Description

Kraft Foods is an under-performing, asset-rich consumer staples company trading at approximately 10.5x FY2011 EPS of $3.00 to $3.50 per share. After being acquired by Philip Morris in 1988 for $12 billion, KFT was carved out in June 2001 and subsequently spun off in its entirety to shareholders in April 2007; it is the largest spin-off in US history and a member of the S&P 100 and S&P 500 indices.

This report will argue that Kraft’s low valuation is due to the following reasons:

1)      KFT’s former parent company Altria Group has been the focus of litigation for years. The association with Altria Group and its well-known legal risks have prevented KFT from maintaining an appropriate capital structure, managing working capital, making strategic acquisitions and divestitures, and achieving a valuation comparable to its peers.

2)      KFT’s FY2007 operating margin of 14% is low relative to normalized levels and competitors’ margins. By the end of 2010, KFT has the potential to improve margins to a 17% to 18% range. This will be achieved from the execution of its $3 billion restructuring plan, modest top-line synergies from recent investments in existing core brands as well as the $7 billion acquisition of Groupe Danone Biscuits, and a continued ability to modestly grow volumes and pricing. 

3)      Investors are not giving sufficient credit to and/or recognizing the strategy of the superior management team—highlighted by CEO Irene Rosenfeld and Timothy McLevish who joined in June 2006 and August 2007, respectively.  

At current price levels, KFT has not appreciated in value since its IPO six years ago. It is important to remember KFT (formerly known as National Dairy Products) is one of the best performing stocks in the history of the S&P 500 with consistent double-digit earnings growth for over 50 years. With clear catalysts in place at this point to unlock value, there is an opportunity to join a rarely intertwined group of investors including Warren Buffett, Carl Icahn, and Nelson Peltz. By the end of 2010, KFT offers investors an annualized return of approximately 25% to 30% a year including dividends.

Business Profile

With food and beverage brands including Kraft, Nabisco, Oscar Meyer, Post, Maxwell House, Philadelphia, Jello, and Oreo, KFT has strong customer loyalty as evidenced by its #1 market share position in over 70% of its categories. KFT has marketing and/or distribution channels in over 155 countries and is the second largest food producer in the world behind Nestle.
 

% of Revenues             % of Operating Profits 

 

Total US                                              59%                                         68%                                                    

Total EU                                              26%                                         19%

Emerging Markets                                15%                                         13%

 

US Cheese and Foodservice                 15%                                         16%

US Snacks and Cereals                        16%                                         18%

US Beverages                                        8%                                           7%

US Grocery and Prepared Meals          19%                                         29%

EU                                                       26%                                         19%

Emerging Markets                                15%                                         12%

For more information about the business breakdown of KFT, you can review research reports from the sell-side; there are 21 research analysts who cover the stock. The salient information about the above breakdown is that KFT is concentrated in the US, but has a balanced product offering that ensures strong and stable free cash flow generation. The percentage of international business will grow over time due to acquisitions. This will be discussed below in greater detail. 

Management Team

After years of rumors and delays, Altria Group became very adamant about the desire to spin off KFT in October 2005 when the news first came over the tape. Shortly after that point, a restructuring plan was announced in January 2006 designed to save over $1 billion annually or approximately $0.40 a share. Then in June 2006, CEO Irene Rosenfeld was recruited from Frito Lay to execute the turnaround. It is worth noting that she received stock options worth $12 million of KFT stock priced at approximately $31 per share. 

Due to pending lawsuits, the spin-off was not officially announced until January 2007. The fact that KFT had two years to prepare for the spin-off and that half of the management team is new creates a clear incentive to invest heavily for future profit growth through restructuring and new product launches. 

CFO Timothy McLevish, who was hired in August 2007, cemented a reputation as a dealmaker at Ingersoll-Rand; he did a great job selling non-core assets over the last few years. The odds are high that he was recruited to do the same thing at KFT due to his past success. It is challenging to know how the events will unfold but on the second quarter conference call, management was very clear: “we are not finishing reshaping our portfolio…we’ll divest those businesses that don’t fit into our long term growth plan.” 

