Coffee Relief for Mondelez

Gevalia Coffee, a well-known Mondelez coffee brand. Image by Slipp D. under Creative Commons license.

When Starbucks announced recently that it was raising prices on some of its retail and packaged coffee, Mondelez International  (NASDAQ: MDLZ  ) executives must have breathed a sigh of relief. That's because coffee pricing is something they don't have to worry about anymore -- at least not directly.

Back when Mondelez spun off its lower-margin Kraft grocery division in the fall of 2012, the company presented to investors both a rationale for the spinoff and a long-term goal: Mondelez would promote its snacking power brands such as Cadbury and Oreo, and grow organic revenues by 5% to 7% each year.

Several factors emerged that made it apparent that this goal, at least for the present, was an overreach. Among them, Mondelez miscalculated its rate of expansion in emerging markets. One of the more surprising weights on the company's organic revenue growth turned out to be coffee. Coffee pricing is inherently difficult, and as climate change increases the unpredictability of supply, it won't get any easier for multinationals to hedge their purchases with precision, while engaging one another in price competition on grocery-store shelves. Coffee futures are up 65% just this year alone.

From the first quarter that Mondelez reported earnings post-Kraft (Q3 2012) to its last reported quarter (Q1 2014), coffee has been cited as a drag on either organic revenue or operating income in every single earnings report. The pressure on organic revenue has not been insignificant: In one quarter the drag was as high as 1.3%, and in many quarters coffee pulled down top-line results anywhere between 0.5% and 0.8%. When one considers that the company has recently come painfully close to the bottom end of its projected range of 5% to 7% organic revenue growth, it's clear that coffee was acting in some fiscal quarters as a very visible and frustrating barrier to breaking through.

Douwe Egberts coffee, a flagship brand of D.E. Master Blenders. Image courtesy Andrew Currie under Creative Commons license.

This is why Mondelez's recently announced sale of its coffee business to European coffee titan D.E. Master Blenders 1753 is an astute reshuffling of assets. Mondelez will receive $5 billion in cash and retain a 49% equity stake in a new joint company to be named Jacobs Douwe Egberts. JDE will have annual revenues of over $7 billion, and will occupy the No. 2 position in coffee worldwide behind Nestle S.A. 

By selling its coffee business and retaining a significant but minority stake in the new company, Mondelez essentially turns its coffee business into an equity investment, which removes the effects of coffee from its normal operations. In other words, the earnings from Mondelez's share of JDE will only appear at the bottom of the income statement, in a line item for equity investments.

As coffee revenue will thus not appear on the top half of Mondelez's income statement, it will cease to hamper the company's organic growth rate. But Mondelez still gets the benefit of the coffee portfolio, by participating in earnings of the new company. And more important, management doesn't have to devote its attention to balancing out the effects of bulk coffee inventory in its revenue and operating earnings mix.

This spinoff is the opposite of a situation I have described in an article regarding Coca-Cola, in which it will be advantageous for Coke to add to its position in Keurig Green Mountain and acquire that company outright, in order for it to see the fast-growing Keurig's revenues on its income statement.

Benefits of decreased distraction
Focusing Mondelez more on its snacks business (projected to be 85% of total company revenue after the coffee division is sold off) will help management achieve its latest goal of increasing bottom-line results. Mondelez projects that through 2016, a supply chain optimization effort will yield about $1 billion in increased annual cash flow. These actions, coupled with a $3.5 billion restructuring program, should provide significant support to the company's goal of increasing its operating income margin some 400 basis points, from a current level of 12, to as high as 16%, in the next couple of years.

Mondelez's D.E. Master Blenders transaction is the sort of proactive, muscular deal that shareholders should appreciate. While the sale will remove about $4 billion of revenue from Mondelez's top line, the trade-off -- a company more focused on snacks, with better margins, less distraction to management, and no drag from the vagaries of coffee pricing -- is desirable. Investors will own a leaner, faster-growing company that concentrates on its power brands. And Mondelez will enjoy regular checks from a dominant global coffee business, of which it will be a roughly one-half owner when the transaction closes in 2015. Deals like this will set Mondelez up nicely in one to two years for a return to chasing 5% to 7% growth.

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Asit Sharma

Midnight oil burners, unite! A CPA and CMA with a deep interest in business strategy, I also hold a Master's degree in English Literature from NYU -- my left brain and right brain spend their days locked in epic spitball battles. Follow me on Twitter for finance & a broad range of odds & ends.

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