A Difficult Operating Environment Leads To A Lacklustre Q3 For Kraft Foods

In our pre-earnings article for Kraft Foods Group (NYSE: KRFT), we had reflected on how rising commodity costs will make it difficult for the company to defend its gross margins. ^[1] This has proved to be the case, as gross profits in Q3 2014 declined 13.1% when compared to the figures in Q3 2013. Kraft’s Q3 2014 EPS came in at $0.74 a share, a cent down from the Bloomberg Businessweek analysts consensus estimate of $0.75. This included a 3¢ loss on account of market movements affecting its post-employment benefit plans corpus. Unfavorable volume changes due to price increases and changes in consumer behavior, led the net revenues to fall from its Q2 level of $4.75 billion to $4.4 billion. ^[2]

Our valuation of Kraft Foods Group stands at $66 a share compared to a market price of ~$57.

See Our Complete Analysis For Kraft Foods Group

Rising Commodity Costs

The rise in commodity prices affected the cheese products sales most badly. Milk prices hit a record high in September at $25.00 per unit for Class III milk futures. This is 16% higher than the second quarter high of about $21.50. 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 has reduced the cheese divisions profit margin as pricing was done early in expectation that these commodity prices would stabilize, but they continued to be volatile.

Sales And Marketing Execution Issues

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. This quarter there was some moderation in the effect of such coupon stacking and trade offers. The management commented that it was difficult to curb it sufficiently when the purchasing power of consumers wasn’t sufficiently high. ^[3]

The company reported a double digit decline in its Sales, General and Administrative (SG&A) expenses. In the conference call, the management identified three drivers of this reduction. The first was the decrease in advertising expenditure in Q3, year on year. Secondly, consumer spending declined as in-store activity was less and finally the third cause was the reduction in overheads.

What To Look Forward To For The Rest Of The Year

We have written in our pre-earnings report that milk prices are expected to cool going into 2015. Based on milk future prices, it could decrease to $18 per unit next year. If this decrease moves ahead in time a bit, Kraft may yet be able to end 2014 on a positive note than an indifferent one. Falling gas prices, it is hoped, will improve consumers ability to spend on food and beverage. As noted by the Kraft CEO, gas prices remain high in certain places whereas they have fallen elsewhere.

Kraft has promised action to address execution issues that plagued it this year. These issues were for the most part relating to recalls in cheese products. The company has decided to add more quality experts, conduct audits more frequently and not be pressurized by deadlines to launch products.

For 2014, the Trefis model sees revenues of $18.1 billion for Kraft, as opposed to an analysts consensus of $18.3 at Bloomberg Businessweek.

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1. Kraft Food Third Quarter Earnings Preview [↩]
2. Kraft Foods Q3 Earnings [↩]
3. Kraft Foods Group Q3 Earnings Conference Call Transcript, seekingalpha.com [↩]