Mondelez Offers a Sweet Treat

Irene Rosenfeld orchestrated significant change during her nearly decade-long reign at wide-moat

We believe that while the initial phase of Rosenfeld’s tenure was characterized by empire building following the acquisitions of LU Biscuits and Cadbury, the latter phase was geared toward honing the company’s focus--facilitating the spin-offs of the North American grocery business (now Kraft Heinz KHC) and the international coffee operations. We think slimming down created an opportunity to bolster underlying financial performance, particularly as Mondelez’s sales and profitability lagged peers. In 2014, the company laid out a path to extract more than $1.5 billion in costs from its operations over a multiyear horizon; this is set to wrap up at the end of calendar 2018. While a portion of these savings could have been defined as ensuing from low-hanging fruit, including reducing unnecessary spending on travel, information systems, and consultants, the more meaningful undertaking for Mondelez centered on upgrading its aged production line. Management has suggested that compared with the lines being retired, this upgraded technology has offered 1,000 basis points of margin improvement by taking up a fraction of the floor space, running twice as fast, and necessitating just one third of the human capital investment and half as much operating costs.

We never believed that the singular motivation of this agenda was to generate excess profits; rather, we thought Mondelez also sought to free up funds to reinvest behind its brands as a means to ignite its sales trajectory. However, sustainable top-line growth has failed to ensue. While a portion of the company’s lagging sales can be attributed to macro and competitive headwinds (sales have languished at domestic peers as well), we also think management’s focus on enhancing profitability may have come at the expense of leveraging opportunities to bolster its top line. While operating margins jumped to more than 16% in fiscal 2017 (double the 2010 level), reported sales languished, down by a low-single-digit clip on average over the same horizon.

We thought that by pruning its costs and reinvesting in its brands, Mondelez could enhance its results and secure its competitive edge. However, the company has yet to post much in the way of sustained, broad-based gains, and as such, the shares have generally been range-bound for the better part of the past three years, a horizon over which we’ve tended to view the stock as attractive. This performance appears even more bleak when contrasted with the 35%-plus rise in the S&P 500 during the same period. However, we believe upside will ensue as Mondelez implements Van de Put’s strategic agenda.

Van de Put's Potential Underappreciated We think investors fail to appreciate Van de Put's experience of the past few decades and aren't giving credit for the gains he helped craft at McCain Foods, a leading global frozen potato manufacturer, which we estimate generates more than $7 billion in annual sales. We believe that his tenures at Novartis, Danone, and Mars worldwide should also benefit shareholders as Mondelez works to hone its operations and win with local consumers around the globe.

While financial disclosures for privately held McCain are far from abundant, it has been widely reported that Van de Put helped orchestrate consolidated net sales growth of more than 50% (three fourths of which was driven by its organic mix) while also nearly tripling EBITDA during his six years heading the company. We view this performance as even more notable in light of the low- to mid-single-digit growth that has characterized the mature categories in which McCain plays, including frozen potatoes, frozen vegetables, and frozen pizza.

Further, in a number of the aisles where its business is concentrated, McCain goes to head-to-head with other leading brands and lower-priced private-label fare. Despite this, McCain has held or expanded its share position, even in categories that are more prone to intense competitive pressures and where consumers may make purchase decisions based on price rather than brand. We think this suggests Van de Put understands the importance of innovation geared toward consumers’ evolving preferences and touting these offerings in front of shoppers to ensure that the brands don’t lose clout. In the North American frozen potato category, McCain’s share held around 5% during 2014-16, even though Kraft Heinz and private-label offerings each control around one third of the space. Further, in the Western Europe frozen potato market, McCain consistently boasted just more than one fourth of the category over the same time horizon versus the 35% share held by lower-priced private labels. As a result, we don’t expect Van de Put to chase short-term market share gains at the expense of sustained, profitable growth.

But we also think Van de Put understands how essential it is to invest to support growth opportunities. McCain has funneled capital to expand its manufacturing and distribution facilities to take advantage of growth potential (particularly within its core North American footprint), directing more than $1 billion to add capacity and enhance its infrastructure and capabilities during the 18 months before his departure. As such, we don’t think the pendulum at Mondelez will swing entirely toward igniting top-line gains, but we believe management will concentrate its capital spending where its growth prospects are most favorable, including the on-trend snacking and chocolate aisles and faster-growing emerging markets where it still maintains white-space opportunities for expansion.