Danone Acquisition 

In February 2007, KFT indicated that there will be “ample capacity for acquisitions. Our focus will be on building scale in key international geographies and gaining access around the world to new categories, new capabilities, and new technologies. We will only pursue acquisitions; however, when we’re convinced they are strategically compelling, financially attractive, and enhancing to shareholder value.”

In July 2007, KFT did not waste much time. Just a few months out of the gate, KFT acquired Groupe Danone’s Biscuits business for $7.2 billion. KFT paid 2.7x forward sales and 13.2x EBITDA, which is comparable to previous food transactions. The acquisition was the Company’s largest since the $19 billion acquisition of Nabisco Group Holdings in October 2000. 

As a result of the acquisition, the stock declined 3% in a strong market due to unwarranted investor concerns about price and strategy. In the consumer staples sector including beer, soda, and food companies, the market consistently forgets to look at acquisitions on a 'pro-forma' basis. Investors need to look at not just cost-savings, but also top-line synergies that result from the ability to leverage brands and distribution. With cheap interest on an all-debt transaction and an increase in operating margins from 16% to 23%, KFT can generate accretion of $0.05 to $0.10 a share. The “pro-forma” EBITDA multiple of Groupe Danone Buscuits will decline to under 10x.

With modest revenue synergies of 10% at a 35% incremental margin, KFT has the potential to generate an incremental $0.05 of earnings per share. The revenue synergies are difficult to quantify, but would result from leveraging Nabisco and other iconic brands in the EU and/or emerging markets including China, Russia, Malaysia, and Indonesia. KFT’s conservative guidance doesn’t even include any revenue synergies. 

It is very difficult to understand how this acquisition could be viewed negatively since KFT clearly had an overcapitalized balance sheet. At worst, KFT gains manufacturing scale, new products, and an opportunity to expand into new markets. This is why consumer staples companies in moderate-growth categories continuously depend on acquisitions and cost-cutting to fuel growth.

A great example for reference is Johnson and Johnson’s acquisition of Pfizer Consumer Healthcare in June 2006. Because JNJ possesses global scale and distribution similar to KFT, JNJ was willing to pay what seems like a high price of 4.1x EV / Forward Sales for Pfizer’s dominant consumer brands. This occurred despite mediocre organic top-line growth, similar private label and commodity risks, and comparable historical operating margins in the mid-teens. 

In the future, it is likely that KFT will continue to make similar bolt-on acquisitions that are low-risk and offer good upside. In discussions with rating agencies, IR indicated that it is theoretically possible to increase leverage another turn to 4x EBITDA without losing the investment grade rating. IR stated that the rating agencies are more comfortable with a roll-up strategy than a stock buyback.

One rumored acquisition is Nestle’s cookies and crackers business with $1.6 billion of sales—50% of which are in Latin America and another 10% to 15% in other emerging markets, according to Bernstein Research. For $4 billion to $5 billion, KFT should be able to complete this acquisition or one of a similar size while staying within target debt levels. 

Divestitures

Not surprisingly, activist investors including Nelson Peltz and Carl Icahn have supposedly been pushing management to divest Post Cereals, Maxwell House, EU Chocolates, etc. Moreover, CEO Irene Rosenfeld has been on record stating that large-scale divestitures are unlikely because of tax reasons. 

Notwithstanding, pressure will continue because KFT is an asset-rich company with many underperforming brands. There are two $1 billion+ brands/categories that are the most likely divestiture candidates. First, Post Cereals is #3 behind Kellogg and General Mills in the US and #5 globally. Second, KFT is a distant #4 globally behind Mars, Nestle, and Hershey in chocolate sales.

Cereals, chocolates, and many smaller brands/categories are worth a lot more to competitors with greater scale and core competency. That being said, one wild card scenario is a reverse Morris Trust structure where KFT’s assets could be contributed via a merger / leveraged recapitalization with a smaller company in the space who thinks that they can run the assets more efficiently.

In the past year, Disney and Verizon have been two high-profile S&P 100 companies that have gone this route; it is interesting to note that both companies exited similar slow-growth, highly cash-generative businesses with no international exposure in radio broadcasting and landline telecom, respectively. 

