(By Erin Lash, CFA) Earlier this month, Kraft separated its North American grocery business (Kraft Foods Group (KRFT
)) from its global snack operations (Mondelez International (MDLZ
)). We think investors looking for sweeter growth prospects from a packaged food firm may want to consider the Mondelez global snack business, while income investors are likely to find Kraft Foods appetizing because paying a top-tier dividend is to be the firm's main use of cash.
Kraft's decision to split mirrored what we've seen from other consumer product firms, such as Sara Lee and Fortune Brands. But in the latter cases, there was a strategic rationale for the deals, and we think that both Sara Lee's and Fortune's segments could be acquisition targets down the road. In our opinion, Kraft's motivation leaned more toward unlocking a higher multiple for its faster-growing snack business that had been unappreciated when combined with the more mature North American grocery brands. In addition, we doubt that either of Kraft's business units will garner much interest from acquirers, as the sheer size of the units (with global snacks' revenue at about $36 billion and North American grocery at nearly $19 billion) makes them unlikely targets.
Global Reach and Potential for Sweet Growth Prospects Are Pluses for Mondelez
When the former Kraft management group announced its intentions last summer to split its business into two, we believed this would merely undo the acquisition of Cadbury a few years prior. However, after further examination, it is clear that the snacking operation is not just a sweets company. It will continue to operate as a leading player in global confectionery, with 15% share of the chocolate market, 30% of the gum category, and 7% of the candy aisle worldwide. But Mondelez will also hold a dominant share of the biscuit category with 18% of the market, which is far above its two closest peers, Kellogg (K) (4%) and Campbell Soup (CPB) (3%), as well as a leading share in powdered beverages (16%). Its portfolio includes several well-known brands--11 of which produce annual sales in excess of $500 million, like Oreo, Chips Ahoy, Club Social, Halls, Trident, and Lacta. This, combined with an expansive distribution platform, affords Mondelez a wide economic moat, in our view.
We've long touted the strategic rationale surrounding the decision to buy out Cadbury's operations beyond just garnering a more expansive global network. For instance, the high-growth and high-margin prospects that characterize the confectionery category are attractive relative to other packaged food segments. Further, private-label competition is minimal at just 5% of the confectionery market (versus the approximate 20% share private-label offerings maintain in the total food and beverage market).
Despite its broad category dominance and limited private-label competition, Mondelez has encountered its fair share of challenges in recent years. In addition to having to try to win over employees who were less than thrilled at the consummation of the Cadbury deal, the gum category has come under pressure. We recognize that a portion of this weakness reflects tough macro conditions (high unemployment rates particularly among teenagers, who are avid users). However, some of the wounds have been self-inflicted. Management admits that reduced advertising support, combined with a proliferation of stock-keeping units, dragged on category sales. Between 1998 and 2008, the global gum market grew at a 7% compound annual rate, which slowed to just 3% between 2008 and 2011. Management's plans to right the ship include simplifying brands and launching products to appeal directly to teens, as well as rolling out more integrated marketing support while returning advertising and consumer spending to a midteens level as a percentage of revenue.
In addition, with 44% of sales resulting from faster-growing emerging and developing markets, Mondelez should be able to offset more sluggish growth prospects in mature, developed markets like Western Europe (37% of sales) and North America (19%). Despite the challenges that could result from operating in sometimes politically unstable regions, we are encouraged that no single developing market country accounts for more than 7% of revenue. Even with its vast global presence, we think the opportunity to further expand into untapped markets (like China and Indonesia, as well as more mature regions like Germany) could be in the cards. Given that tastes and preferences for snacks and confectioneries are highly regional, we expect Mondelez will put its balance sheet to work by pursuing local market players.
Mondelez is not immune to headwinds. Input cost pressures for raw materials like cocoa, sugar, dairy, and grains can fluctuate wildly, which could pressure profitability. In addition, consumer product firms around the world are on the prowl for a larger emerging-markets presence, so any tie-up that Mondelez could pursue may come with a hefty price tag. Still, management has proved to be prudent stewards of shareholders' capital, and we doubt this will change. Further, we think the brand equity inherent in its portfolio as well as its extensive global platform should ensure that Mondelez remains a leading player in the savory snack aisle.
Expansive Scale and Leading Share Support Mondelez's Wide Moat
As a leading player in the worldwide snack arena, Mondelez earns a wide economic moat because of the economies of scale that result from its expansive global network--with more than 80% of revenue derived outside North America--and its portfolio of well-known brands. Following the acquisition of Cadbury, the combined firm leapfrogged Mars/Wrigley as the leading player in the higher-growth, higher-margin global confectionery industry. In addition, Mondelez holds the top spot in the biscuit aisle and the global candy category. The low level of private-label penetration and the prime shelf space afforded to firms in the confectionery industry--combined with our forecast for adjusted returns on invested capital in the midteens--support our stance that Mondelez has earned a wide economic moat.
Despite Its Competitive Muscle, Mondelez Appears Fully Valued
Our fair value estimate of $24 per share is based on a discounted cash flow analysis and implies fiscal 2013 price/adjusted earnings of 17 times, enterprise value/adjusted EBITDA of 11 times, and a free cash flow yield of 5.9%. As Mondelez begins operating as an independent organization, it is likely that there will be significant noise in its results for the next few years. As a result, we think looking at its longer-term prospects is more appropriate. We anticipate top-line growth of just more than 5% annually beginning in fiscal 2014 (at the low end of management's 5%-7% long-term guidance). We don't expect an immediate return to growth in the gum category, but think that Mondelez will benefit from new products as well as its developing markets platform. While we believe the global snack business will incur some added costs as it begins operating independently, we think it possesses the ability to leverage its global scale to realize some margin improvement. We anticipate that a portion of any savings generated will be reinvested in the business (in the form of marketing support and research and development), but forecast that operating margins will increase to 14.5% by fiscal 2016, about 100 basis points above the average adjusted operating margin over the past two years. Through 2016, we believe that returns on invested capital (including goodwill) will average north of 14%--in excess of our cost of capital estimate--supporting our take that Mondelez maintains an economic moat.