Mondelez's Focus Centers on Driving Top-Line Growth We never thought righting the ship at Mondelez would require vast changes in operations, but surmised Van de Put would pursue tactical initiatives to elevate performance. In line with our thinking, his prime objective centers on accelerating Mondelez's top line by extending the distribution of its fare and reinvesting in product innovation aligned with consumer trends.

Beyond facilitating cost savings, one of the benefits that we initially perceived from efforts to roll out upgraded manufacturing lines centered on Mondelez’s ability to be more flexible in terms of the pack sizes it sends to market, allowing it to more efficiently tailor its packaging to extend its distribution reach in channels such as club and dollar stores, where it is relatively underrepresented. We estimate that the company’s distribution in these channels is around 10% of its total versus our estimate of its exposure to more traditional grocery outlets and convenience stores of more than 50%. This is particularly important as consumers are shopping an increased number of channels to meet their needs.

A decreasing number of individuals consider traditional grocery stores as their primary outlet. Consumers viewed the grocery channel as the prime shopping outlet less than 50% of the time in 2016, down from nearly 70% five years prior, according to the Hartman Group/FMI U.S. Grocery Shopper Trends 2016 survey. Further, more consumers are shopping at supercenters and limited-assortment outlets, and many are migrating online: Nielsen research shows that 23% of American households are buying food on the Internet, which is a particular challenge for the impulse-driven snacking and confectionery categories where Mondelez operates.

As Mondelez expands its reach into these alternative-format outlets, particularly on its home turf, this could weigh on volume, given that the company’s volume is reported in pounds versus units. However, we believe this constraint will be offset by the benefits of ensuring its products are placed where consumers are shopping. This underlies our North American sales growth forecast of around 3% average segment growth each year over the next decade, with about 60% of these gains reflecting increased volume and favorable mix.

We also expect Mondelez will increase investment behind its leading brands, potentially starving its noncore offerings. Over the past few years, the company has derived an increased proportion of its sales from its power brands (including Oreo, LU, belVita, Milka, Cadbury Dairy Milk, Toblerone, Trident, and Halls), which have been outgrowing its nonpower brands by about 500 basis points on average. These core offerings now account for about 75% of sales versus just two thirds of sales in 2014.

But we aren’t surprised management has suggested a commitment to also elevating the investments behind its local products (which are often characterized as nonpower brands, given their lack of broad global appeal) to ensure its winning in markets around the world. We believe Van de Put recognizes the importance of fostering growth on a local level and empowering local leaders to drive this growth, versus relying on centralized decisions to drive the company’s course in each of its geographic markets. We’ve long thought that varying tastes and preferences around the world have stood as hurdles to amassing outsize share and volume gains, and we think permitting those individuals who understand local consumers to make decisions regarding product innovation, distribution, and marketing (among other facets) should better equip the company to funnel insights (and additional spending) to elevate sales and ultimately stem the pronounced declines of its local brands on an aggregate basis.

Further, management’s rhetoric suggests a desire to move away from large-scale launches to a “test and learn” approach whereby it will bring a product to market in a select locale, assess consumer response, and adjust the offering as necessary to more effectively win with consumers globally. We view this as a prudent means to more nimbly respond to evolving consumer trends. We think an inability to bring products to market in a timely fashion (with product innovation taking 18-24 months to move from concept to shelf) has stifled top-line gains for companies throughout the category. As such, we look favorably on efforts to combat these challenges.

In this vein, our 10-year explicit forecast calls for Mondelez’s power brands to drive mid-single-digit top-line growth, accounting for just north of 80% of total sales by fiscal 2027. We expect the company’s nonpower brands will also show modest improvement relative to the degradation over the past several years, posting generally flat sales growth on average during the next decade.

