Highlights From KFT's Q3 Conference Call: Significantly Improved Discretionary Cash Flow; Raises FY Guidance

November 4, 2009 1:55 PM EST

Kraft Foods (NYSE: KFT) reports Q3 EPS of $0.55, 7 cents better than the analyst estimate of $0.48. Revenue for the quarter was $9.8 billion, which compares to the estimate of $10.32 billion. Shares are down 2.7% today.

Highlights From KFT's Q3 Conference Call:

• Sees FY EPS of at least $1.97 (up $0.04 from prior guidance), versus the consensus of $1.97.
  
• (CEO) On the topline or organic growth of 0.5% reflected the impact of three important factors. First, our strategic decision to discontinue less profitable product lines and to forego some unprofitable volume. This reduced topline growth by about one percentage point. Second, consistent with our
  adaptive pricing model, we lowered prices to reflect the impact of lower dairy costs. This reduced our topline growth by about 1.6 percentage points. And third, we faced difficult Q3, year ago comparisons with a highly successful merchandising program at a key North American customer.
  
• Volume mix again improved sequentially as it has in each quarter this year. In Q3, it was up 0.7 percentage points despite the significant headwinds I just mentioned as well as weakening economic conditions in certain Western and Eastern European markets.
  
• Priority brands continue to pay off. In fact, the strong growth of these brands fueled our vol/mix gains in the quarter, and these gains in turn drove a 70 basis point expansion in profit margins.
  
• EPS from continuing operations grew 62%, and about half of that growth was driven by operating gains.
  
• In addition, we delivered a significant improvement in our discretionary cash flow. Year-to-date we've generated approximately $2.7 billion; that's up 67% due to working capital efficiency as well as disciplined management of our capital expenditures.
  
• We've raised our 2009 diluted EPS guidance by $0.04 to at least $1.97.
  
• Last year our advertising and consumer spending as a percentage of net revenue was 6.7%. For 2009 our A&C spending will be up high single digits to approximately 7% of net revenues, even though advertising rates have declined considerably.
  
• On the topline we've revised our forecast for 2009 net revenue growth to about 2% from about 3%.
  
• We will spend more than $200 million this year to jumpstart the significant near-term opportunities we outlined in September. Going forward, we'll generate substantial savings in procurement, manufacturing, customer service and logistics.
  
• Looking ahead we continue to target the following: restoring profit margins to industry benchmarks, achieving the high-end of our seven to 9% EPS growth target and growing cash flow in excess of EPS growth.
  
• (CFO) On the topline, growth was modest but of higher quality as vol/mix became the key driver of our organic growth. As you can see in this chart, organic growth in the quarter was 0.5% including a positive vol/mix contribution of 70 basis points.
  
• Pricing was essentially flat. Carryover pricing was fully offset by about 160 basis points from applying our adaptive pricing model to lower dairy costs in the U.S. and a negative impact of 20 basis points from a value-added tax credit in the year ago quarter. So on a normalized basis, organic growth would have been much closer to our 4% long-term revenue growth target.
  
• The momentum we're seeing in operating gains is being driven by improvement on three fronts: the leverage benefit from sequential improvement in vol/mix driven by the growth in our priority brands, the positive impact from our conscious decision to discontinue less profitable product lines and walk away from unprofitable volume, and more effective management of our cost base.
  
• In Q3 we delivered OI margin of 14.5%; that's up from 11.8% in the year ago quarter.
  
• Year-to-date we generated $2.7 billion in discretionary cash flow.
  
• Through nine months, we're already ahead of our previous full year expectation of $2.6 billion. As a result we now expect to deliver over $3 billion of discretionary cash flow for the full year.
  
• Organic revenue growth in North America declined 1.8% overall. This was entirely due to a 3.5 point decline in price levels.
  
• Lower dairy costs and the related adjustment under our adaptive pricing model represented more than 2.5 percentage points of the decline. Vol/mix was up 1.7 points fueled by growth in priority categories.
  
• In contrast to the Q3 topline profile of total North America, revenue in our priority categories grew solidly. This once again demonstrates the success of our focused investments in product quality, innovation and marketing.
  
• On the bottom line, North America delivered a 290 basis point increase in operating margins to nearly 18%.
  
• There is no question that our 52-week share numbers continued to be challenged (in the U.S.). At the same time, the latest 13-week data indicates we are picking up momentum, and the improvement trend is strong.
  
• Going forward, we expect to see this positive trend continue, most notably as we lap the two quarters most influenced by the pricing actions and decline in consumer sentiment.
  
• In U.S. Beverages, organic net revenue grew 1.5%. Focused investments in innovation and marketing continue to pay off. Kool-Aid powdered beverages and Capri Sun ready-to-drink each delivered double-digit revenue growth in the quarter.
  
• In U.S. Cheese, organic net revenues fell 10.3%. This is entirely due to a 17 percentage point decline in pricing, as dairy input costs have fallen dramatically versus prior year.
  
• We achieved a 12.2% increase in operating income that reflected the impact of improved vol/mix, which was partially offset by a double-digit increase in marketing.
  
• Now let's move on to U.S. Convenient Meals where strong momentum continues. On the topline, organic revenues grew 5%. Our focused investment on priority brands and new products drove improvements in vol/mix.
  
• Some key drivers: DiGiorno Pizza was up more than 20%, the successful introduction of our DiGiorno and CPK flatbread melts drove incremental revenue, and Oscar Mayer Deli Fresh cold cuts grew double-digit.
  
• U.S. Grocery organic revenue fell 3%; however, our investments in innovation and marketing continue to pay off.
  
• Investments behind Miracle Whip and Kraft Mayo drove growth in spoonable dressings, and Jell-O dessert continued to deliver strong growth behind value oriented marketing.
  
