Add Some Ketchup to That Mac and Cheese

After incorporating the pending merger with H.J. Heinz, we've raised our fair value estimate for

As a result of the firm's focus on investing in new products that resonate with consumers, combined with the potential to extend the distribution of Kraft's brands over Heinz's global network, we forecast that annual sales growth will amount to 3%-4% longer term. Further, Kraft has continued to take a hard look at its cost structure by realigning its U.S. sales organization, consolidating domestic management centers, and streamlining the corporate and business unit organizations, and we think these efforts will be accelerated when it combines with Heinz. The company plans to cut $1.5 billion in costs from its operations, representing 10% of Kraft's annual cost of goods sold and operating expenses. While high, this is probably quite achievable, given the success Heinz has realized. In light of these efforts, we believe the firm is poised to generate operating margins exceeding 21% over our 10-year explicit forecast, well above the midteens its peers tout.

Deal Boosts Competitive Position From our vantage point, Kraft's deal with Heinz stands to boost the competitive positioning of the combined entity. Kraft-Heinz would leapfrog Coca-Cola KO to become the third-largest food and beverage firm in North America behind PepsiCo PEP and Nestle NSRGY, boasting more than $22 billion in sales in 2014 ($29 billion on a consolidated global basis). Further, brand strength would be sound, with eight brands generating more than $1 billion in annual sales and another five garnering $500 million-$1 billion in sales each year.

Despite the opportunity to extend the distribution of Kraft's fare across Heinz's vast global distribution platform, we suspect a fair amount of brand pruning could be in the cards, similar to the actions 3G has taken since owning Heinz (shedding Shanghai Long Fong Food in China and the domestic food-service dessert business in 2013). For one, we've thought for some time that Jell-O, which continues to falter despite multiple stabs at putting it on more stable ground, could be axed in favor of allocating more capital to faster-growing categories such as organics, or even pursuing a tie-up outside the United States. These actions strike us as likely under new management.

Brand Investment Should Bring Growth Kraft has been challenged as an independent organization, given the ultracompetitive operating environment combined with rampant cost inflation and soft consumer spending at home, which has been exacerbated by the recent reduction in the federal food-assistance program. However, Kraft's brands had been underinvested in by its previous owners, and we think that by expending resources to tout its product set in front of consumers (both in terms of product innovation and marketing support), the firm should realize a decent level of top-line growth. We also surmise that revenue synergies are attainable, as Kraft--the bulk of whose sales come from the U.S. and Canada--can now sell its fare across Heinz's vast global distribution platform, which derives 60% of sales outside North America, including 25% in emerging and developing markets. As a result, over the longer term we forecast that annual sales growth will amount to 3%-4%, driven by new products and higher prices.

Management further anticipates beefing up the efficiency of its business, similar to the success Heinz has realized--its EBITDA margins soared to 26% in fiscal 2014 from 18% predeal in mid-2013. It plans to do this by cutting $1.5 billion in costs from its operations (representing 10% of Kraft's annual cost of goods sold and operating expenses). Because we think the company's ability to realize further cost savings should persist for some time, we forecast that operating margins will expand to nearly 20% by fiscal 2017 (200 basis points above fiscal 2014) and more than 21% by fiscal 2024. Over our 10-year explicit forecast, we anticipate that returns on invested capital will exceed our cost of capital estimate, supporting our take that Kraft maintains a narrow economic moat.

Economies of Scale Bolster Moat In our view, a tie-up with Heinz would enhance Kraft's narrow economic moat, which is derived from the firm's solid brand intangible asset and economies of scale on its home turf. As a combined firm, Kraft-Heinz will be the third-largest food and beverage firm in North America. Kraft's offerings already span the grocery store, but as a merged business, brand strength could prove even sounder, with eight brands generating more than $1 billion in annual sales (including Kraft cheeses, dinners, and dressings; Oscar Mayer meats; and Philadelphia cream cheese) and another five (including Kool-Aid, Capri Sun, and Ore-Ida) garnering $500 million-$1 billion in sales each year. We further believe the enhanced scale afforded by the deal stands to beef up negotiating leverage with retailers that depend on leading brands to drive traffic in their stores. According to management, Kraft products account for 4%-6% of every American grocery store's sales, highlighting the strength of its brand set. While we intend to revisit our moat rating as we get a better understanding about the company's brand portfolio going forward, the firm still falls short of a wide moat at this time, in our view, because some of the categories in which it competes--like packaged meats and cheeses--have become commodified, as consumers are less willing to pay up for the company's brands. This is a particular challenge given that switching costs are nonexistent in the consumer product industry. However, if the combined organization steers away from these commodified categories, we may increase our rating to wide.