Acquisition Candidate

Due to Altria Group’s low tax basis, KFT was never a viable acquisition candidate between 1988 and 2007. Now that KFT is fully independent, the prospects of an acquisition are higher but remain relatively low. KFT does have strong brands, recurring revenue, and high levels of free cash flow; this will definitely interest private equity firms. 

That being said, the restricting factor for a private equity acquisition would be a steep valuation multiple and a large enterprise value. It is unlikely that KFT would accept a valuation of under 2.7x FY2008 sales of $41 billion—the midpoint of comparable transactions. At this valuation, KFT would command $110 billion.

Yet, it is still difficult to imagine private equity buyers being able to leverage to a 6x to 7x EBITDA multiple that would generate decent returns. That would be a $25 billion to $30 billion debt offering. As a current reference point, the LBO of the Cadbury Schweppes plc beverages unit, which is smaller than KFT, just got cancelled because of weak credit market conditions.

According to the WSJ, investment banks have a massive backlog of $370 billion of LBO paper to unload as of the first week of October. The credit environment could get much better, the private equity golden age may continue, and debt investors might return to selling their soul to the devil with PIK coupons, cov-lite loans, etc.

If this happens, the chance of KFT being acquired is as high as almost any other company. The infamous figure of $1 trillion of buying power will have to be utilized somewhere and KFT’s business is as simple to leverage as any business around. This is exemplified by the fact that in the first week of August 2007, KFT was one of the few companies able to finance debt at a reasonable spread. 

In other words, KFT will be basically needed for an LBO because there are not enough large companies in the US to put all of that money to work. But, the continuation of a virtuous environment for financial buyers and thus a KFT LBO should not be part of a base-case scenario.

Although food products companies tend to be outbid by strategic investors more than financial investors due to brand synergies, there are also a very limited number of companies that are large enough to acquire KFT. As a result, Nestle or Pepsi would probably be interested in KFT but antitrust issues are very significant. It is difficult to imagine a deal being approved by the US DOJ or EU. Thus, a strategic buyer is unlikely to materialize.

Valuation and Price Target

In FY2007, KFT is expected to earn $1.80 to $1.85 per share. The implied P/E multiple is 18.9x, which is the average of the peer group. However, the key data point is that P/E multiple is derived from an operating margin of 16.5% for KFT’s peer group whereas KFT is currently generating a 14% operating margin. The market is not valuing KFT based on margin expansion or improved capital management. The results will improve gradually until FY2010 when KFT should be fixed.

In FY2011, KFT has the potential to generate $45 billion of sales based on a 4% organic revenue growth rate. IR estimates reasonable category growth of 3% to 5% in North America, 1% to 3% in the EU, and 8% to 10% organic revenue growth.

In this event with a 7% cost of capital, a 17.5% operating margin, leverage at a very manageable amount of 3.0x EBITDA, an improved tax rate of 30%, and better working capital management, KFT will earn $3.25 to $3.50 per share by FY2011. If Kraft earns the same margins as its competitors are earning now, EPS should be at the $3.00 - $3.25 level in FY2011.  

With management estimating long-term EPS growth at 8% coupled with a 3% dividend yield, KFT should return 11% to shareholders without any multiple expansion or margin expansion.

If KFT reaches the projections that IR did not officially confirm, but at the same time indicated were very reasonable and appropriate without being aggressive, KFT deserves an 18x P/E multiple of $3.25 of earnings in FY2011. This combined with approximately $3.50 a share in dividends yields a $60 to $65 per share price target by the end of 2010. 

If KFT margins do not improve at all because of weak pricing power, higher commodity costs, and poor execution, KFT should earn at least $2.50 a share in FY2011; a 15x P/E multiple on these low-case earnings plus dividends will result in 7% annual appreciation to the $40 range. This would be a lackluster but not terrible outcome.

Catalyst

1)KFT beats earnings estimates in FY2008 and FY2009.
2)KFT integrates Group Danone’s cookies and crackers division and other bolt-on acquisitions successfully.
3) KFT divests non-core brands as expected and continues to buy back large amounts of stock.