YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

Good time to buy Kraft?

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Kraft is the second largest food maker in the world behind Nestle, with #1 market share in over two-thirds of its categories. They have a long list of popular brands that you would recognize – Kraft Macaroni & Cheese, Velveeta cheese, Oscar Mayer lunch meats, Oreo & Chips Ahoy cookies, Ritz crackers, Planters nuts, Kool-Aid, Cheez Wiz, A1 Sauce, DiGiorno pizza, Philadelphia Cream Cheese, Miracle Whip, and many other well known brands. However, their growth prospects are admittedly low.

By now, you’ve surely heard Kraft is after Cadbury. Our recent blog on Comcast questioned if an NBC and Comcast merger makes strategic sense. But in the case of Kraft and Cadbury, there’s definitely a fit. Not only would there be cost cuts by eliminating overlap, but Cadbury would provide the growth prospects Kraft is seeking. Cadbury is the second largest candy and chocolate maker (which typically has higher margins than packaged food) in the world behind Mars, who recently acquired Wrigley. A combination of the two companies would create a massive global food & candy maker with $50 billion in annual sales, and would put their share in the global confectionary market neck and neck with Mars. This would not only give Kraft access to additional popular brands such as Cadbury’s Trident, but more importantly, access to distribution channels for Kraft’s existing products in faster growing foreign markets, in places such as India, Latin America, Egypt, and Thailand. Furthermore, Cadbury could possibly increase their sales through Kraft’s strong presence in U.S. supermarkets.

However, our biggest concern is the fact that Kraft is using their stock as currency – this is a much different situation than where Comcast is doing an asset swap. In other words, Kraft is indirectly paying more than $16.7 billion due to the fact that they are using their currently undervalued shares as currency.

Cadbury seems to think Kraft offered a low ball bid which values Cadbury around 14 times EBITDA, compared to Mar’s 19 times EBITDA in their purchase of Wrigley. We disagree. First, Wrigley is a better company and should command a higher premium. Second, even though Wrigley is a better company, we think Mar’s paid a rich premium and just because they overpaid doesn’t mean Kraft should. Third, stock market multiples are depressed since that deal. Fourth, as already mentioned above, 14 times EBITDA is a misleading number because it doesn’t take into account the fact that Kraft is using its undervalued shares as currency.

Cadbury vehemently rejected the offer, now putting pressure on Kraft to increase its bid. Just like the trading of baseball players, there seems to be countless incidences of anxious CEO’s overpaying in the M&A realm. But there are some reasons to not be overly concerned here. For one, it’s unclear if there will be a competing bid, and obviously, there’s no reason for Kraft to increase its bid if nobody else can step up to the plate. The two most likely candidates are Hershey and Nestle. However, in order for Hershey to top Kraft’s bid, they too would need to use stock because they are too small to support a debt load that would raise that much cash. With stock, they would end up threatening the family trust’s current 80% voting control of the company, to which prospect they have previously shown strong opposition. Nestle, who has a strong presence in the U.K., would have a difficult time acquiring Cadbury without facing anti-trust regulatory hurdles. We also take some comfort in knowing Warren Buffet has a 10% stake in Kraft and so hopefully he will have some sway to prevent them from overpaying.

Under our Investment Philosophy section on our website, we talk about the “Three P’s” of investing. The last “P” stands for “People” – the individuals who manage the company and allocate its capital. We expect Kraft’s management to look at the Cadbury deal objectively, just as we would look at it if we were considering it as an investment. Hopefully, they will not give in to the desire to build an empire and end up overpaying due to Cadbury’s greed for a higher offer.

Yesterday, Kraft issued disappointing results and the stock is down. Good time to buy? We think so.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | November 04, 2009 | Permalink

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