Recently, in addition to such issues as currency headwinds and company cost-cutting initiatives, Kraft Foods (NYSE:KFT) shareholders have to keep track of another big issue from 2008 -- the negative impact of higher product prices on sales volumes.
So when I read last week that the company had responded to coffee bean supply issues by raising prices on its Maxwell House 100% Colombian ground coffees by a frothy 19% -- despite predicting falling coffee costs as recently as February -- the news hit me like a sandy espresso shot. (Do note that competitor J.M. Smucker (NYSE:SJM) recently raised the price on its Folgers 100% roasted Colombian coffee a similar amount.) Was my reaction appropriate, or would I have done better to pour myself one of those calming teas made by Hain Celestial Group (NASDAQ:HAIN)?
Cup o' concern
To widen the view for a moment, the heart of the issue here is price elasticity, or the extent to which consumers alter their behavior in response to price changes. Because consumers have many options in the form of store and value brands, Kraft, along with competitors ConAgra Foods (NYSE:CAG) and Unilever PLC (NYSE:UL), has to be particularly attentive to price elasticity. Raise prices too far, too fast, and consumers may choose products from a lower rung on the shelf.
In fact, Kraft recently felt the effect of some of that consumer trade-down behavior. In the fourth quarter of 2008, volume across product segments was 5.2% lower than the year-ago period. As management tells it:
We priced aggressively because it was the right thing to do to address rapidly rising input costs and to preserve our ability to invest in our brands ... As expected, these actions adversely affected our 2008 volume performance. The peak impact was clearly felt in Q4, mainly due to the cumulative effect of pricing actions taken during the year
In all fairness, management attributes only half of the volume decline to price elasticity, ascribing the rest to other factors. Furthermore, although I am cautious on this point, the company expects volume to pick up as the year advances.
Cup o' confidence
Getting back to beans: While coffee sales accounted for 14% of Kraft's 2008 revenue, Maxwell House is only one of several coffee brands that Kraft sells, so any sales drop that results from the 19% price increase should be tiny teacups at the companywide level. Importantly, even though sales declines are a never a good thing, we should note that net revenue from the brand will actually decrease only if volume slumps by 16%. That could happen over time, but it is not likely to occur in the space of a single quarter.
What investors should take away from this development is a certain watchfulness. If unexpected and dramatic price increases start to spread to other brands, it may be time to question whether Kraft's growth will continue to percolate at expected rates.
For related Foolishness, grab a cup of joe and read on:
