Mondelez's 2014 Strategy: A Gift from China

When Mondelez International (NASDAQ: MDLZ  ) freed itself from the perceived anchor of its North American Kraft grocery business in October 2012, and repurposed itself as one of the world's largest snacking companies, both management and investors were focused on how fast revenues might grow. During 2013, third-quarter weakness in the company's biscuits category in China brought home a realization that at least for 2014, the company's long-term goal of achieving 5%-7% organic growth will have to be scaled back. A preliminary range mentioned by CFO Dave Brearton sees the company achieving organic revenue growth of 4%-5% in 2014.

Lowering the revenue bar out of necessity may prove to beneficial to Mondelez's profitability in the future. This is due to the company's need to focus on improving operating margin, a deficiency very publicly demonstrated by hedge fund activist Nelson Peltz earlier this year.In July, Peltz's Trian Fund Management pointed out in a white paper that Mondelez's annual operating income margin trailed its peer group by more than 380 basis points. Shortly thereafter, and perhaps in response, the company announced that it had revised its current operating goals, and planned to improve operating margin by more than 300 basis points in the near future. China's gift of provoking a time-out on revenue goals allows management to devote an appropriate amount of time on this plan to pull its operating margin in line with its peers.

Finding margin
Part of the operational efficiencies will derive from opening production capacity nearer to consumers. For example, in India, chocolate revenues grew by 20% in Q3 2013 over the prior year's quarter, but the company can barely keep up with demand. This month, Mondelez announced that it will build its largest manufacturing facility in the Asia-Pacific region in the Indian State of Andhra Pradesh. The $190 million plant will be India's largest chocolate production plant.

"Greenfield" plants like this one, built from the ground up, and utilizing state-of-the-art technology, give Mondelez the opportunity to significantly affect gross margins, as its current supply chain is the result of a patchwork of acquisitions from its years under the Kraft banner. The company plans to bring 14 such plants online by 2020.

Mondelez will also modernize existing production lines, most prominently those used in the manufacture of Oreo cookies, one of the company's most valuable brands. The cost savings targeted for Oreo production lines alone is approximately $600 million over the next three years.

A question of cash
How will Mondelez fund new plants and the revamp of current production lines? The company currently has committed significant amounts of cash flow to dividends and share buybacks. After accounting for the recent $1.7 billion arbitration settlement with Starbucks (which was passed through to shareholders), the company still has roughly $4.8 billion of shareholder repurchases authorized through 2016. Add in some $2.8 billion of projected dividends -- assuming no increases -- for 2014 through 2016, and the company has marked a maximum of $7.6 billion of potential cash flow dedicated to shareholders on its calendar.

While Mondelez is quite profitable -- it posted a net profit after taxes of more than 12% in the third quarter of 2013 -- every bit of operational cash flow will be utilized to carry the company through its supply-chain improvements, dividend payments, and authorized share repurchases through 2016. It's still early to know what Mondelez's annual cash flow will look like by 2016, as the company is only a year removed from its Kraft spin-off. Based on performance thus far, we can safely project that Mondelez will generate about $1.5 billion to $1.6 billion of operating cash flow each year, not accounting for any improvement in operating margins. This in itself will not provide enough cash for all three goals without some dipping into other balance-sheet resources. Mondelez's management estimates that the 300 basis points of operating margin it is targeting could improve cash flow by $1 billion annually; so, to make the math work, Mondelez must deliver on these improvements.

Plant investment and optimization will probably trump more cash to shareholders
It would appear that the investment community has faith in Mondelez's game plan: The stock has gained more than 40% in 2013 on a total return basis -- not bad for a $35 billion blue chip snacks company. In 2014, and 2015 as well, management may ride on this implicit investor endorsement and slow share repurchases somewhat as it focuses on plant investment and supply-chain optimization. While not averse to increasing long-term borrowing, management has indicated in earnings calls that it will only add incrementally to current debt. So most likely, we will see Mondelez expend both cash and corporate elbow grease to reach its margin targets, thus creating the free cash flow to enable higher dividend payments to shareholders and continued share repurchases. Again, the rewards from this effort will likely be realized in 2015 and 2016, right around the time management hopes that organic revenue growth begins to jell again.

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