Kraft Foods Is Set to Expand Its Margins

Kraft Foods (KRFT.DL) is among the leading food and beverage companies in the U.S. Since its spin-off a couple of years ago, the company has been focused on the North American Grocery business and has been working to improve its cost structure in a bid to expand its margins. Margin expansion opportunities available with Kraft seem to be realistic and will help it grow its EPS in the mid-to-high single digit. Other than the potential to make its cost structure leaner, Kraft is likely to benefit from an expected improvement in consumer spending in the U.S., which will bode well for its top line numbers. 

Margin expansion potential
Kraft Foods has a dominant position within the industry with a solid market shares in various product categories; however, the company's margins remain lower than its competitors, as it is currently not among low cost food manufactures in the industry. The company has gross margin of 34%, which is below those of its peers, namely The Hershey Company (HSY -0.53%) and Kellogg Company (K -0.51%), who have gross margins of 46% and 40%, respectively. Kraft has the potential to improve its cost structure and margins in the near-to-medium term, given its large operational scale, solid brand portfolio and significant market share in different product categories.

The company, in the recent past, has been consistently working to make its cost structure leaner and on attaining low cost producer status. Cost cut measures undertaken are likely to result in gross productivity improvement of about 500bps and net productivity improvement of 250bps in the coming years. Kraft has the potential to improve its margins by leveraging its scale.

The company has been making efforts to improve its supply chain, which offers greater opportunities for cost savings. Also, Kraft has been aiming to derive savings through strategic distribution sourcing contracts, by lowering distribution costs and by improving capacity utilization of plants. Moreover, to lower its overhead costs, it has been opting to close some of its inefficient plants and distribution centers. Kraft also opted to close its Glenview headquarters and decided to stick with its headquarters in Northfield to lower its overhead costs.

Making progress
The company seems to be making progress with regards to its efforts to improve productivity, which is evident through the margin expansion enjoyed by the company in the last three quarters, as displayed below in the table.

Consistent efforts are required by the company to make its cost structure leaner and attain low cost producer status. As Kraft lowers its costs, it will be able to reinvest its savings in its products, and effectively address the prevalent competition in the industry. This will in turn fuel Kraft's long term earning growth.

Cost cuts remain popular
As the industry remains highly competitive, cutting costs remains an important tool in the company's hands to support earnings growth. Dean Foods (DF) is another company that is targeting cutting costs in efforts to support its earnings in the current industry environment. Cost cuts targeted by the company are to be achieved through improving the efficiency of its production and distribution network. Under continuous cost productivity efforts, Dean Foods plans to close 8-12 plants or 10%-15% of its plant network by mid-2014. So far, the company has successfully closed eight facilities. Also, Dean Foods is working to make its distribution network more efficient; it's also growing its national distribution and is extending the shelf life of its products. In the first quarter of 2014, through cost productivity, Dean Foods was able to reduce its SG&A costs by $12 million as compared to last year. Also, the company's management has indicated that as its cost control measures continue to materialize, its performance will improve in the second half of 2014 as compared to the results of the second half of 2013.

Similarly, Kellogg has been working to make its cost structure leaner to support growth in the long term. Also, the cost savings will be directed toward brand building investments. The company, through its four year 'Project K', is aiming to achieve annualized cost savings of $425-$475 million by 2018. Under 'Project K', Kellogg will be mainly focusing on planned closure/reduction of capacity of its plants in developed markets, while increasing capacity investments in fast growing emerging markets (India, Poland and Southeast Asia). In the last quarter, Kellogg announced the closure of two production lines in Cincinnati, and the closure of its snacks plant in Charlotte, N.C. by the end of 2014. The Project K cost savings seem to be on track, as the company expects cost saving benefits to have a positive impact on its performance in the second half of 2014; they should result in a 40-50bps YoY increase in gross profit for 2014.

Final thoughts
Kraft Foods has a strong market position in the industry and remains a quality consumer food stock. The company has attractive and realistic opportunities to expand its margins in the medium-to-long term through cost productivity improvement, which will offer growth and will allow the company to reinvest savings to further strengthen its product portfolio. Kraft seems to be executing its plan well to attain low cost producer status, as it margins have been growing in the recent three quarters.