A Margin Improvement Story in the Making

With weak personal income growth and high unemployment weighing heavily on the wallets of consumers, many have not filled up their shopping carts with familiar branded food products in the way they used to. Kraft Foods (NASDAQ: KRFT  ) , a leading U.S. manufacturer and marketer of branded food products, has set a target of becoming the most innovative company and the lowest cost producer in order to survive in this difficult environment.

Driving innovation
In the face of severe price competition from private label products, a steady stream of new innovative products is critical in driving volume growth and customer loyalty to brands.

In 2013, Kraft identified a few core big bets such as MiO Fit, a new variation of its liquid water enhancer brand MiO, which was first introduced in March 2011. Mio Fit allows consumers to turn their water into a personalized sports drink. Electrolytes and B vitamin replace sugar and artificial coloring in MiO Fit, making it a perfect zero-calorie drink for health-conscious fitness enthusiasts. Innovation is not just about new products or brands, but is also about breathing new life to existing classic brands. For instance, Kraft introduced a new marketing campaign in August 2013 to put the "fun" element back into its dessert and snacks brand Jell-O. 

Kraft is also shifting its spending to where it matters most. This is a result of its observations that the three most successful products launched in 2009 were the same ones that incurred the highest amount of advertising & consumer (A&C) expenditure. With this at the back of its mind, Kraft has increased A&C spending for the 13 big bets (Tier-1 products) it identified in 2011 fivefold, increasing spending from $5 million per launch to $25 million per launch. As a result of the shift in spending, Kraft increased the revenue contribution of Tier-1 products from 42% in 2011 to 67% in 2012.

Revenue contribution from new products and market share are two of the best indicators of the results of Kraft's innovation efforts. The company doubled its revenue contribution from new product innovation over the last three years from 6.5% in 2009 to about 13% in 2012. During its recent third quarter results conference call, Kraft also indicated that it has gained or held its market share across more than 50% of its portfolio. This represents a significant improvement from 2009, where it ceded market share for approximately two-thirds of its portfolio.

Kraft's peer Campbell Soup (NYSE: CPB  ) also scores high on the innovation scale. It has plans to launch three new varieties of Campbell's Fresh-Brewed Soup in 2014, all of which will be brewed in Keurig coffee brewers and come packaged in K-Cups. Not everyone is a coffee drinker, and there are plenty of soup lovers around. Consumers will now be able to get their favorite soups at the press of a button, without the need to meddle with a pot and hot water. These new products allow Campbell Soup to capitalize on both increased consumer demand for convenience and the growth of single-serve beverages.

Revenue growth through innovation is only half of the profitability equation, however, with effective cost management being the critical other half.

Cost cutting
Kraft's cost efficiency does not measure up to the best companies in its space. According to Kraft's internal benchmarking study, its percentage of overhead to net revenues is about 70 basis points higher than its best-in-class competitors. In addition, Kraft has a longer cash conversion cycle of 40 days, compared to 30 days for its best-in-class competitors.

Kraft has put several initiatives in place to streamline costs and improve margins. It is targeting a 20% reduction in stock-keeping units (SKUs). Not all products are equally profitable, and it makes perfect sense for Kraft to focus on higher-margin products at the expense of their lower-margin counterparts. The company also plans to double the percentage of direct shipments (from factory to customer) from 30% to 60%, cutting down on warehousing and distribution costs. As a further initiative, Kraft intends to derive further bulk buying cost synergies by consolidating its supplier base. Its ultimate goal is to reduce the number of suppliers it utilizes from 7,000 to below 1,000.

The results have been encouraging so far. CEO Anthony Vernon commented during Kraft's most recent earnings conference call that "cost savings and productivity programs are fully on track." This has been reflected in margin enhancement, with Kraft increasing its operating margins from 14.7% in fiscal 2012 to 18.4% for the trailing twelve months.

Kellogg (NYSE: K  ) , is another branded food products manufacturer that has jumped on the cost-cutting bandwagon. It announced a four-year-long restructuring program named "Project K" in November, targeting $425-$475 million in incremental annual costs savings by 2018. It plans to do this by consolidating facilities, eliminating excess capacity, and reducing its global workforce by 7%. Kellogg plans to reinvest the cost savings derived from Project K to where it matters: brand building and emerging markets.

Conclusion
With its trailing twelve months gross margins (33.7%) still lagging behind those of peers such as Kellogg (37%) and Campbell Soup (36.2%), Kraft is a margin improvement story in the making. Given that all three stocks trade at similar 15-16 times forward P/E ratios, I think that Kraft is more attractively valued relative to its peers on the basis of its high potential for margin enhancement.

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