased marketing efforts by the company and easier y-o-y comparisons. ^[4] We currently project 2013 full-year grocery sales to decline by ~450 basis points y-o-y. However, if the decline in grocery sales accelerates during the fourth quarter, there could be some downside to our price estimate for the company.

Productivity Measures To Drive Thicker Margins

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 nine months of 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. We estimate that Kraft’s consolidated EBITDA margins improved by more than 140 basis points y-o-y during the first three quarters of 2013. ^[1]

However, higher commodity costs are expected to partially offset productivity gains for the company. Wholesale prices of dairy and meat products have been over 3.5% higher in 2013, compared to 2012. ^[5] This was also reflected in thinner operating margins for Kraft’s Cheese and Refrigerated Meals divisions during the first nine months of 2013. Apart from this, coffee prices also rose from their historically low levels during the fourth quarter, which is expected to weigh on the profitability of the Beverages segment as well. Moreover, 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 during the fourth quarter. However, for the full-year, we expect Kraft’s EBITDA margins to be almost 80 basis points higher y-o-y.

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1. Company SEC Filings, sec.gov [↩] [↩]
2. Salad Dressings Are Getting Squeezed, wsj.com [↩]
3. Kraft Launches Comeback Plan for Jell-O, adage.com [↩]
4. Q3 2013 Earnings Call Transcript, morningstar.com [↩]
5. Changes in Producer Price Indexes, 2012 through 2014, ers.usda.gov [↩]