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Morningstar | Although Fiscal 2019 Outlook Leaves a Sour Taste, Mondelez Cooks Up Sweet Recipe for Long-term Gains

After nine months at the helm, Mondelez’s new CEO Dirk Van de Put has provided clarity as to the direction the firm is slated to embark upon and the gains he believes are likely to ensue from these plans. We’ve never been in the camp that righting the ship at Mondelez would necessitate seismic shifts in its operations, but rather more tactical initiatives to facilitate sustainable improvement , particularly in terms of sales. And we weren’t surprised that accelerating the top line is at the forefront of the firm’s updated strategic direction. More specifically, Mondelez is targeting 3%-plus sales growth longer term, as it works to extend the distribution of its fare and reinvest in product innovation aligned with consumer trends both at home and abroad. However, in line with our thinking, Mondelez doesn’t aim to sacrifice the strides in adjusted operating margins realized over the last five years (more than 500 basis points of improvement to north of 16% as it has improved the efficiency of its supply chain and manufacturing footprint) to bolster its sales trajectory, targeting high-single-digit adjusted earnings growth, which strikes us as achievable.

While management maintained its outlook for fiscal 2018 (1%-2% organic sales growth and adjusted operating margins around 17%, versus our 1.3% and 16.9%, respective forecast), the firm’s fiscal 2019 profit expectation (just 3%-5% adjusted EPS growth) was more tepid than we were anticipating, as Van de Put ups the ante on near-term brand spending to support long-term growth, which we view as prudent. Even after trimming our fiscal 2019 profit outlook, we don’t intend to alter our long-term forecast (3%-4% average annual top-line growth through fiscal 2027 and another 300 basis points of operating margin expansion to around 20% by the end of the decade) and see little change to our $52 fair value estimate. We view shares in this wide-moat operator as attractive, trading 20% below our valuation.

As we suggested in our August Select piece “While Shares Have Soured, Mondelez Still Offers a Sweet Treat,” the firm’s tactics to igniting its sales trajectory are multifaceted. For one, management repeatedly stressed the importance of empowering its local leaders. We've long surmised that varying tastes and preferences around the world have stood as hurdles to amassing outsize share and volumes gains, and we think that permitting those individuals who have a pulse on the local consumer tastes to make decisions regarding product innovation, distribution, and marketing (among other facets) should better equip Mondelez to funnel insights (and additional spending) to innovate its local product, helping elevate its sales and ultimately stem the pronounced declines of its local brands on an aggregate basis (the erosion that management attributes to the lack of spending in both R&D and marketing to necessary to ensure each remains competitive). In this vein, management is targeting mid-single-digit long-term sales gains in its emerging market regions (which account for around 40% of its sales), in excess of the low-single-digit growth it aims to chalk up in developed regions, both of which align with our forecast.

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 around the world. We view this as a prudent means to more nimbly respond to evolving consumer trends. From our vantage point, an inability to bring products to market in a timely fashion (with product innovation taking anywhere from 18 to 24 months to move from concept to shelf) has stifled top-line gains for firms throughout the category. As such, we look favorably on efforts to combat these challenges.

We think the benefits from this shift in product innovation cadence could prove particularly beneficial for the firm’s ailing gum business, which currently represents just 8% of its total sales base but yield margins north of the company average. A portion of its weakness in this category has reflected tough macro conditions (including elevated unemployment rates five to 10 years ago, particularly among teenagers, who were avid users), but some of the wounds have been self-inflicted, as reduced ad spend and a proliferation of stock-keeping units have also kept a lid on category sales. 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 spend 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 course of the next decade.

Although boosting sales is at the heart of his strategic agenda, we’ve never thought that Mondelez would hold on to poor performers merely to prop up growth. In this vein, management expressed an openness to divest noncore brands and businesses, with an eye on maximizing returns (as such, fire sales are unlikely). While management refrained from providing much context on where it could look to slim down, we’ve long thought it may prune its mix in the beverage and cheese and grocery categories over time (which in aggregate account for around a low-teens percentage of sales), as we'd argue these categories don't maintain the same clout with retailers or the end consumer and as such, 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 firm could ultimately part ways with about 5% of its sale mix, or around $1 billion in sales, as it narrows its scope to focus on the brands and businesses that possess the most pricing power without sacrificing its own scale edge with retailers and suppliers. And at 2 times sales (just less than the 3 times sales expended for recent transactions in the space based on data from PitchBook and company filings), we think these funds could be used to finance additional organic and inorganic investments in the business

Despite an outsize focus over the past few years on its underlying operations, management also 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 more than 3% sales growth targets over the longer term). In this vein, we continue to believe that its bent toward acquisitions will generally center on smaller, bolt-on deals that are unlikely to move the needle on its financial performance (similar to the recent tie-ups with Tate’s Bake Shop, Enjoy Life Foods, and Kinh Do). However, we posit the benefits stem from adding niche businesses to its mix extend beyond the increased exposure to faster-growing categories or markets. Rather, we believe smaller niche operators have demonstrated an ability to be more agile in adapting their mix to changing preferences. As such, we perceive tie-ups with these operators as potentially affording Mondelez the opportunity to extract insights into how to respond to evolving consumer trends in a timelier fashion. We think the inability to do so has plagued firms throughout the grocery store and view efforts to grease the wheels of its innovation cycle positively.

And while much attention centered on its opportunities to bolster sales, we never surmised the pendulum would shift entirely to sales gains under Van de Put’s direction; rather, based on his tenure at privately held McCain Foods and his recent rhetoric, we suspected he would opt to put the firm on a path to drive sustained, profitable growth. As such, 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-savings objectives, we see an additional $1 billion in excess costs that it could remove (on top of the $1.5 billion realized over the past several years), primarily by extracting further complexity from its operations (including rationalizing its suppliers, parting ways with unprofitable brands, and continuing to upgrade its manufacturing facilities). But we didn’t anticipate the bulk of these savings stood to bolster its profitability. And 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 both R&D as well as marketing), supporting the intangible asset that underlies its wide economic moat. This aligns with our forecast calling for research, development, and marketing to edge up to 8% of sales over the next 10 years (or about $2.6 billion annually), above historical levels of 6%-7% ($2 billion).