Wednesday, September 9, 2009

Kraft/Cadbury

The market was all giddy today with this deal. Here is a suggestion: go short Kraft stock (KFT). They lost 5-6% today but I think they will lose more: all intuition. Since I ran out of envelope backs, I am writing here.

(1) KFT is offering currently 12x CBY's 2009E EBITDA. This is a very rich multiple even if you factor in the mythical "synergies" they claim are achievable. The market expects that the multiple will go up which is, again, bad news for KFT shareholders. "Synergies" are pretty dangerous: there is no way to track those once the deal closes. KFT in the letter says that the footprints are complementary. You cannot have complementary product and geographic footprints AND substantial synergies. Expect to see massive baths in Q1-Q2 after the close for "integration costs" and related. Nothing gooses EPS better than big, fat write-downs.

(2) KFT does not appear to be a "best in breed" business. There are many reasons for this but it is evidenced by the fact that the share price is 13%+ lower today vs. the price at which they went public in....2001 (total return might be slightly positive with dividends). Also management has faced criticisms regarding their turnaround plan. They even had to put it verbatim on a presentation slide that "our plan is working". If it really were, you would not have to write it down.

(3) KFT seems dead-set on completing the acquisition. This is a very poor negotiation stance which will hurt the KFT shareholders as KFT will likely overpay. I found it astounding that they would communicate that so clearly. Since KFT management is not dumb, it makes me wonder if the whole acquisition is an attempt to both distract from KFT's performance and roll the dice with a large acquisition.
Call me paranoid, but remember that management has options which incentivize them to act imprudently (from a food co. shareholder point of view) and seek volatility. KFT is overly reliant on low value-add generic categories in the US (cheese, mayo, dressings) so their performance recently has not been great as private label takes share there easily, so let's invade Iraq.

(4) KFT has also explicitly committed to maintaining IG. They are currently at Baa2 and already have $18 bn +/- of debt on EBITDA of $5ish. A CBY deal would likely be at around $18-19 bn EV with a best-case EBITDA of $1.5. Assuming that the current 3.5x is the IG threshold, even call it 4.0x, this implies that CBY can carry $6 bn in debt. They have to refi $1.5bn, leaving them down to $4.5bn in new debt. This means $15 bn of new KFT equity, on a current market cap of under $40 bn.
Now, they still have a notch down to go on the IG scale. Assume that 4.0x is the limit there. The combined company could then potentially carry $7.5bn x 4.0 = $30bn in debt. This still implies $7-9 bn in new KFT equity.

In other words, dilution is coming.

Update: Well, this was quick. "Kraft Foods Inc... is in talks to arrange about $8 billion of financing for the bid, Bloomberg said..." So, if closing EV is $18 bn, you're looking at $10bn of new equity. Short-term currency trends are not favoring KFT, either...

Update 2 9/11/2009: Here is a great post on why the offer price makes no sense. I am not familiar with their MVIC metric, I do not agree with their delevering paragraph for the most part (yes, KFT is aggressive with debt) and I am not sure how they figure out what CBY's growth and margins ought to be in order to "justify" the current purchase price. They also do not adjust for the DPSG spin-off, pretty typical of generalist finance types.
I just looked at it from an EBITDA basis, and thought the bid was high. CBY hit a low of under $28 in March, and is now at $51. Does KFT really believe that CBY is now 80%+ more valuable than it was 6 months ago? Just asking.

Update 3 9/16/2009: Now there are reports that Kraft will be selling assets, such as Maxwell House and Oscar Mayer to pay for the acquisition. Again, this is poor negotiating: the buyers will clearly know that KFT has boxed itself in and needs to sell. This is not a way to deliver value to the shareholders. Now, the coffee asset is interesting, if one looks at the wonders Folgers is doing for JM Smucker (SJM): three-four quarters of blowing past expectations. Coffee has been on a roll for the last year or so (see GMCR and, more striking, DDRX) with both increased store traffic/at-home-coffee and the success of the k-cup systems. I do not know how much Maxwell House has benefited from this, may be they are the big loser there. It is hard to tell without fresh Nielsens. Oscar Meyer is closer to a non-brand in my view. Sara Lee (SLE) would be a good buyer but the combined share might be too big. Smithfield (SFD) recently communicated that they want to move more into packaged foods but I do not know how much they can afford it.

Update 4 9/21/09: Cadbury is doing what they are supposed to do, which is act tough to get. Just like early-stage dating: don't seem too interested. I think a deal will happen, KFT will likely raise its price to the further detriment of its shareholders, and CBY's board will "unanimously approve" the new offer. There are no indications of a serious white knight bid from HSY, either. They have not retained what I'd call "conventional" advisers. One is a PE shop, run by a former banker (possible coinvestment?) and the other one is a small boutique called Watch Hill. One would think that there would be at least one adviser with a balance sheet.

Update 5 9/23/09: I just made the parallel to dating two days ago, and now ResearchRecap is saying that KFT and CBY are circling the dance floor. I can even hear ABBA's "Dancing Queen" in the background. In what should put to sleep any doubts about this deal happening, CBY's CEO Mr. Stitzer even named his price: 15x. Ok, basic negotiations, you ask for more than you expect to get. The question now is whether the deal happens at 13x or 14x, and at what cash/equity split. I can already see the teary-eyed joint press conference with the two outsized logos in the back, the talk about the new and exciting future, the cornucopia of free snacks for the press corps in the back, someone mentioning that Milka's and Dairy Milk's brand colors are so close that the merger was meant to be, etc. I think I will layoff following this deal now unless something substantial emerges.

Update 6 9/27/09: I was just thinking that this will be quiet for a while. But both management teams seem to have been on a sugar high. First, we had reports denying that Cadbury has said what it would sell for. Ok. "CEO Todd Stitzer said on Friday he did not believe Kraft's offer for the company made strategic sense, as he tried to clarify remarks he made that drew scrutiny from Britain's Takeover Panel." His original remarks: "Stitzer was quoted as saying Kraft's 10 billion pound ($16 billion) bid made some strategic sense." Confused already?
And this morning, the more interesting news come out, Kraft might go hostile. I would like to assure you that hostile bids are bad news for the buying shareholders. There is no such thing as hostile: it is all a matter of price. With CBY's stock now probably largely held by arbs, you can bet that they will try to squeeze every triscuit from KFT. That's what they do for a living. And, there even isn't a credible white knight bid. My original thesis stands: this merger is bad news for KFT shareholders. If new facts emerge (or I bother to read up), I may change my mind.

Update 7 9/30/09: How did I get stuck with this job? Again, I was thinking I'd lay this deal off for a bit, and, again, developments show up. First, CNBC is reporting that the WSJ is reporting that HSY "remains stymied in its ability to assemble a takeover offer...so far have no financing or strategic plan for a bid...realized it is several billion short of matching the current offer..." Just as I suggested in Update 4 above. Also Nestle yesterday mentioned something about their focus on wellness "as it seeks higher margin businesses": in my view their CEO is signaling to the market that Nestle will not be chasing CBY.

Also, the UK is telling KFT to make an actual offer by November. Mrs. Rosenfeld's letter, if you remember, said that it is not an offer (under something like "for further avoidance of doubt").

Update 8 11/3/09: Finally some substantial news ahead of the deadline. Reuters is reporting that KFT has secured a $9 bn bridge, as UK regulations require that KFT show that it has the financing. In the article, some analysts are saying that KFT will sweeten the offer, while "people familiar with the situation" are saying that it won't. From a KFT shareholder perspective, I hope they stay put. Their shares tanked 3% after-hours on the earnings report, and are now $26.70, roughly in range of where they have been trading post-offer.

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