Commodity Cost Pressures Weigh On Kraft’s Second Quarter Earnings

Kraft Foods Group’s (NASDAQ:KRFT) second quarter earnings growth was muted by increased commodity costs that more than offset the impact of price increases. The company’s reported earnings per share (EPS) for the quarter declined by over 42% y-o-y to just $0.80. However, EPS adjusted for the one-time benefit realized by the company from market-based adjustments to the post-employment benefit plan last year came out almost flat year-on-year. ^[1]

Kraft’s second quarter organic net revenues increased by around 1.5% y-o-y, primarily due to the shift in the timing of Easter-related shipments, compared to last year when Easter fell during the first quarter. However, if we look at the company’s top-line performance during the first six months of the year, which evens out the impact of Easter timing, organic net revenues were down by around 0.4%, compared to last year, as volume declines more than offset the impact of pricing actions.

Kraft has taken pricing actions on a large chunk of its portfolio this year in order to sustain its margins amid rising input costs. However, the company’s second quarter gross margin was down significantly compared to last year as higher dairy, meat and coffee prices more than offset the impact of these pricing actions. On the brighter side, Kraft’s sharp focus on improving its productivity and reducing the overhead costs has helped it largely mitigated the impact of steep commodity inflation on its cash operating margins so far this year. While the company’s gross margin declined by more than 300 basis points during the first six months of this year, its adjusted EBITDA margin has remained almost flat over the same period, by our estimates.

Going forward, we expect Kraft’s top-line performance during the next six months of the year to be almost similar to what we have seen in the first half. However, the decline in its gross margin is expected to moderate as the year progresses, primarily due to the impact of pricing actions, which were mostly announced and implemented during the second quarter.

Based on the recent earnings announcement, we have revised our price estimate for Kraft Foods Group to $66/share, which is almost 14.7x our 2014 full-year GAAP diluted EPS estimate for the company. Most of the increase in our price estimate for Kraft can be attributed to the fact that we have extended our forecast period for the company and are now discounting its cash flows to the mid of next year. This basically implies that we have adjusted our price estimate for Kraft to reflect what its intrinsic value should be about a year from now.

See Our Complete Analysis For Kraft Foods Group

Pricing Actions, Cost Savings To Reduce Margin Pressures

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. On the other hand, coffee prices have also been steep, as one of the worst droughts in the history of Brazil has hit the country’s coffee plantations this year, leading to a downward revision in production forecasts. Furthermore, the prices of meat commodity products such as pork and beef have also been on an uptrend recently due to supply shortages. (See: Higher Commodity Costs To Weigh On Kraft’s Margins This Year)

This does not bode well for Kraft since it uses large quantities of these commodities as raw materials. Therefore, in order to tone down the impact of higher input costs on its gross margins, the company has either announced or implemented price increases across more than 50% of its product portfolio. During the second 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. Since most of these pricing actions were taken by the company during the second quarter, we expect the decline in Kraft’s gross margins to moderate in the coming quarters. ^[2]

We also expect the company’s operating margins to improve over the next few quarter on continued productivity improvements and reduction in overhead costs. Kraft’s productivity drive has enabled it to mitigate the impact of commodity price inflation on its profitability over the last couple of years. The company has been effective in reducing its per unit costs by increasing production capacity through Lean Six Sigma based enhancements of its manufacturing processes. During the recent CAGNY presentation, Kraft CEO, Anthony Vernon, said that 28% of the company’s manufacturing facilities were now operating on four-sigma, which yields 40% increase in productivity. This implies an improvement of over 10% in the company’s production capacity since it launched this program. As a result, Kraft delivered net productivity of around 3.3% of cost of goods sold (COGS) last year, which was ~80 basis points higher than the company’s long term target of 2.5%. ^[3]

Apart from Lean Six Sigma based enhancements, Kraft has also been focusing on a lot of other measures to reduce total operating costs. For example, in the procurement of cashews used for manufacturing Planters, the company has formed a strategic partnership to create a seamless supply chain from the producer to its plants, which would reduce the breakage of cashews by around 80% and increase the yield of whole cashews. Kraft is working on a number of such cost cutting opportunities to reduce total operating costs. Although the impact of these measures might not reflect in its operating margins this year, due to sharply higher input costs, we believe that these would eventually pay off in the long run as commodity prices cool down. ^[4]

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1. Kraft Foods Group Reports Second Quarter 2014 Results, kraftfoodsgroup.com [↩]
2. Kraft Foods Group Second Quarter 2014 Earnings Conference Call, kraftfoodsgroup.com [↩]
3. Kraft Foods Group, Inc. to present at Consumer Analyst Group of New York Conference, kraftfoodsgroup.com [↩]
4. First Quarter Earnings Call, kraftfoodsgroup.com [↩]