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Appetizing Profits

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Matthew Grainger
Morgan Stanley
[email protected]

Kraft Foods Group Inc.’s (KRFT) Q1 2014 [results] marked a balanced start to the year, with soft organic sales (-2.4%) offset by gross-margin upside and increased marketing reinvestment. Our full-year outlook is largely unchanged, and we reiterate our Overweight rating and confidence in low double-digit earnings per share growth for 2014.

While organic sales of -2.4% (+0.5% excluding timing factors) may have been below consensus, we believe they were broadly in line with investor expectations. Given both higher pricing and perhaps approximately 200 basis points of Easter timing benefit, Q2’14 should be much improved (estimated at 4%) and offer a stronger normalized indicator across the first half of 2014. Cheese results were also encouraging, offsetting weakness across a number of other segments (we would hope to see a more balanced profile going forward).

In contrast to earlier commentary, gross margin increased approximately 200 basis points year over year to 34.6%, benefiting from lower restructuring, coffee deflation and a sizable hedging gain. While inflation is imminent and restructuring timing should reverse through the year, we would still view underlying trends as positive, and were encouraged to hear that Kraft had already took pricing in categories representing about 45% of its portfolio (5-12% on cheese, 10% on cold cuts). While this may weigh near term on shares, we would note that Kraft’s proactive pricing tactics were a key driver of strong results in 2011.

Timing benefits [were] largely reinvested in marketing: EPS of $0.83 was flattered by timing factors such as: (1) a $0.05 hedging gain; (2) lower restructuring costs; and (3) a $0.03 tax benefit. That said, we would view any perceived “underlying” shortfall during Q1’14 as attributable to higher reinvestment in marketing, which was up across nearly all segments (albeit off an easy comp). Q2’14 should see further support for Maxwell House (Q2), Planters Nuts and A.1. Steak Sauce.

No change in the full-year outlook: With volume trends set to improve and KRFT exhibiting solid progress on margins, we remain confident in low double-digit EPS growth ($3.17 estimate) for 2014. While pending inflation is a headwind, pricing — coupled with tax/interest flex — appear more than capable offsets.

Christopher R. Growe
Stifel Nicolaus
[email protected]

As expected, Kraft did not offer any specific guidance for the year (with its Q1 2014 results), instead offering its long-term growth algorithm of sales growth at or above its category growth rate, mid-single digit operating income growth and mid-to-high single digit EPS growth. We continue with our 2014 EPS estimate of $3.19 (+12% growth), which represents a level of EPS growth greater than its long-term guidance given the reduction in one-time charges this year (8% or so underlying EPS growth).

We believe the first quarter places Kraft very much on track to achieve strong EPS growth for the year. We would note that in the second quarter we anticipate less Easter shift than we had previously expected (closer to a 2% benefit vs. our previous estimate of a 3% benefit), and we believe the company will likely see some market share erosion in the early stages of raising prices in relation to input cost inflation.

While pricing net of input costs was positive in the first quarter (input costs were down and pricing was up slightly at 0.4%), we believe this will turn to a drag in the second quarter as important input costs such as cheese, meats and coffee start to turn up significantly —cheese and turkey prices, for example, have hit all-time highs of late (cheese at least has backed off its highs most recently), which could provide some challenge in the short run as elasticity levels likely remain high while the company is leading price increases across so many categories.

We remain confident in the company’s ability to swiftly raise prices at retail to offset input cost inflation, but we also acknowledge the likely market- share erosion that could occur in the short run. The company has announced price increases in its Cheese division (5%-12% across the line) and Refrigerated Meals division (50% of the Oscar Mayer division will see roughly 10% price realization starting May 25), with the Beverages division (coffee) the other large business likely to see pricing later this year.

In total, 45% of Kraft’s business will see a significant increase in pricing starting here in the second quarter, providing some caution in the short run around the company’s growth profile. We have lowered our 2Q’14 EPS estimate to reflect this conservatism and expect a strong pick-up in growth in the second half [of 2014].

We maintain our Buy rating and target price of $60 per share, which we derive by assigning a 17-times multiple to 2015 estimated EPS (this multiple stands at 16.5 times, excluding one-time costs which Kraft uniquely includes in its earnings base).

We continue to believe the company has the opportunity to outperform its long-term goals in the short run, which we believe could produce some upside potential for the shares at least up to our target price.

We continue to expect the company to return a high level of cash to shareholders (70% dividend payout, and 2014 likely features the first share repurchase activity — we estimate $500 million), which should boost the overall shareholder return.

We believe the company will start repurchasing its shares in the second quarter, and our estimate assumes a flat share count for the year. However, we estimate $525 million in share-repurchase activity in ‘14 and another $600 million in ‘15, leading to a 1% reduction in the share count across 2015.

Erin Lash, CFA
[email protected]

Kraft felt the strain from a later Easter in its first quarter, which hindered both volumes and sales; however, we think these pressures are temporary. First-quarter underlying sales slipped just north of 2%, entirely reflecting compressed volumes. This volume degradation was most pronounced in the firm’s Meals and Desserts segment, where underlying sales tumbled nearly 8%, as 1% higher prices were unable to offset 9% lower volumes.

Adjusted gross margins jumped 170 basis points to 34.8%, but adjusted operating margins slipped 70 basis point to 19.9%, which reflects higher marketing investments, spending we view positively. We point to the firm’s investments behind product innovation and brand marketing (which approximate around 5% of annual sales or just less than $1 billion) as a plus and what will ultimately drive sustainable top-line momentum over the longer term.

As such, we stand by our take that Kraft’s expansive scale on its home turf combined with its leading brand portfolio (a positive contributor to retail traffic) will drive excess returns on invested capital for at least the next 10 years, supporting our narrow-moat rating.

While we intend to update our discounted cash-flow model for recent results, we don’t anticipate a material change to our $53 per share fair value estimate (which incorporates our longer-term expectations for 3%-4% annual sales growth and operating margins expanding to 18.5% by fiscal 2017, about 300 basis points above the average reported operating margin over the past five years) beyond the time value of money … [I]n light of the firm’s commitment to returning excess cash to shareholders through a top-tier dividend payment (the dividend is yielding around 3.7% annually), we think this is definitely a name that income investors should keep on their radar screens.


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