Some people built

Income investors got an early holiday gift in October, when Kraft was split into two: A high-growth international snack-food business — Mondelez International (Nasdaq: MDLZ) — and Kraft Foods Group (Nasdaq: KRFT), a North American packaged-food business that’s more focused on paying nice dividends to shareholders.#-ad_banner-#

The deal was structured as a tax-free spinoff, with Mondelez shareholders receiving one Kraft share for every three Mondelez shares held. At the time of the spinoff, Kraft was North America’s fourth-largest packaged-food company, with reported revenue of $19 billion in 2011. As two separate entities, Mondelez now owns the Oreo, Cadbury and Nabisco snack food brands, while Kraft hung on to its familiar household U.S. brands — Oscar Mayer, Miracle Whip and Velveeta.

The deal was intended to unlock shareholder value, and now the “new” Kraft is a far more enticing income investment than the “old” Kraft. For starters, the $27.4 billion company was launched from a position of strength, with three-quarters of its revenue earned from product categories where Kraft is either the market leader or a close second.

In addition, as a now leaner company, this new Kraft is now able to focus on profitable growth and on returning cash to investors. This can already be seen in its laser-focused dividend policy. For example, the new Kraft pays a richer annual dividend ($2 versus $1.16 per share) and has a better yield (4.4% versus 3%). In addition, the new Kraft is committed to 5-9% annual dividend growth, while the old Kraft had hiked the dividend only twice in the last five years. To be fair though, the company rarely raised dividends because it was too busy with its aggressive overseas expansion, which consumed large amounts of cash flow each year (Kraft plowed back billions into international acquisitions — such as its $10 billion purchase of Cadbury– and expansions in Europe and Asia.)

Here are six other reasons Kraft is a top income stock worthy of consideration in every investor’s portfolio…

1. Dominant brands
On average, Kraft brands have twice the market share of the next branded competitor. The company estimates 98% of U.S. households have Kraft products in their refrigerator. The reliable earnings produced by its iconic brands make Kraft a true cash-generating machine. Each of the 10 brands Kraft owns generates at least $500 million in annual sales.


2. Generous cash flow
Kraft produces more than $4 billion of cash flow annually and has better than two-fold coverage of the dividend. 

The company is content owning a mature, but highly profitable North American operation, and has no plans to siphon off cash to invest overseas. Instead, Kraft plans to reinvest 50% of cash flow in operations and return the other 50% to investors through share repurchases and the dividend payments.


3. Currency risk removed
Another key advantage of the Kraft spinoff is greater safety and predictability of results due to an exclusive North American focus. There is now minimal exposure to currency fluctuations and no risks from a weakening European economy. These issues are hurting packaged-food competitors like Proctor & Gamble (NYSE: PG), General Mills (NYSE: GM) and Unilever (NYSE: UL), which have significant sales overseas.


4. Opportunities to boost profits…
Margins were eroding before, but the new Kraft is trying to reverse this trend by allocating more resources to larger and more profitable brands. This strategy should enable new Kraft to capture market share and grow faster than competitors. The breadth of Kraft’s product line had led to a scatter-gun approach to advertising, and spending that was only two-thirds that of packaged-food peers. The new Kraft has more resources to invest in marketing and a tactical approach that allocates advertising dollars based on profit margins and momentum of each brand. This new marketing plan has already produced 20% sales gains for Velveeta Shells & Cheese and Kraft Mayo, and 10-11% higher sales for Capri Sun and Philadelphia Cream Cheese. Kraft also plans to re-energize familiar but languishing brands such as Jello, Maxwell House Coffee and Planters Nuts through targeted ad spending.


5. …and productivity
Because of its smaller, more tightly-focused brand portfolio, Kraft expects to deliver industry-leading productivity as well as cost savings through specialized quality management initiatives, supply chain simplification and strategic sourcing. The company has already delivered four straight quarters of top- and bottom-line growth, and predicts high single-digit earnings-per-share growth on a consistent basis. For every dollar of cost savings achieved, Kraft plans to reinvest 50 cents in the business and return 50 cents to shareholders.


6. Firm commitment to dividend
Cash will be king, according to the new CEO W. Anthony Vernon, and Kraft will live and die by its dividend. “This dividend reflects our intention to deliver a significant return of cash to shareholders through a superior dividend payout that’s targeted to grow consistently, year after year,” he recently said in a statement. 

The company declared an initial quarterly dividend of 50 cents per share ($2 annualized) in December that yields 4.4%, as stated earlier. In addition, it targets 75% dividend payout on an ongoing basis (versus 50-60% payout for old Kraft) and more consistent dividend growth, which will be funded by steadily increasing free cash flow. The new Kraft targets free cash flow at 85% of earnings, while the old Kraft rarely produced free cash flow above 60-70% of earnings.

Risks to Consider: There are risks associated with Kraft’s new strategy and the company warned investors to expect flat-to-declining sales next quarter, as it prunes less profitable brands and incurs restructuring costs. Kraft is reportedly in the process of selling its Breakstone dairy business and estimates $490 million of restructuring costs, including $180 million of cash expenditures, through 2014.

In addition, Kraft was debt-free before the spinoff, but had to borrow funds to pay a special dividend to Mondelez. As a result, the new company has $9.6 billion of long-term debt versus just $7.5 billion of shareholders’ equity. There are no debt maturities before June 2015.

Action to Take –> Income investors should find plenty to like about the new Kraft. As more focused firm, it is able to invest in the growth of its dominating brand names, but without the lavish spending or bureaucracy that hindered before the spinoff. In addition, Kraft shares appear reasonably priced currently, with a price-to-earnings (P/E) ratio of 14, below the average P/E ratio of 18 for food industry peers.

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