• Operating margins, however, rose 380 basis points to 33.2%. Margin benefited from better price to cost alignment and vol/mix.
  
• In U.S. Snacks, organic revenues fell 3.3%, entirely due to lower price levels. Price levels reflected reduced input costs as well as fixing our price gaps in snack nuts. Revenue for our top five biscuit brands were up about 5%, and snack nuts began to rebound.
  
• Turning now to Canada and North America Foodservice. Our business in Canada continued to perform well.
  
• In Europe, revenues were down slightly as we've taken actions to improve the profitability of this important business. The planned discontinuation of product lines and our decision to forego profitable volume resulted in a negative 1.7 percentage point impact on vol/mix.
  
• (Europe) Despite the difficult economic conditions, our priority brands led by Milka, Carte Noire, Philadelphia and Mikado grew around 2% and gained share, particularly in chocolate and coffee. While we expect these near-term headwinds on organic revenue growth to remain, we are making progress on our profit margin, progress that will continue.
  
• The priority brands in Latin America and Asia Pacific grew about 20%, and in CEEMA more than 9%.
  
• (Q&A) Tim, you mentioned specifically walking away from unprofitable volume. Could you tell us a little bit more about that? Was it a specific customer, specific product line? What unprofitable volume are you talking about, and what were the circumstances there? (A)Yeah, I mean as you know, we are in the process of pruning some of our product lines, and this is in addition to that, where there's particular circumstances where we have - it's not a long-term sustainable, but where we have situations where we have business that - there's a lot of price pressure, and we deem it more appropriate and to the health of our business, short-term or long-term, or particularly long-term, to decline participation in that particular business.
  
• You mentioned that in North America, adaptive - the combination of adaptive pricing and the pass through businesses accounted for, I think, 2.5 percentage points of the 3.5% sort of negative pricing. And I guess that leaves another 100 basis points or so of negative pricing in other non-pass through kind of businesses. And I'm curious, first off, that sounds -- I guess that's promotional spending to some extent, but I'd be curious if there's any list pricing actions in there. And that seems maybe somewhat higher, perhaps, than we're hearing from other kind of branded packaged food companies. But I guess the most puzzling thing is it didn't seem to lead to much improvement, obviously, in volume sequentially. Or at least I don't think it did because we don't have exact clarity on volume versus mix. But maybe you could kind of address that because I just get the feeling that's clearly one of the bigger sort of overhangs on the stock right now, understanding the headwinds that you have around SKU reduction and all, but you've had that for the last couple of quarters? (A)Yeah, I think that the - you can certainly see the impact on volume in our Cheese business, which as we said was the single biggest contributor to the price reductions. And so I'm quite pleased with the performance that we're seeing in processed cheese and cream cheese. We've talked a lot about our revitalization of those businesses, and I think you're starting to see that play through not only in the volumes, but as well in the shares on those businesses. Similarly another key contributor was Meat, and I feel very good about the performance of our Meat business in this past quarter. So I think you're seeing it play through. The other business that was impacted by pricing, as Tim mentioned, is our Snacks business and there is two parts there. The one is the nuts business which we've talked about the - our desire to get our price gaps in better alignment there, and we actually are starting to see a moderation in the performance of that business. So I think we certainly saw - we're not quite seeing the growth we'd like, but we definitely had a lesser decline on our nuts business in this last quarter. And lastly biscuits, in response to the drop in wheat. We executed those actions through promotional changes as opposed to through list price reductions. So I think we've described to you the various places where we chose to make some changes. We made the bulk of those changes through impacting them through our trade promotion as opposed to through list price reductions, but I feel quite comfortable where our pricing stands today.
  
• Is it - did volume improve sequentially in the quarter? I think it was flat last quarter. (A)Well, as - we've talked about vol/mix, and you see a significant improvement, and I would say volume as well. We obviously had some mitigating factors that we alluded to: the combination of really the pruning and as well as the fact that we had a significant change in our promotional timing year-over-year, particularly in North America. But we are definitely seeing sequential improvement in vol/mix as we've said we would, and we anticipate in the fourth quarter, that we will continue to see further sequential improvement in its contribution to our overall revenue performance.
  
• And the last thing, and that was a good segue into the fourth quarter. If I think about where your current full-year guidance would imply for the fourth quarter, it looks like an earnings number that's either flat or down a bit versus last year, and yet, when I think about, I guess where maybe an EBIT estimate might be for the fourth quarter, it's pretty similar to where maybe you were on a restated basis back in the fourth quarter of 2006, but you've obviously got almost $2 billion of incremental sales. And so I'm thinking about, despite Wall-to-Wall and restructuring and improving the brand equities and the pricing power, and yes, you've had higher costs across the board. But I guess, I'm just trying to get a sense of- in a bigger picture sense, why are we not seeing any kind of profit leverage on that higher sales base? (A)Andrew, what you're seeing, if you look at 2009, I mean, I think we've said, first and second quarter that 2009 was going to be a little bit unusual year in terms of the seasonality of it. Typically, we're fairly balanced across the fourth quarter, and the first two quarters of this year as a
  result of the financial - the financial crisis in the market out there, we - we gated a lot of our spending to make sure that we had especially plenty of liquidity and we had a healthy financial profile. And so, we reduced a fair amount of the spending, some of the A&C for instance, was a little bit back-end loaded. We're going to see a lot of that pick up in the fourth quarter. That may be a little bit why you're not seeing some of the volumes and vol/mix pop as much as you might expect, because we have a fairly heavy fourth-quarter investment there. Also the investment in some of the cost savings initiatives is also pushed into the fourth quarter. So, we're doing pretty heavy spending in the fourth quarter, again to stage the 2010.

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