Building out its distribution network, empowering local leaders, and a renewed focus on investing in value-added production innovation around the world underlie our geographic segment forecast. We expect Mondelez to chalk up outsize gains in several of its emerging and developing markets, with management’s mid-single-digit long-term sales target in emerging markets (which account for around 40% of sales) and low-single-digit growth in developed regions aligning with our forecast.

Despite its focus on advancing the top line, we don’t expect Mondelez will hold on to poor performers as a means to foster growth. From a portfolio mix perspective, Mondelez’s Achilles heel has been its gum arm (less than 15% of sales, including candy), which remains in the doldrums. As a category, the global gum market grew at a 7% compound annual rate between 1998 and 2008, but growth 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. It has generally held about flat over the past two years. A portion of this weakness has reflected tough macro conditions (including elevated unemployment rates 5-10 years ago, particularly among teenagers, who were avid users), but some of the wounds have been self-inflicted, as reduced ad spending and a proliferation of stock-keeping units have also kept a lid on category sales.

However, this story has been bifurcated, with growth languishing in developed markets like the United States (down by a low- to mid-single-digit clip annually over the last five years, by our estimates) and blossoming in emerging markets like China (which had been chalking up low-double-digit category gains). In the past two years, this growth in China has come under pressure as local consumers have opted for healthier alternatives. However, we don’t believe this suggests Mondelez’s growth potential is off the table in China. Rather, we think the opportunity for Mondelez (which maintains just 12% share of the gum market in China) resides in the fact that in the Chinese gum space, foreign brands continue to win at the expense of local brands. While the company’s share pales in comparison with the 40%-plus that Mars-Wrigley boasts, we think this actually signals the robust inroads Mondelez has made since entering the local category 5-10 years prior, particularly as it has stolen this share from its dominant industry foe, which has incurred an approximate 600-basis-point erosion in share. We think Mondelez could be poised to steal share from other local operators, particularly if it adeptly alters its fare to align with local tastes and preferences and spends to market its offerings.

Despite its lagging performance in gum on a global basis, we expect Mondelez will remain committed to the category, given the benefits afforded by the scale this business provides. We think management recognizes the shortcomings of its past directives, as it now is opting to boost innovation (particularly concentrated on the refreshment attributes of gum and mints) as well as increase marketing spending to tout its new offerings. We believe this focus should aid sales long term and expect Mondelez’s gum and candy segment to grow at a low-single-digit clip over the next decade.

However, we think the company could look to shrink its exposure to other underperforming brands and businesses. Management has expressed an openness to selling noncore brands and businesses, with an eye on maximizing returns; as such, fire sales are unlikely. While management has refrained from providing much context on where it could slim down, we’ve long thought it may prune its mix in the beverage and cheese and grocery categories, which in aggregate account for around a low teens percentage of sales; we'd argue these categories don't maintain the same clout with retailers or end consumers, and as a result, fail to amass much in the way of pricing power, given that in these categories, consumers tend to make purchase decisions based on price as opposed to brands. With this in mind, we assume that the company could ultimately part ways with about 5% of its sales mix, or around $1 billion in sales, as it focuses on the brands and businesses that possess the most pricing power without sacrificing its own scale edge with retailers and suppliers. At 2 times sales (less than the 3 times sales expended for recent transactions in the space, based on data from PitchBook and company filings), these funds could be used to finance additional organic and inorganic investments in the business.

As a result of a diverging category landscape and our contention that Mondelez will look to drive growth in the on-trend and higher-margin snacking realm, we forecast that chocolate and biscuits will boast mid-single-digit sales gains over the next decade; this generally aligns with estimated sector prospects. This exceeds our expectations for the low-single-digit growth we forecast for gum, beverages, and cheese and grocery. Our outlook calls for chocolate and biscuits to make up an increasing portion of the mix over time, with gum, beverages, and cheese and grocery shrinking to just one fifth of sales in the aggregate, down from more than 30% on average over the past three years. Overall, we forecast 3%-4% annual organic sales growth for the company on average over the next decade, fairly balanced between higher prices and increased volume.

