Tuesday, January 26, 2010

A Look at Kraft-Cadbury (KFT-CBY)

This article was featured on the Reformed Broker and on the Rational Walk twitter stream.

Barbarian Capital was asked to express an opinion on the Kraft/Cadbury deal. This is a long post (definitely not for ADD readers) and there is nothing “actionable” in it. In short, Barbarian Capital is neutral to mildly negative on the transaction. There are better-run, less risky staple stocks with better track records than Kraft’s out there. This also grew to be a mini-lecture on staples stocks so beware.

I am breaking up the analysis in two parts: the business part and the financial part. For the business part, I will look at the actual business units (something that does not happen very often in the financial press).

One of the most basic questions a fundamental analyst can ask is whether the business is a commodity business, or not. A commodity business is largely a price-taker business, offering undifferentiated, fungible product or service. On the other hand, non-commodity businesses have products or services that are distinct, have high switching costs, etc. The non-commodity businesses tend to have steadier margins, less volatile earnings, and other generally “desirable” characteristics. Not to say that commodity businesses are bad investments: they can be great so long as you are riding the wave up and recognize that you are doing so. Stay away from commodity businesses whose management claims unique abilities when, in fact, they are simply in the right elevator at the right time.

Most consumer packaged good (CPG) companies try to stay away from the commodity side of the business. They try to have distinct, innovative branded products with unique value propositions. They develop a lot of new things every year that you see in the marketplace. A lot of these products are “high value added products.” If you think about it, it is not easy to replicate the taste of Coca-Cola, Oreos, Cheerios, Snickers, etc. These are generally “good” businesses: with steady earnings growth, predictable margins, low betas and small changes in the earnings multiples, among other characteristics. They will not double overnight, nor will they disappear overnight. Think of them as the bonds in the equity world.

Kraft has some genuinely good businesses here and abroad: Nabisco (i.e. Oreos, Triscuits), Jell-o (“owns” the market for jello), Lu (Europe and here, higher-end biscuits, like Le Petit Ecolier), Milka/Toblerone (dominant Europe chocolates), Jacobs (dominant Euro coffee), etc.

However, despite its marketing to the contrary (especially in the materials facing the investment community), Kraft has a substantial commodity-like business, or rather businesses. These ugly step-children are not featured in management’s presentations but they do appear on a regular basis around the quarterly calls.

Who are they? There is the dairy business (the eponymous cheese, along with Philadelphia cream cheese, Breakstone sour cream, Polly-O mozzarella, Velveeta cheddar). Then there is the nuts business (Planters). Then there is the supermarket coffee business (Maxwell House). There is also the dry mix drinks (Crystal Light). There is the dressings and mayo business. You get the picture: these are largely low value-added products with dubious brand equities. They compete largely on price, and are likely to be economically unprofitable in the long run. Further, they expose the company to single commodity price risks.

Further, for various reasons, Kraft over the last 2-3 years has shed 3 high value-added businesses: Post cereals, snack bars and, most recently, frozen pizza. It has acquired one high value-added business (Lu biscuits from Danone). However, KFT has not shed any of the low-value units.

Then there are the non-stop Kraft restructuring efforts. They have been at it for a while now, doing all sorts of realignments and such. I personally have no idea whether they will be successful. On top, Kraft just did a large acquisition in Europe (Lu), which also prompted reorganizations there. My view is that constant reorganizations/fire drills are distracting, harmful and are no way to run a business. There will be more on the way, of course, with the Cadbury acquisition.

On the other hand, Cadbury is a high value-add “pure play” confectionary business (chocolates, gum, breath mints, etc.). The confectionary business is a good business. The products are difficult to make at home or by small players (especially of equal quality). There is also a very, very low private label penetration in the space. Further, globally, the confectionary business is quite consolidated: Kraft, Cadbury, Nestle, Hershey and Mars/Wrigley are the major players. Oligopolies are good businesses to invest in.

Adding to Cadbury’s attractiveness is their presence in emerging markets. Emerging markets are attractive for CPG companies because packaged good consumption there is just beginning to take off. If you look at the charts, the spending on CPG goes up dramatically with GDP. Since earnings growth at home has a limit due to slower population growth and high product penetration, EMs can provide a good “kicker.”

EMs have been tricky for most CPG players. Here is why:

If you look at any business, there is what I would call a “natural optimal scale.” On one extreme, there are the true global businesses because it makes “optimal” sense to be global. Look at a mining company: they have to be where the deposits are. Once there, the drill is largely the same: same equipment, same materials, same process, same shipping, same customers. You can extend that to almost any extractive industry.

On the other extreme, you have businesses that are optimally what I would call “niche national”: think of law firms. Even the “global” ones are simply brand-connected independent groups with very high local specialization which may not be worth anything outside of its immediate context. Sure, having offices in Country X can land the big deal but this brings little to no direct business outside of Country X.

CPGs are somewhere in between. Some products are highly local (think prepared meals) while others are near-global (think cigarettes or “thirst” products). Obviously, emerging markets expansion is easier if your products are near-global. Philip Morris International does a superb job with Marlboro across the world, as do Coke and Pepsi with their mainstay beverage offerings. So products being closer to global are better, and I think Cadbury’s are “closer” to global: chocolate, gum, candy. There are other trickier parts in EMs, such as appropriate marketing, lack of scale, lack of proper infrastructure, on top of the “regular” emerging markets risks.But this would be another topic.

