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H. J. Heinz Company’s ( HNZ - Analyst Report ) second quarter 2013 adjusted earnings of 90 cents per share beat the Zacks Consensus Estimate of 88 cents by 2.2%. The Ketchup and Sauce Company has now outpaced earnings estimates for four straight quarters.
Earnings also exceeded the prior-year earnings by 11.1% on the back of growth initiatives in emerging markets, improving volume trends in North America and a lower tax rate. Currency fluctuations hurt earnings by 2 cents per share, excluding which earnings would have increased 13.6%, higher than management expectations of 10%.
During the quarter, total sales for this maker of Heinz ketchup increased only 0.5% to $2.83 billion. Foreign currency fluctuations against a strong dollar is pulling down revenues of most of the companies that have significant business outside U.S. Heinz generates more than two-thirds of its sales from outside U.S. markets and this headwind primarily dragged the revenues down. Currency fluctuations hurt revenues by 2.4%. On a constant currency basis, revenue was up 2.9%.
Revenues also marginally missed the Zacks Consensus Estimate of $2.85 billion. Organic top-line growth was 3.3%, slightly less than management expectation of at least 4% growth. In the quarter, volumes grew 1.4% while net pricing added 1.9% to top-line growth. Divestitures reduced net sales by 0.4%.
Core Top-Line Drivers
The emerging markets recorded organic sales growth of 13.2%, while the reported growth was only 10.3% due to negative impact of currency. Emerging markets comprised 23% of total sales.
Global Ketchup sales grew 5.0% organically driven by strong performance in U.S., Brazil and Russia. However, global ketchup sales improved 3.8% on a reported basis.
The company’s top 15 brands recorded 4.6% organic sales growth, driven by strong sales of brands like Heinz, Quero, ABC, Classico, Golden Circle, Master and Ore-Ida brands. However, on a reported basis, the top 15 brands revenue improved only 1.7% due to currency headwinds.
Among the food categories other than ketchup, meals and snacks declined 1.7%, while Infant/Nutrition declined 5.4%.
Excluding productivity charges, Heinz’s gross profit grew 1.8% to $1.01 billion, despite a $22 million unfavorable impact from foreign exchange. Gross margin went up 40 basis points to 35.8% driven by productivity improvements, which offset impact from commodity cost inflation. As expected by management, gross margins were better than the first quarter.
Selling, general and administrative expenses increased 230 basis points to 17.8% due to growth initiatives in emerging markets. Marketing expense increased 10.0% to $119.6 million in the quarter, much higher than a decline in the first quarter.
On a constant currency basis, these expenses rose 13.5% as the company increased investments behind its brands, both in domestic as well as emerging markets. Management was expecting marketing spend would increase significantly in the second quarter due to new marketing initiatives in U.S., U.K. and emerging markets.
Adjusted operating income declined 1% to $391.7 million, hurt by currency headwinds. On a constant currency basis, operating profit improved 0.5%.
Sales in the North American Consumer Products segment, which sells products to grocery channels in the US, was almost flat at $795.0 million. Organically, sales were up 0.4% due to an improvement in volumes.
Volume improved 1.2% driven by Heinz Gravy and Ketchup, Classico pasta sauces and Ore-Ida frozen potatoes. Sales of Ore-Ida frozen potatoes, which were sluggish in the recent past, have shown improvement in both the quarters of fiscal 2013 driven by efforts to optimize pricing. Overall, pricing pulled down revenues by 0.8%.
The divestiture of the Boston Market license negatively impacted sales by 0.6%. The segment operating income declined 5.7% to $190.0 million due to increased marketing investments.
Sales in Europe declined 4.2% to $808.4 million in the reported quarter mainly due to currency headwinds of 3.8%. Organically, revenues were almost flat as slight gains from volume growth were offset by decline in pricing. Pricing declined 0.2%. Volumes grew 0.3% as growth in Russia and U.K. was offset by declines in Italy and Netherlands.
The segment operating income declined 2.8% to $140 million, as volume gains were offset by currency headwinds and increased marketing investments.
Sales in Asia Pacific grew 2.3% to $606.3 million, while organically revenue was up 4.1% with both pricing and volume registering increases of 2.2% and 1.9%, respectively. Pricing increased in Indonesia, while volumes grew in China. Currency hurt revenues by 1.9%. The segment operating income improved 24.5% to $50.0 million.
Sales in the US Foodservice segment, which manufactures and sells some branded and customized products to food outlets and distributors across US, increased 4.1% (both organic and reported) to $348.0 million driven by pricing growth. Pricing increased 4.1%, while volumes were almost flat. The segment operating income improved 26.8% to $44 million driven by higher sales and productivity gains.
Sales in the Rest of World segment increased 8.6% to $269.6 million in the quarter in spite of unfavorable foreign exchange translation of 11.3%. Organically, revenues were up 19.8%, driven largely by pricing gains. Volumes grew 6.6% led mainly by the Quero brand in Brazil. Pricing improvement of 13.3% was driven by Brazil and Venezuela. Despite the top-line growth, segment operating income declined 15.6% to $27.0 million due to strong prior-year comparisons, currency headwinds and weakness in Venezuela due to economic challenges.
The company maintained its fiscal 2013 organic sales growth guidance to be at least 4%. It continues to expect earnings in the range of $3.52–$3.62 per share, representing constant currency growth of 5–8% from fiscal 2012 levels. Operating free cash flow is expected to be slightly more than $1 billion.
We currently have a Neutral recommendation on Heinz. The stock carries a Zacks #3 Rank (a short-term Hold rating). However, its peer ConAgra Foods, Inc. ( CAG - Analyst Report ) carries a better rank, Zacks #2 (a short-term Buy rating).
We believe Heinz’s robust brand portfolio, continued strong growth in emerging markets, strong marketing investments and ongoing cost saving efforts will boost long-term growth. However, continued sluggishness in its largest segment, the North American consumer business, is a significant concern. Though management’s effort to turn around this business is slowly improving revenue trends, we prefer to stay on the sidelines until the company shows significant success from its efforts.
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