Profitability Won't Be Ignored While much attention centers on the company's opportunities to bolster sales, we never thought the pendulum would swing entirely to sales gains under Van de Put's direction. Following the Kraft-Heinz tie-up three years ago, the strategic focus for packaged food companies has been on extracting efficiencies. Mondelez's current cost-saving targets (which approximate $1.5 billion) equate to about 7% of cost of goods sold and operating expenses, excluding depreciation and amortization expense, which generally aligns with the 6%-9% savings targeted at other domestic food and beverage manufacturers.

But we didn’t believe recent improvement signaled a cap on Mondelez’s profit potential. Because of that, we weren’t surprised by the suggestion that Mondelez is poised to realize additional efficiency gains between fiscal 2019 and fiscal 2022. While management was reluctant to quantify its cost-saving objectives, we see an additional $1 billion in excess costs that it could remove, primarily by extracting further complexity from its operations (including rationalizing its suppliers, parting ways with unprofitable brands, and continuing to upgrade its manufacturing facilities). However, we didn’t anticipate that the bulk of these savings stood to bolster its profitability. In line with our thinking, management stressed that a portion of any savings realized would fuel additional spending behind its brand mix (in the form of research and development as well as marketing), supporting the intangible asset that underlies the company’s wide economic moat. This aligns with our forecast for R&D and marketing to edge up to 8% of sales over the next 10 years (about $2.6 billion annually), above historical levels of 6%-7% ($2 billion).

We recognize that some of Mondelez’s peers have chosen to cut costs too far in the past, notably Kellogg K, which sought to remove costs 5-10 years ago but failed to concurrently invest in its manufacturing and distribution network to support growth, leading to a handful of recalls as quality control languished. However, we don’t expect the same fate will befall Mondelez’s operations, given Van de Put’s past directives to invest to fuel growth opportunities during his time at McCain.

We compared the spending Mondelez currently earmarks for its brands and our forecast relative to its peer set, specifically related to cost of goods sold, selling, general, and administrative expenses, marketing, and R&D. In this context, Mondelez’s SG&A, at nearly 9% of sales, would still be a touch above the 8% of sales we forecast its peers will spend. This indicates to us that Mondelez maintains capacity to shed additional costs beyond the current restructuring plans. In addition, we expect Mondelez will allocate slightly higher spending behind its brands in the form of R&D and marketing (about 100 basis points in aggregate). As such, our forecast for margin improvement doesn’t hinge on the degree to which the company invests behind its brands, unlike Kraft Heinz. We forecast Mondelez will shell out around 8% of sales to fund research, development, and marketing (in total), far outpacing the low single digits Kraft Heinz currently directs toward those avenues.

Further, unlike the last couple of years, we anticipate that raw material inflation will persist longer term. Adding to the pressure on the cost of goods sold line are investments Mondelez is likely to make to improve the health profile of its fare, particularly given the constrained supply but pronounced demand that exists for these raw materials. As such, we forecast gross margins to improve just 50 basis points on average over the next decade to 39%-40% relative to the last three years, squarely in line with peers.

Rising commodity costs present a predicament for consumer product manufacturers as to whether offsetting this inflation with higher prices is wise. Unlike other categories in the grocery store, though, confectionery and snacking maintain lower levels of private-label competition, at just a mid- to high-single-digit level versus the high teens to low 20s in U.S. food and beverage overall. As a result, this category has not historically not succumbed to lasting volume pressures when companies have opted to raise prices. Brands can be a significant advantage if a consumer product company is able to garner value from its portfolio mix by passing through these higher costs to end customers. In this vein, we estimate that Mondelez’s price/mix, adjusted for inflation (as measured by the consumer price index), has averaged more than 1% during the past five years, among the strongest performance in its peer set. Further, we believe the resources the company maintains to reinvest in its brands have entrenched its business with leading retailers that depend on leading brands to drive traffic into outlets, supporting Mondelez’s wide economic moat.

When taken together, we think these factors put Mondelez’s consolidated operating margins around 19% on average over the course of our explicit forecast, modestly trailing the 20% we foresee for a group of industry peers but still above the low- to mid-teens that have historically characterized its operations.

