Saturday, April 17, 2010

Corporate Governance Malpractice Case Study: Kraft Foods

In the earlier article about Kraft, I discussed at length the potential benefits and dangers of the combination with Cadbury. To summarize, I was mildly positive on the transaction as it provides a diversification away from KFT's commodity business. Additionally, I provided some color on Kraft's subpar performance vs. its comps. Pershing Square/Ackman came out with a presentation saying a lot of the same things a few days later but with the view that one should be long KFT into the transaction. Today's missive is about Kraft's problematic corporate governance and its link to shareholder value destruction. I have no position in Kraft Foods but this can change at any time.

One of the "textbook" problems in governance is the so called "agency" problem. Many years ago, when most owners ran their businesses, they made sure that things were running for their benefit. As businesses got bigger and more complex, the owners saw fit to bring in professional managers to run things for them. This is today's equivalent of the shareholders and the managers. And the relationship gives a rise to the "agency" problem. The interests of the managers are not always aligned with the interests of the shareholders. If you are a manager, you want to do as little as possible for as much money as possible. The shareholder wants the exact opposite. Since it is impractical for the shareholders to supervise managers, shareholders elect a board to keep an eye on the managers, set goals, set comp, hire, fire, vote on major decisions and so on. The most powerful position on the board is the board chairman (but you already knew that). Obviously, a hallmark of good governance is the separation of the chairman and the CEO role. After all, the board is supposed the defend the shareholders' interests, and the chairman should be spearheading the effort.

Enter Kraft Foods. The company brought in Irene Rosenfeld, a professional manager, from Frito-Lay in June 2006. She also became chairman of the board in March of 2007, and if you do not think that the chairman role was a part of the initial deal, you should keep your money in an index fund. The chairman has strong influence in the selection process of other board members. Since Mrs. Rosenfeld's appointment as a CEO (remember the high likelihood of her chairmanship being a part of the deal), the following individuals have joined the board: Mr. Banga (1/07), Mrs. Hart (12/07), Mrs. Juliber (11/07), Mr. Ketchum (4/07), Mr. McDonald (1/10), Mr. Reynolds (12/07), Mr. von Boxmeer (1/10), Mr. Zarb (11/07).

You might be asking yourself, was there a "friends and family" discount for Kraft board memberships? It sure seems this way: only 3 board members pre-date Mrs. Rosenfeld (vs. 8 post-2006). One also wonders about issues like continuity. More interestingly, management's compensation is set by the compensation committee of the board. Who are the members of the comp committee? Well, those are Mr. Banga (Chair), Mrs. Juliber, Mr. Ketchum and Mrs. Wright. Three out of four are "Rosenfeld appointees," so to speak. Last year, Mrs. Juliber's seat was held by Mrs. Hart, another "Rosenfeld appointee."

The only non-Rosenfeld member is Mrs. Wright, who, according to the proxy materials, is qualified to serve on KFT's board, in part, because she is the CEO of Carver Bancorp ("CEO of a federal bank"). You might be forgiven if you have never heard of Carver: their market cap is $21 mm. Yes, that is twenty-one million dollars, 2,000 times smaller than KFT's. They have 9 branches. She is also on a few non-profit boards, including The Sesame Workshop. Oreo cookies, Cookie Monster. You get the picture.

A cynic might call this board composition "stacking the deck." There is no way they would get tough on management. But cynicism alone is not a good investment approach, so let's look at some numbers from Kraft's latest proxy. I am looking just at actual comp, not at the golden parachutes and other uncertain/potential provisions, nor am I looking at the pay % based on "adjusted" measures.

How has the board done in the past with defending the shareholders' interests by rewarding performance and aligning incentives?

Rosenfeld total comp for 2007: $13.5 mm; 2008: $18.7 mm; 2009: $26.3 mm

So, Mrs. Rosenfeld doubled her income between 2007 and 2009. Not bad at all, I wish I could do the same thing. Surely the shares must have done very well if what should be largely a fixed cost is so variable on the upside.

How did Kraft shareholders do during the same period?

Kraft Foods share price: Jan 1, 2007: $31.45 Dec 31, 2009: $26.92 (both adjusted for dividends received, looks much worse without, $35.61 in '07 to $27.18 in '09).

You can judge for yourself. Like they say, where are the shareholders' yachts? And the shareholders pay the board members $250- $270k per year for this.

The increase in the 2009 compensation was justified with "Ms. Rosenfeld’s leadership in executing on the formal bid for Cadbury in November 2009 and closing this complex deal in early 2010 as exceptional" (this quote is the #1 reason given).

My guess is that the board did not bother with the question "what if the deal is ultimately value-destructive and how are we going to measure it, and how are we going to adjust comp if the deal turns out to hurt shareholder value?"

But wait, there is more, just like in a Billy Mays infomercial. Note that the board describes the leadership as "exceptional". Is it? Here are some recent developments to keep in mind. Also remember that the deal was uncontested: there were no other bidders.

During the due diligence process, Kraft had missed a substantial pension liability with some of Cadbury's UK workers and ended up forcing 3,600 workers to opt out of the plan or to have a 3-year pay freeze. During the bidding process, Kraft also lied about not planning to close the Somerdale factory: KFT changed its mind post-takeover, based on unknown new production capacity in Poland (if I remember correctly). While this has not been reported widely in the US, the scandalous takeover the iconic British candy marker led to Parliament hearings (!) during which Kraft promised NO more job losses in the UK for the next two years. Further, the EU mandated that Kraft divest some product lines in some geographies.

Poooof! This is the sound of your mythical "synergies" disappearing. You could add paying 100% more than the 52-week low for Cadbury's stock. "Exceptional leadership" in deed.

Here's something else, from My Investing Notebook, Jamie Dimon of JPMorgan possibly takes a stab at Kraft in his latest shareholder letter: "We do not pay bonuses for completing a merger, which we regard as part of the job. When the merger has proved to be successful, compensation might go up." Cold.

So, is it any wonder that Buffett, KFT's largest shareholder, is upset? There might be more to his displeasure than just the use of KFT stock in the acquisition.

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