Cash-conscious consumers continue to seek value offerings, but we think the firm's portfolio (convenient meals, beverages, and cheese) should appeal to consumers opting to dine at home. Further, we expect brand investments to support its competitive edge will remain at the forefront of Kraft-Heinz's strategy. Kraft spends nearly $650 billion (nearly 4% of sales) on advertising and dedicates more than $150 million annually to research and development, and we suspect this will persist under the new management team. From our perspective, launching new products differentiates branded offerings from lower-priced private-label items, and touting brands in front of consumers is key, given the competitive landscape. This renewed focus on innovation has been yielding measurable improvements for Kraft, as revenue from innovation increased to around 14%, more than 2 times the level generated in 2009--which we view as an impressive turnaround. We surmise new management could look to build a more notable presence in the natural and organics aisle. However, we don't believe this would enhance the firm's competitive position and margin profile. While in general the price premium afforded to organic products seems to support a brand intangible asset, we don't view this as a sustainable source of competitive advantage. We believe organics' pricing power may wither away if supply catches up with demand, or if consumers lose confidence in the quality of organic products--a possibility if the designation is too wide and deep to be well regulated.

Integration and Competition Are Risks Kraft's planned tie-up with Heinz could encounter a number of pitfalls. The integration could prove more difficult to digest than the firm anticipates, particularly as management attempts to extract a significant amount of costs from the business. Further, attempts to extend the distribution of Kraft's products through Heinz's international network may fall flat with consumers.

Beyond the challenges that could arise as a result of the merger, promotional spending appears to be running rampant throughout the consumer goods space as packaged food firms (both other branded players and lower-priced private-label products) battle to garner more of consumers' reduced discretionary budgets. However, Kraft cites limited participation in this activity, highlighting macaroni and cheese as well as desserts as areas where it looked to defend its share position over the past few quarters.

In addition, consumers perceive a few of the categories in which Kraft competes--namely cheese and packaged meats--as commodified, meaning they are more likely to consider price rather than brand when making purchase decisions. Further, Kraft generates 26% of its sales from Wal-Mart and 42% from its five largest customers. As such, Kraft's bargaining power could be diminished as the base of retail outlets consolidates and market share shifts to mass merchants and warehouse clubs at the expense of traditional grocery stores.

Bouts of unfavorable weather, as well as increased demand in emerging markets, could place upward pressure on raw material prices for products such as dairy, coffee beans, meat, wheat, soybean, nuts, and sugar longer term. In response to rampant cost inflation in the cheese, meat, and coffee categories in the recent past, Kraft has put through significantly higher prices. However, the firm has been unable to fully offset the hit to profitability, given the lag in the benefit.

New Management May Shed Underperformers We doubt Kraft's stewardship will veer from optimizing shareholder returns after merging with Heinz. Heinz CEO Bernardo Hees is poised to assume the top spot of the combined firm, while recently appointed Kraft CEO John Cahill will become vice chairman. Hees formerly served as CEO of Burger King. From what we've been able to gather, Hees has proved to be an adept leader at Heinz, and we think the firm, and ultimately shareholders, will benefit from his leadership. Further, Cahill possesses significant experience in the food and beverage industry after spending about 20 years at Pepsi Bottling Group and PepsiCo, which is also a plus. If the company can meet its cost-cutting targets while maintaining a prudent capital-allocation strategy, we may look to raise our stewardship rating to exemplary from standard.

We think this series of leadership changes signals that Kraft might eventually take more aggressive actions to shed underperforming brands. As an independent organization, Kraft has reignited several lackluster products that had been underinvested in previously, such as Kraft mayonnaise. However, despite multiple attempts to put the Jell-O brand on more stable ground, the business continues to falter. We think management might now reallocate investment dollars toward more profitable initiatives (expending additional resources toward faster-growing categories, such as organics, or even pursuing a tie-up outside the U.S.). We don't expect to garner any insights into the strategic direction for the combined firm for another few months, and we will refrain from making any changes to our view in the meantime.