Industry Consolidation Poised to Persist Enhancing underlying fundamentals is a key component of Mondelez's strategic roadmap. But what does that imply for the company's priorities for cash? We forecast Mondelez will generate free cash flow as a percentage of sales at approximately a low- to mid-teens level on average annually over our explicit forecast (at the high end of its peer set). We expect Mondelez will continue to direct around 3%-4% of sales toward capital expenditures, down from 4.5%-5% over the past five years (a period that included outsize efforts to build out and upgrade its global manufacturing footprint) but generally consistent with the levels at other leading packaged food manufacturers.

While acquisitions have generally not been a significant component of Mondelez’s cash priorities since the 2010 tie-up with Cadbury, management has expressed an appetite to pursue select inorganic opportunities as a means by which to enhance its scale in growth markets, build out its position in snacking adjacencies, and bring new capabilities in house (the benefits of which would ultimately be additive to its 3%-plus sales growth targets over the longer term). In this vein, Mondelez announced in May a deal to add Tate’s Bake Shop to its mix for $500 million. At just a low-single-digit percentage of sales, this deal is not material enough to move the needle on overall results. We see the benefit as beefing up exposure to faster-growing areas of the store. Smaller niche operators have demonstrated more agility in adapting their mix to changing preferences. Thus, we perceive tie-ups with these operators as potentially affording Mondelez insights into how to respond to evolving consumer trends in a timelier fashion. We think the inability to do so has plagued companies throughout the grocery store, and we view efforts to grease the wheels of its innovation cycle positively.

Although Mondelez could become a more active acquirer--we estimate it could assume an additional $6 billion-$7 billion in long-term debt, which would take debt/adjusted EBITDA from the mid-3s to the mid-4s)--we think it will still operate as a prudent capital allocator. Its adjusted returns on invested capital have exceeded our cost of capital estimate in each of the past five years. In support of our thinking, Mondelez made a $23 billion advance for Hershey HSY in an attempt to gain a foothold in the U.S. confectionery market, since Hershey controls the license of Cadbury’s confectionery offerings in the U.S. But Mondelez abandoned its pursuit in August 2016 as a tie-up seemed unlikely, partly because Hershey is a controlled company.

From a strategic perspective, we thought a deal could have been advantageous for both companies, affording Mondelez entry into the attractive U.S. chocolate space while facilitating Hershey’s expansion beyond its home turf. However, we weren’t convinced that even a higher price tag would have made Hershey amenable to an agreement. Mondelez’s decision to walk away supports our contention that the company will remain focused on extracting costs from its bloated operations and reigniting its top line, as opposed to merely looking to boost sales prospects at any cost. We think it will continue operating with this level of discipline, and we haven’t wavered on our view that management is a standard steward of shareholder capital.

Beyond pursuing further tie-ups, we think returning excess cash flow to shareholders--through dividends and share repurchases--will be another priority for cash ahead of debt repayment, given the interest held in the company by activist investors like Nelson Peltz and Bill Ackman. We forecast Mondelez will increase its shareholder dividend in the high-single-digit range on average annually through fiscal 2027, implying a payout ratio of 30%-40%, while also repurchasing around 2%-3% of shares outstanding annually. However, we don’t think income investors will view Mondelez’s 2.4% yield as favorably as the yields of packaged food peers like General Mills GIS at 4.1% or Kellogg at 3%.

Mondelez Is Undervalued We think the market is extrapolating the company's recent top-line struggles and not taking into account the opportunity for Mondelez to improve the efficiency of its organization, increase future demand for its products, and hone its focus on a greater proportion of sales from more brand-loyal categories like confectionery and snacking, where private-label penetration is nascent.

Our $52 fair value estimate incorporates 3%-4% annual sales growth, about 50 basis points of gross margin improvement (relative to the average for fiscal 2015-17) to just north of 39% over the next decade, and 400 basis points of consolidated operating margin expansion to about 20% by fiscal 2027. We believe the shares offer investors an attractive risk/reward opportunity, trading more than 15% below our valuation.

Despite intense headwinds, particularly in the form of intense competition from other branded companies and smaller niche operators, combined with the need to fuel brand spending to maintain entrenched retail partnerships, we believe Mondelez offers investors an opportunity to build a position in a competitively advantaged name at a discount.