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KFT & CBY - Good Thing Kraft Mac N Cheese Does Not Taste This Bad!
Kraft Foods Inc (KFT), the world's second largest food company and the largest in North America, unveiled a surprising bid for Cadbury Plc (CBY) over the Labor Day weekend. For each Cadbury Plc share, Kraft Foods proposed to buy for 300 pence in cash and 0.2589 new Kraft Foods share, for a total value of 745 pence. The entire share capital of Cadbury Plc is valued at £10.2 billion or approximately $16.8 billion (based on share prices and exchange rates on September 4, 2009). So far, Cadbury has turned down the offer.
Kraft management branded the proposed acquisition as the company's strategic move to build a global powerhouse in snacks, confectionery, and quick meals. Specifically, Kraft believes combining KFT&CBY can be justified by the following value propositions:
1. The combined company could target long-term organic revenue growth in excess of 5% and sustainable long-term EPS growth of 9 to 11%, whereas Kraft targets long-term organic revenue growth of 4% and EPS growth of 7 to 9% on a standalone basis.
2. The higher long-term growth rates in revenues and bottom lines will be driven by revenue synergies and $625 million identified annual cost savings.
3. Cadbury is highly complementary to Kraft's geographical footprint and will increase developing markets' contribution to Kraft's net revenue from about 20% to about 25%.Kraft management has been banging the familiar synergy/strategy drum hard regarding the significance of the acquisition, and claims itself a disciplined buyer. While increasing exposure to developing markets does sound appealing and increasing top line growth by 1% on a large revenue base is worthy of applause, we are not sure those promises justify the price tag. Based on the proposed price of 745 pence per ordinary share or approximately $50 per ADR, CBY needs to deliver top line growth of 10% and EBITDA margins of 27% each year from 2010 to 2014 to justify the purchase price. Historically, CBY's organic top line growth has been in the range of 4-6% and its EBITDA margins have declined from 22% in 2004 (peak) to 15% in 2008 (trough). It doesn't take a brain surgeon to conclude, it will be very hard for CBY to achieve those lofty operational assumptions in the future to deserve the purchase price. If we boldly assume all the projected $625 million annual savings will come from Cadbury and be realized, CBY's standalone EBITDA margin will increase by approximately 8%, still falling short of the implied 27% margin, based on its profitability track record from 2006 to 2008 (17%, 16%, and 15% respectively each year). In other words, even if the annual cost savings assumptions are realized, it is likely that Kraft is still overpaying for the projected cash flows CBY can bring to the table. Needless to say, as with many deals spurred by enthusiastic I-Banker cheerleaders, Kraft may overestimate its ability to achieve the operational excellence required to justify its own assumptions of the transaction.Turning to Kraft Foods. On a standalone basis, if Kraft is able to deliver annualized top line growth of 4%, grow EPS at the high end of its targeted 7-9% range, and achieve higher asset efficiency via productivity gains as management has been promising, its shares could be worth as much as $32, rather attractive relative to their current trading levels. It seems logical for us to suggest that Kraft should focus on improving its existing operations to maximize shareholder value, rather than overpaying for Cadbury to achieve non-substantial incremental growth. The market seems to agree with us as well, given since the announcement KFT has under-performed the S&P 500 by nearly 8%. In addition, Kraft will likely use $8 billion new debt to finance about half of the purchase, increasing its leverage to a higher level amid continuous economic uncertainties. While we appreciate KFT management's confidence in the credit market and the overall economic environment, we are skeptical of the wisdom in pursuing the Cadbury acquisition at this moment. Needless to say, most companies in corporate America are tirelessly deleveraging. Management has insisted there is no threat to its existing investment-grade credit rating. Sadly most people purchased tech stocks up to the crash, and continued to buy real estate as the bottom fell out. In today's environment, we turn to the wise Chinese saying, "Hope for the best, but prepare for the worst". Leveraging up in this environment to purchase pricey assets does not seem very wise.Consumer Staple stocks such as Kraft and Cadbury generally have stable cash flows but limited growth opportunities. In the past five years, the median annualized sales growth for Staple companies in the S&P500 was 6.4%, vs. 9.5% for the overall S&P500. However, just to achieve that 6.4% growth, companies in the sector have consistently turned to acquisitions to drive top line figures. In fact, from 2003 to 2007, the median % of intangible assets / invested capital for the S&P500 Consumer Staple companies has grown from 19.2% to 27.2%. Aside from creating enormous fees for I-Bankers, and building mega empires for corporate managers, how much wealth has such activity generated? In order to measure such wealth creation, we like to look at a metric we call Market Value to Invested Capital, or MVIC. MVIC tells us how much the market is willing to pay for a pile of assets. It is a multiple of total market value relative to the economic investment a company's management team has put in place. When this figure is rising, a firm's assets are becoming more valuable; when it is falling, a firm's assets are becoming less valuable; when it stays the same, a firm's assets are not changing in value. While Staple companies were spending billions on goodwill from acquisitions, the market yawned, as over this same time period, the median MVIC (Market Value/Net Invested Capital) for the sector remained largely flat at 2. In contrast, the S&P500 median MVIC increased from 1.65 to 1.91 in the same 4-year period, or close to a 20% improvement. It seems the market was not rewarding Staple companies with higher multiples, probably as the assets to the sector were not any more valuable than they were prior to the growth generated by the sector's significant acquisition activity. Note that from 2007 to 2008, MVIC dropped for the market as a whole due to the financial crisis. Staple companies having a safe haven reputation experienced a smaller decline. Graph 1 below show these various trends.In short, we don't believe Kraft Foods should pursue the acquisition of Cadbury at the price it has offered. Instead, Kraft should maximize its shareholder value by delivering the organic growth and profitability targets management has laid out from its existing business. Cadbury shareholders, however, should take the money and run. While it has been the modus operandi for the Consumer Staple companies to achieve extra growth through acquisitions (shown in graph 2 below), it is more often than not a-much ado about nothing. As we have shown time and time again (Good and Bad Management Strategies), growth only matters when it generates increasing economic profits. Growth for the sake of growth typically leads to distracted management teams and underperforming stock prices. If Kraft carries out the acquisition, its management may be yet another management team that seems to have forgotten the core principles that create value "“ investing in projects that earn a return above the cost of capital. At its offered price, CBY is likely a negative NPV project and KFT should find a way to either lower its bid or walk away from the deal.
Graph 1
- The medians below are for respective sectors in the AFG universe.
Graph 2
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