An Ex-Dog of the Dow to Buy

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With a significant margin opportunity (+300-400 bps over the next three years, inclusive of substantial reinvestment back into the base business), ample free cash flow generation, a peer-leading dividend yield, and an expectation from the company to become a consolidator of the large-cap Food group, I believe Kraft Foods (NASDAQ: KRFT) offers compelling value and is poised for double-digit shareholder returns over the next few years. 

The Business Drivers

It seems like Kraft is on the verge of experiencing margin expansion in the future. Looking at Kraft’s margin structure, there are three ways to form an analysis about the future margins:

1) Top-down

2) Bottom-up

3) Leverage from productivity and volume growth

Kraft earns its revenues from the following segments:

As we can see, the company’s US grocery business is one of its key segments. The company enjoys leading market positions in several branded categories including meat, beverages and cheese. The company is among the five largest Food & Beverage companies in the U.S. The company is expected to post $19 billion worth of sales next year. 80% of those sales are expected to come from those categories in which the company is a market leader. The following table shows its market share in some food segments: 

The margin expansion (+300 – 400 bps) is expected to materialize over the next three years. This margin opportunity stems from management’s plans to use pricing to fully offset commodity costs and its productivity savings to fuel its base business reinvestment and expand margins.

Kraft operates in an industry which currently faces rising commodity prices. Not only this, there are many other competitors that have made the overall economic environment challenging for Kraft. The direct competitors of Kraft include:

1) Kellogg Company (NYSE: K)

2) General Mills (NYSE: GIS)

3) The Hershey Company (NYSE: HSY)

However, it can be argued that if Kraft increases its advertising expenditures, it can improve its brand power and customer loyalty. There is certainly room for increased advertisements given that the company has the lowest advertising expenditure/revenue ratio among its peers:

Plus, management is expected to pay a $2.00 dividend for 2013, which implies a yield of ~4.5%, well above the Packaged Food average of ~3%. Considering these two factors, we see the potential for double-digit shareholder returns over the next few years. The following table shows the current dividend yields of its competitors:

Upside Scenario

If Kraft is able to capitalize on my expectation for potential margin expansion more quickly than expected, work down post-spin dis-synergies, and drive low-single-digit top-line growth, I see a potential upside of $3.35 in 2014’s EPS (assuming a normalized input cost environment). Assuming a 16.7x multiple on this forecast implies an upside scenario of $56, or nearly +26% upside from the current level.

Downside Scenario

However, if the commodity cost inflation is more severe than forecasted and Kraft is unable to fully price to offset costs, I see the potential for flat EPS in CY14 of $2.65. Applying a discounted 15.5x multiple implies a downside scenario of $41. Interesting to note is that a bearish price target implies nearly a 5% dividend yield.

Valuation Analysis

At current levels, Kraft trades at a multiple of 17.2x and a CY13 EPS forecast of $2.65, which I believe gives little credit for the medium-term margin opportunity at the company and implies a dividend yield (~4.5%), well above that of the Packaged Food group. For this reason, I continue to believe a premium multiple is justified. Of course, the thesis around the margin opportunity is predicated on management’s ability to effectively cover its input costs with pricing. I am bullish on it given that the company’s pricing strategy was more effective than its peers in this regard in the enduring significant inflation in CY11.


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