Near Future Looks Tough for Kraft

Updated from 8 a.m. EDT on Oct. 30.

Kraft (KFT - commentary - Cramer's Take) reported diluted EPS, excluding items that affect comparability, of 44 cents vs. last year's 46 cents and an average Street estimate of 41 cents.

Organic revenue growth was 6.2% overall and 5.2% in North America, 5% in the E.U. and 13% in developing markets. Of the 6.2%, volume and mix contributed, respectively, 2% and 1.9%. Pricing, not keeping up with input cost increases of around 9%, rose 2.3%.

Gross profit increased only 2.5% as the margin fell 240 basis points, to 34.0%. Marketing admin and research cost rose 8%, as advertising and promotional as a percentage of sales is now in the 8% to 9% range and was the big mover of the total. Operating income fell 6%, to post a 13.1% margin, down from 15.3%. Higher interest expense and a 1.4% lower tax rate made net earnings 7% lower, and there were 4% fewer outstanding shares.

Guidance overall was not changed for the year, with EPS at $1.80 to $1.82, adjusted for comparability, combined with 4+% organic sales growth and investments on the high end of the $300 million $400 million range previously given. Cumulative annualized savings from the restructuring program are expected to reach $775 million, up from $725 million, coming from the $500 million of restructuring charges for the year. But the tax rate is now going to be 32.5%, 1% lower than before, implying a worsened fourth-quarter expectation at the operating income line.

New product sales were generally good, as reflected in the mix number. The overall volume gain of 2% is about trend line for Kraft's product and geographic mix. The 2.3% of pricing combined with input inflation shows that price elasticity of demand is the big issue, or alternatively that the company's brands are not strong enough to warrant more pricing pass-through. This problem shows through in most Kraft product areas more intensely than the food company average.

While Procter & Gamble (PG - commentary - Cramer's Take) has not yet seen any problems here, as management said on that company's call, Kraft's cheese division is at the opposite end of the spectrum and was the biggest problem in the quarter. North American cheese and foodservice had organic revenue growth of 5.6%, which included lower sales volumes. Operating income fell 31% as a 40% increase in dairy costs and increased marketing expenses overwhelmed pricing. Pricing should recover somewhat here as lack of pricing decline in a seasonally slow quarter will likely lead to some private label pricing actions to deal with what management believes is a new secularly higher demand for cheese around the world (It is a very cheap way to get more protein in the poorest developing countries, which can now afford to buy more of it but will not buy more of it at branded prices.)

Other brands, such as Maxwell House, are going to have marketing campaigns to focus on product improvements to upgrade their images and hopefully get higher pricing. Third-quarter marketing spending was significantly more than in the first and second quarters, and fourth-quarter spending will show another significant ramp, with a likely continued increase in 2008. Therefore, we should soon see whether stronger brand equity and pricing is forthcoming in many of Kraft's businesses.

Some comments from the Q&A:

• The CEO did not answer a question as to whether she worries about any more businesses turning out to have the price elasticity problems akin to cheese when further cost increases are passed along in pricing. She did say that "we are in uncharted waters in some categories."
• Pricing has been taken on most of the product line now, and while management thinks that the visibility of incremental mix benefit to the next years' revenue is high, future incremental mix has to come mainly from new products. (Combining that with the "uncharted waters" of price elasticity does not make me feel confident.)
• The earnings before interest and taxes margin is still expected to be up in 2008 because the overhead savings are to be very significant.
• The volume gains seen were not pipeline fill.
• The fourth quarter, like the third, will have more top-line growth and more input cost inflation.

So, I think the next few quarterss will be interesting -- and tough. I do not see the long-term EPS growth expectation moving up from 6% over the next two quarters at least.

Kraft Preview: Not Expecting Any Good News

Kraft's (KFT - commentary - Cramer's Take) $33 valuation is consistent with a 6% five-year growth rate, which is about average for the food industry, especially for a company with fairly mature middle-of-the-store dry grocery products. Kraft is expected to report EPS of 41 cents vs. 46 cents last year, with a 5.3% sales increase, to $8.68 billion. Just to start to make a bull case on the stock, which would be maybe a 9% long-term growth rate at best, in my opinion (deserving of $38, a 14% appreciation), one has to be able to point to the beginnings of CEO Rosenfeld's concentration on five key reinvestment areas starting to work. Those areas delineated at a recent conference are macaroni and cheese, pizza, biscuits (cookies, crackers), cheese and coffee. Before going into what these areas may report, I think that the fact that they are only 47% of North American sales makes them a bit small for a turnaround of the whole company, especially when you consider the commodity nature of cheese and the fact that Folgers already has twice the market share of Maxwell House.

A.C. Nielsen data showed a 2.9% weighted average sales increase for Kraft in its latest four-week period after 1.8% in the prior period. Price/mix is coming to bear, especially with pricing, to try to stay somewhat whole with commodity price increases. The problem is that the price elasticity of demand is taking its toll. Take cheese for instance. Even though private label has to price up to recover higher commodity costs, just as does Kraft, Kraft's cheese sales grew 7% in one period, powered by a 12% price increase, but were offset by a 5% volume decline, resulting in 58 basis points of share decline. IRI numbers for cookies and crackers will likely show market share losses for the entire quarter. Maxwell House has gone back to using Arabica beans, which were eliminated some years past, but I also saw "100% Arabica" on the Great Value brand the last time I was cruising through Wal-Mart (WMT - commentary - Cramer's Take). And, incidentally, for those who believe that a focus on these five categories is enough -- I espouse focus but believe that it has to be beyond these five -- Post volumes were down 9% in one four-week period on a 5.5% price/mix increase while that business has shown about a 4% trend line volume decline for most of the year.

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At the time of publication, Thomas was long Procter & Gamble.