Unlocking Kraft's potential

by L. Joshua Sosland
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NEW YORK — Food analysts initiating coverage of Kraft Foods Group, Inc. offered upbeat to neutral assessments of the company in the aftermath of the breakup of Kraft Foods, Inc.

Robert Moskow, an analyst with Credit Suisse, initiated coverage with an “outperform” rating, and Andrew Lazar, who covers U.S. Food for Barclays Capital Inc., rated Kraft an “overweight.” Eric Katzman, an analyst with Deutsche Bank, is ranking Kraft a “hold.”

The analysis was published ahead of the spin-off of Kraft Oct. 2. The fourth largest packaged food and beverage company in the United States, Kraft has annual sales of about $19 billion with brands that include Kraft, Maxwell House, Oscar Mayer, Planters and Jell-O. The company has 25,000 employees in the United States and Canada. Kraft Foods shares began trading Oct. 2 on NASDAQ under the KRFT symbol.

Separated from the global snacks division, a different, more disciplined culture at the company will lead to better results at Kraft than was the case pre-spin-off, Mr. Moskow said. Management focus on free cash flow and return on capital represent a “positive change for a Kraft culture that tends to trip itself up in bureaucracy and slow decision-making.”

“The company’s 77% dividend payout ratio is a bold statement about where the new priorities lie,” Mr. Moskow said. “We expect the company to grow its dividend at a pace of 7% to 8% per year, and we think that a dividend increase in late 2013 will provide a positive catalyst for the stock.”

Expectation of a different mindset than before the spin-off represents the centerpiece of the investment thesis for Kraft Foods Group, Mr. Lazar said.

“With Kraft only committing to grow in line with or better than its categories, it suggests to us that its employees won’t be incentivized to go after unprofitable volume or use trade spend programs that don’t necessarily come with a requisite payback,” he said.

Mr. Moskow of Credit Suisse highlighted gross margin improvement opportunities.

“Tony Vernon (Kraft Foods chief executive officer) almost gleefully points out that the company isn’t the low cost supplier in any of its categories and has yet to leverage its scale,” Mr. Moskow said. “This sounds a bit like puffery, but the truth is that the supply chain has tremendous potential for cost savings just by catching up to its peers. At 32%, Kraft’s gross margin is woefully below the peer average of 37%. We expect Kraft’s gross margin to improve substantially as it generates procurement savings from strategic sourcing agreements, increases focus on lowering delivered product costs, leverages information from SAP, and leverages capacity utilization improvements at its plants to reduce overhead.”

Mr. Moskow also predicted Kraft will cut manufacturing and administrative costs, closing plants, distribution centers and its Glenview, Ill., headquarters.

“We conservatively estimate 250 basis points of gross margin expansion by 2015 assuming ‘normal’ inflation,” he said.

Mr. Lazar anticipates even greater margin improvement. He said operating margins may expand by between 300 and 400 basis points over the next three years. Forecasting margins of 15.5% in fiscal year 2013, he projected 19.3% margins in 2016.

“This would close the margin gap with peers and could drive double digit e.p.s. growth in the near term, well above Kraft’s mid- to high-single digit algorithm,” Mr. Lazar said. “As such, we are above management’s e.p.s. guidance for 2013 and 2014.”

Longer term, Mr. Lazar anticipates acquisition opportunities for Kraft, not as a vehicle for stimulating top-line growth but to benefit from synergies and cash flow.

Major acquisitions are not likely in the near term, Mr. Lazar said. In addition to an initial focus on enhancing margins, he said a major acquisition would raise leverage excessively at Kraft.

“But, on this front, we would note that a willingness to use equity (in light of the compelling financials) could perhaps speed up the timeline a bit, should the company look to do this sooner post-split than we imagine,” Mr. Lazar said.

More skeptical about Kraft’s prospects was Mr. Katzman with Deutsche Bank. Mr. Katzman, who is ranking Kraft a “hold,” does not anticipate rapid margin expansion in coming years, suggesting the current levels reflect factors other than a counterproductive “culture” before the spin-off.

“We view the company’s 17-18% EBIT margin as reasonable, particularly considering (Kraft’s) more pass through-oriented categories / brands,” he said.

Mr. Katzman also suggested cost cutting actions will be undertaken in less than ideal circumstances.
“These efforts are likely to take years to implement,” he said. “Yet industry conditions remain challenging including the specter of 2013 inflation.”
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