The way many sell-side analysts talk about Kraft Foods (Nasdaq:KRFT) and the company's CEO Tony Vernon, you would think they make sure to never go to bed at night before kissing a picture of them both and writing their names with little hearts substituting for the “o's”. And this is for a company whose organic growth just hasn't been that good since the split with Mondelez (Nasdaq:MDLZ).
Now, to be fair, I do think Kraft is a good business and a very well-run company. In more than a few cases, Kraft either dominates its category or frankly is the category. Moreover, I like the motivational approach the company takes toward incentivizing employees, the company's focus on innovation, and its willingness to shift resources away from brands that can't carry their own luggage. On the other hand, while I do share Wall Street's optimism that Kraft will eventually post margins and free cash flow that are just as good as, if not leading, its peers, the valuation already assumes precisely that.
SEE: Kraft Foods Retained At Neutral
Another Sluggish Quarter
Kraft did beat the average Street estimate by a sizable amount (10 cents on the operating line), but investors may want to question why expectations were as muted as they were for a company that's supposed to be improving.
Revenue declined 1% as reported, missing expectations by about 2%, as organic contraction of slightly more than 1% was driven by a nearly 1% decline in volume and a slight decline in price. While Kraft management pointed out that organic growth could have been up 1% if not for the timing of Easter and product pruning, I don't see any reason that a packaged food company should get credit for the latter, as it is something that companies like Kraft, General Mills (NYSE:GIS), and Nestle (Nasdaq:NSRGY) do (or should do) on a regular basis.
Kraft's International/Foodservice business led the way in terms of organic growth (up more than 3%), with the often-volatile cheese business delivering just under 3% organic growth. Refrigerated meal sales declined almost 1%, while beverages were down more than 3% and grocery was down almost 7%.
Margin performance was once again “mixed”. Gross margin declined 30bp from the year-ago level, but did exceed expectations by over half a point. While adjusted operating income declined 13% and the operating margin declined more than two points, here again the company beat expectations (by about 30bp). Amidst all of that, though, it's worth noting that Kraft's overall margins compare well with the likes of General Mills, Kellogg (NYSE:K), and Nestle, and the nearly 27% margins in the Grocery business are exceptional.
Upping The Ad Spend, But They're Not The Only One
Although Kraft posted a sizable operating beat for the first half of 2013, management has been slow to lift full-year guidance. Management acknowledged that some of this can be tied to their own challenges in crafting quarterly forecasts, but some is all due to the timing of advertising expenditures.
Ad spending is a curious thing. Kraft has a good history of generating very cost-effective sales growth with its advertising and marketing, but the timing between allocating the expenses and seeing the benefits can be uncertain and variable. What's more, plenty of other companies, including General Mills, Nestle, Smucker (NYSE:SJM), and Green Mountain (Nasdaq:GMCR) have their own ad spending plans in competing/overlapping markets. The threat, then, is that more and more packaged food companies will be ramping up ad spending during what may prove to be a period of pressure on volumes, and nobody may gain all that much from it.
The Bottom Line
My criticisms of Kraft have a great deal more to do with what the sell-side says about or projects for the company, as opposed to what the company actually does. I think Kraft has a very good business – it's not going to be a growth leader in the space, but the underlying margins are impressive and management's efforts to enhance mix (focusing on brands with better cost structures and/or consumer appeal), control its marketing spend, and drive ongoing innovation ought to lead to solid ongoing performance.
The catch is that the Street already values that growth appropriately in my view. I believe 3% revenue growth (long-term) can drive a fair value in the $55 to $56 area if you're willing to ignore the company's debt (and for better or worse, Wall Street is happy to do so). Likewise, the company's EV/EBTIDA ratio seems pretty much in line with its peer group, suggesting in-line performance potential. With all of that in mind, Kraft isn't an overpriced food stock (particularly given its quality), but outsized capital gains don't seem too likely in the near term.
Disclosure – As of this writing, the author has no financial positions in any stocks mentioned.