We reiterate our long-term recommendation on Kraft Foods Inc. (KFT) based on the weak economic cues that give way to operating and financial leverage risk, lowering of market share coupled with high coffee prices.
The company reported second-quarter income from continuing operations of 55 cents per share, missing the Zacks Consensus Estimate of 58 cents per share by 5.4%. Kraft Foods’ operating income grew 4.4% to $1.9 billion reflecting favorable currency, volume/mix gains and lower overheads.
However, operating income margin declined 120 basis points from the prior year quarter to 14.0%, essentially due to the negative impact of pricing on the margin calculation.
Revenues in the quarter soared 13.3% to $13.9 billion, while organic growth was 7.1% driven by strong top line growth in all regions. Pricing accounted for 5.5 percentage points of growth and volume and mix contributed 1.6 percentage points. However, Easter related shipments partially offset the growth by 1.5 percentage points.
Revenue grew in each of the geographies with the Europe Markets leading the race with an increase in revenue of 26.2%. It was followed by an increase of 22.3% in Developing Markets and 2.5% in North America.
In light of the second quarter results the company expects to have an organic net revenue growth of at least 5%. Management expects the operating EPS to be at least $2.25.
We are encouraged to see that Krafts has strengthened its business model through investments in quality upgrades, promotions and marketing. Further, to make its products more relevant and contemporary, the company has modernized its base business and strengthened its category mix through various acquisitions, divestitures and product pruning over the last few years.
These initiatives have enabled Kraft to enjoy more pricing power and improve product positioning versus lower-priced private label brands.
Additionally, Kraft’s cost reduction program called Lean Six Sigma program has proved beneficial to the company, as we expect the program to increase margins and help the company reinvest in its businesses. Through this program, Kraft has generated increased annual savings to more than 4%, which in turn has been used as increased spending in Research and Development and promotional activities.
However, the company’s above-average exposure to commodities such as coffee and meats, given their high prices has limited Kraft Foods’ pricing policies, thereby squeezing its profitability.
As a result, the market share of Kraft has gone down in many categories recently. The coffee category was hit hard after it lost the retail license of Starbucks. Kraft now plans to sell Gevalia as its premium coffee brand at more than 20,000 retailers, but it has high expectation from Gevalia that it could replace the $500 million in annual revenue that sales of the Starbucks business generated from $50 million 12 years ago.
Further, K Cup of Starbucks is proving to be more acceptable to households than the Tassimo system used by Kraft. Besides, the nut categories is also losing share to pistachios served by brands like Wonderful and Emarald, while the soft drink category surrendered to Pepsi’s Propel brand and private label
Kraft has announced that it plans to spin off its North American grocery business to its shareholders and split into two independent public companies: a high-growth global snacks business with estimated revenue of approximately $32 billion and a high-margin North American grocery business with estimated revenue of approximately $16 billion. the split of its North American business is expected to allow Kraft to focus on its distinct strategic priorities and allocate resources optimally.
Given the pros and cons, the Zacks Consensus Estimate of earnings for the third quarter of 2011 is currently pegged at 55 cents per share, up from 46 cents in the year-ago quarter, reflecting the ongoing economic volatility. Of the 16 firms covering the stock, 5 firms revised their estimate upward in the last 30 days, and 4 analysts revised their estimate in the downward direction. However, the estimate remianed stable at 55 cents.
Additionally, the quantitative Zacks Rank for Kraft Foods is currently #2, indicating upward directional pressure on the shares over the near term.
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