Wide-Moat Mondelez Is Up to the Challenge

We think the recent share price pullback most likely reflects Kraft Heinz’s KHC unsolicited (and rebuffed) offer for Unilever UL/UN, rather than persistent headwinds. Although we doubt Kraft Heinz’s interest in consolidating the space has subsided, it is far from clear where the firm’s intentions lie. We’ve long thought Mondelez could fit the bill, given its outsize exposure to faster-growing emerging markets where Kraft Heinz’s penetration is not as robust, but the strides Mondelez is making to bolster its profitability--adjusted operating margins jumped to more than 15% in fiscal 2016, up almost 500 basis points over the past four years--signal that reuniting Kraft’s North American grocery operations with its former global snack business may be less likely now. This probably took some air out of Mondelez’s valuation.

We maintain that Mondelez’s focus on driving cost savings--which it pegs at $1.5 billion, trailing our $2.2 billion target--is prudent and stands to not only bolster profits, but also fuel brand investments, supporting the intangible asset source of its wide economic moat. We forecast research and development and marketing to edge up to more than 8% of sales in the next 10 years, or $3.5 billion, above the nearly 6% of sales, or $2 billion, the firm has historically allocated toward brand investment.

Despite recent challenges, Mondelez boasts returns on invested capital in excess of our 7% cost of capital estimate. We anticipate that it will continue generating excess returns for shareholders for a long time, averaging 13% over the next five years. We also forecast that free cash flow will average about 12% of sales annually over our 10-year explicit forecast, implying that even at current levels, debt service should not be a concern. However, we anticipate that reinvesting in the business while pursuing additional mergers and acquisitions will take top billing over the next few years. Even with Mondelez’s vast global presence, we believe the opportunity to expand its footprint into untapped markets like Indonesia and Germany could be in the cards. We think that returning excess cash flow to shareholders in the form of increased dividends and share repurchases will be slotted as another priority for cash ahead of debt repayment, particularly given the interest taken in the firm by activist investors like Nelson Peltz and Bill Ackman. We expect the company will increase its shareholder dividend, which currently yields just north of 1%, by the midsingle digits annually through fiscal 2026.

Wide Moat From Economies of Scale and Robust Portfolio As a leading player in the global snack category, Mondelez has earned a wide economic moat from the economies of scale that result from its expansive global network (more than 75% of revenue is derived outside North America) and portfolio of well-known brands (seven generate more than $1 billion each in annual sales, including Oreo, Cadbury, LU, and Trident). After acquiring Cadbury in 2010, the combined firm leapfrogged Mars/Wrigley as the leading player in the higher-growth, higher-margin global confectionery industry, taking 15% global share of the chocolate space. In addition, Mondelez holds the top spot in the biscuit aisle (18% share worldwide, or more than 4 times the 4% share held by Kellogg K and 3% share that Campbell Soup CPB maintains) and the global candy category (7% share as its Halls is the leading worldwide candy brand). Our expectation for returns on invested capital, excluding goodwill, in the midteens supports our stance that Mondelez has earned a wide economic moat.

Commodities Costs and Currency Are Risks Input cost pressures--of commodities such as cocoa, sugar, dairy, and grains--can fluctuate wildly and could pressure Mondelez's profits. Despite its recent efforts, the firm may struggle to remove the level of costs it currently targets, and profits could languish.

The gum category remains under pressure. Between 1998 and 2008, the global gum market grew at a 7% compound annual rate but slowed to just 3% between 2008 and 2011 and a mere 0.4% on average between 2012 and 2014 before falling 0.4% in 2015. A portion of this weakness reflects tough macro conditions, including elevated unemployment rates, particularly among teenagers, who are avid users. However, some of the wounds have been self-inflicted, as reduced ad spending and a proliferation of stock-keeping units have also dragged on category sales.

Volume growth has also languished as Mondelez has raised prices to offset pronounced currency devaluations in select emerging markets. International sales account for around 75% of the firm’s total base, implying volatile currency fluctuations will affect reported results from time to time. Further, stumbles in Brazil, Russia, and Canada as well as allegations from the Indian government that Mondelez avoided $46 million (INR 2.5 billion) in taxes from May 2010 to January 2013 by using a tax holiday for production at a local facility the government claims was not operational at the time have proved to be distractions for management.

Britain’s vote to exit the European Union could prove challenging down the road; Mondelez derives around one third of its sales from the EU versus our estimate of only a mid-single-digit percentage from the United Kingdom. However, the ultimate impact of the vote is highly uncertain at this point, and we think Mondelez’s expansive global network, combined with its advantaged brand portfolio, should ensure that it weathers these impending headwinds.