So, if Kraft can issue its own less-than-inspiring equity for what could be great business, why not go for it? This is why, in my view, the Cadbury holders wanted more cash. I say that Cadbury “could” be a great business because we do not know yet. CBY spun off its beverage unit recently (Dr Pepper Snapple, traded as DPS) and is undergoing its own realignment.

This concludes the operating business review. Now on to the financials overview.

Owning Kraft stock has been a punishing experience for its holders since its float in 2001. The stock reached a high of $43 or so in 2002, and a low $21 last year, and has essentially gone nowhere since going public. The stock itself has a negative 9% return, which becomes mildly positive if you include dividends. KFT’s dividend yield is aligned with the industry but the share performance has really hurt the “total shareholder return.”

Taking a step back, as I mentioned above, staple stocks are the “bonds” of the equity world. The typical staple company is expected to have steady to growing margins, steadily growing EPS, steadily increasing dividends, regular buy-backs, steady earnings multiples and low volatility. If you look at how some management teams judge themselves, they focus on “cash returned to shareholders” via dividends and buybacks: as a shareholder, this is what you want to hear. What you do not want to hear is “our organizational realignment is progressing very well… we’re taking another $500 mm charge this quarter… oh, and yeah, price wars in our business killed the margins…” Kraft has been a lot more of the latter, and their share price shows it.

Comparing Kraft to some of its packaged foods peers, as I mentioned above, Kraft is at negative 9% since going public in 2001. For the same period, we've got KO +8.4%, PEP +35%, GIS +65%, K +105%, SJM +138%, all ex-dividends. If you expand beyond food/bev into other consumer staples, PG +89%, EL +25%, CL +37%, CHD +252%, CLX +73%. CBY (Cadbury’s ADR) is up 105% in USD at the deal price, plus the DPS spin-off, plus dividends.

You get the picture: Kraft has been a disappointment and continues to be a disappointment both from an absolute perspective (not behaving like a staple stock) and from a peer comp perspective.

Does this mean that Kraft stock is undervalued, like Warren Buffet believes? Not necessarily. KFT simply behaves more like a commodity stock like TSN (Tyson) or DF (Dean Foods) due to its large commodity business that I discussed above, even though Kraft goes out of its way to tell investors how many “billion dollar” brands they have. I would rather see the shareholders’ yachts, thank you very much.

So, to repeat from above, Kraft's using some of its not-so-great stock as an acquisition currency is not that bad of a move.

On to Kraft’s debt. Kraft has not been great for its shareholders, but has it been great with its bond holders? To reiterate some corporate finance basics, there is a natural tension between shareholders and bondholders. All the bondholders can hope for is to get their interest and money back as contracted. On the other hand, shareholders have a residual claim on the earnings, and are more likely to want to “go for broke”: exactly the opposite of what bondholders want. Bondholders do not like to fund share buybacks, special dividends or other “shareholder friendly” moves. Again, we know that Kraft has not been great for its shareholders, how has it been for its bondholders?

Not that great either. Kraft was just downgraded to the lowest investment grade level (a downgrade means that the value of the existing bonds drops to reflect the higher required yields). The problem with Kraft is that it already funded the $7 bn acquisition of LU with debt, and has not reduced leverage significantly since then. Now it is going for a major, major acquisition (=risk) by adding extra debt. Bondholders do not like this. A hiccup in the assimilation of the Cadbury assets can trigger a downgrade to non-IG, which itself can trigger a massive dump of KFT bonds as many funds are restricted from owning non-IG bonds. This in turn can trip up other funding venues, like revolving credit agreements and commercial paper (I do not know if they have any). So you get the picture.

Compare Kraft’s behavior to that of InBev before and after its acquisition of Anheuser-Busch. InBev communicated very clearly that they are taking on too much leverage, and that they will work hard to reduce it. They have been selling assets according to their promised plan, reduced or stopped the dividends, and redirected all cash to debt repayment. This is the kind of able, credible management team that both bondholders and shareholders want to see. InBev’s stock is 2x in a little over a year despite poor industry-wide conditions.

Now that we see that both shareholders and bondholders are suffering, what about the multiple Kraft is paying?

I am not worried about it at all. It is very much in line with the transaction comparables I have seen, may be a bit on the lower end due to the size and slower growth of the target. It is not a screaming deal, but it is not a rip-off either. I do not like that they are paying 2x the 52-week lows but this is life: if they had pulled an offer in early March, they would have deserved it.

The bigger issue (which is what my “non-thesis”) is based on, is how well Kraft will do the job of integrating and achieving the mythical synergies with Cadbury. Looking at Kraft’s record, I have my strong doubts that it will be a smooth sailing, and I fully expect “surprise” charges to come soon. Their task is further complicated by the high political visibility of Cadbury in the UK. Moreover, I think that considering Kraft’s difficult results in the US over the last 1-2 years create incentives for “kitchen sink” integration charges: this way the earnings improvement post integration will not be reflective of the true business trends but I would not be surprised if the market does not see through it.

The Barbarian Capital thesis is: keep an eye on Kraft. If the integration is not going well, the stock will be punished. This is the entry point. Why? Because the integration is not rocket science and things will straighten out sooner or later. If things go better than expected, then sit tight until they have a quarter or two of poor performance because of the commodity part of the business. Until then, stick with the guys who take pride in returning money to shareholders or make good on their deleveraging promises. There are plenty of other companies with steadier performance, better margins, and better yields that can fit in your “slow and steady” equity allocation.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

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