As Independent Kraft Is Likely to Serve Up Solid Dividend Payments
Despite losing the international platform that the snack business provided, it's hard to argue that the Kraft Foods domestic grocery segment doesn't maintain significant scale in its own right, with annual revenue of nearly $19 billion. Kraft's competitive advantages also rest in its solid brands (including Philadelphia, Jell-O, Maxwell House, Oscar Mayer, and Crystal Light in addition to its namesake brand), making it a key supplier for retailers. While substantial growth is unlikely for the new Kraft--with all its sales resulting from the mature North American region--we think income investors would be wise to consider the shares, as returning cash to shareholders through a top-tier dividend is to be the firm's prime use of the substantial cash flows it generates.
Kraft operates as the fourth-largest player in the North American food and beverage category behind PepsiCo (PEP), Nestle (NSRGY), and Coca-Cola (KO). Like others in the industry, Kraft Foods has struggled to increase volume in the recent past, and from our perspective, continued investments in brands (in the form of product innovation and marketing support) will be necessary to drive incremental category growth. In that light, we've been impressed by Kraft's commitment to investing behind its brands. New products introduced in the past three years represented about 10% of revenue in fiscal 2011. But more important, it doesn't appear to us that the firm has been launching new offerings for the sake of growth, as it has also been intentionally pruning its product portfolio in North America (which hurt domestic volume in the second quarter by 1%) as it aims to focus on its most profitable brands and products. In addition, we think management understands the importance of marketing its brands in this highly competitive environment. While Kraft's domestic ad spending falls short of other players in packaged food (at just 3% of sales versus an average of 4.5% for the peer group), recent results provide a lens into the potential benefits from such spending, as a 50% increase in ad spending for mayonnaise drove a more than 10% jump in sales.
Despite the brand equity inherent in its portfolio, Kraft's profitability lags its peers, with adjusted operating margins of just 17% versus the 20-plus levels generated by others. This fact hasn't been lost on management. As it prepared for the separation, Kraft announced initiatives to improve the efficiency of its organization, including efforts to realign its U.S. sales organization, consolidate domestic management centers, and streamline the corporate and business unit organizations. We think management is just getting started, as it has openly discussed the opportunity to drive further cost savings in the form of strategic sourcing initiatives, maintenance optimization, and supply chain simplification. However, we aren't forecasting material margin expansion over our five-year explicit forecast, with operating margins amounting to just 17.5% by fiscal 2016 (about 100 basis points above the average margin over the past three years), as Kraft intends to reinvest half of any savings realized back into the business and return the other half to shareholders, which is wise spending, in our view.
Overall, we think Kraft's efforts to launch products that truly resonate with consumers, while not losing focus on enhancing profitability, are a positive for the company and ultimately its shareholders. But Kraft is not without its share of challenges. We expect competitive conditions in more mature developed markets will remain intense for the foreseeable future, as packaged food firms battle to garner more of consumers' reduced discretionary spending budgets. Competition from other branded players as well as lower-priced, private-label offerings is unlikely to subside. Given that prices throughout the grocery store are trending higher, volume could remain constrained. Kraft's bargaining power could also be weakened as the base of retail outlets consolidates and market share shifts to mass merchants and warehouse clubs at the expense of traditional grocery stores. Further, in light of the unfavorable weather conditions in much of the United States combined with record flooding and drought conditions in Russia, commodity costs may stay elevated for quite some time. Even in light of the tough operating environment, though, we think that Kraft will remain a formidable player in the domestic food industry.
A Solid Brand Portfolio and Domestic Scale Give Kraft a Narrow Moat
Operating with a portfolio of powerful brands that span the grocery store, we believe Kraft has garnered a narrow economic moat. Kraft is the fourth-largest food and beverage company in North America, with three brands that generate annual revenue of more than $1 billion each (Kraft, Oscar Mayer, and Maxwell House) as well as another 20-plus brands that produce sales of more than $100 million every year. According to management, 4%-6% of every American grocery store's sales are Kraft products, making the firm a key supplier for retailers. The firm falls short of a wide moat, in our view, because some of the categories in which it competes--like packaged meats and cheese, which account for more than one fourth of annual sales--have become commodified as consumers are less willing to pay up for the company's brands.
Income Investors Would Be Wise to Consider Kraft Foods
Our fair value estimate of $53 per share is based on a discounted cash flow analysis and implies fiscal 2013 price/adjusted earnings of 19 times, enterprise value/adjusted EBITDA of 11.5 times, and a free cash flow yield of 4.8%. As the packaged food firm begins operating independently, it is likely that there will be significant noise in the results for the next few years. But over the longer term, we forecast that annual sales growth will amount to 3%-4%--despite the fact that operations will exclusively focus on the mature North American market, where outsize growth is unlikely--driven by new products and higher prices. Although we're impressed by the firm's intense focus on realizing further cost savings, we don't believe Kraft will produce significant margin expansion but instead will continue investing behind product innovation and marketing support for core brands. Over the next five years, we forecast adjusted operating margins to reach 17.5% (about 100 basis points above the average margin over the past three years), reflecting cost savings from efficiency initiatives. Through 2016, we anticipate that returns on invested capital (including goodwill) will average north of 13%, in excess of our cost of capital estimate, supporting our take that Kraft maintains a narrow economic moat.