Raw Deal for Kraft Shareholders

Recently, Kraft Foods (KFT) not only froze its dividends, but also attempted an acquisition of Cadbury (CBY). One would tend to believe that KFT coming from the stable of Altria Group (MO) would show dividend friendliness. Its management would understand the real meaning of value or growth to shareholders. However, recent actions of freezing dividends, stopping share repurchasing, and attempting an acquisition belies the common school of thought.

I presented a stock analysis for CBY and observed that it is good dividend growth company. CBY is an international dividend achiever has been raising its dividends for last 11 years. The most recent dividend increase was in February 2009. Investors holding CBY shares are hedged against international growth, dollar fluctuations, and emerging markets. In addition, it continues to maintain its leadership position in segments of confectionery business with its unparalleled reach across global, multiple brands, and diversified revenue streams. Therefore, CBY knows its market positioning and brand potential.

In my view, overall KFT’s offer was good for CBY shareholders and they should take the money and run. But the inclusion of KFT stocks in the bid offer is what I think makes CBY undervalued. CBY is a much bigger global brand than KFT, for which KFT needs to dole out cash (and not its shares). Accordingly, CBY rejected the first bid offer hoping to stoke competitive bidding from Nestle and Hershey (HSY). This is a good scenario for CBY and its shareholders.

This leaves KFT in a very intriguing position. KFT acquisition seems to be driven by its quest to become more competitive to Mars, inorganically get into higher profitability business, and expand into emerging markets. KFT made an offer worth USD 16.7 billion which includes cash and stock component. It will have to increase the proportion of cash in its bid offering or raise the offer all together. KFT shareholders are being motivated by the statistics that their revenue growth will increase to 5%+ (instead of 4%+) and earnings per share will grow 9% to 11% (instead of 7% to 9%). If I were KFT shareholder, I would question these projections and its implications. Do I really want to spent USD 16.7 billion, probably more, to get this 2% additional growth in EPS? In a nutshell, management is saying, we cannot increase shareholder value organically, so give us USD 16 billion for inorganic growth of 2%?

Furthermore, KFT already has close to USD 25 billion of debt on the books. The acquisition of CBY will add financing debt and CBY’s existing debt. I would tend to assume that the total combined debt will easily go beyond USD 30 billion. Therefore, two or three years down the road the value proposition or growth projection that KFT management is showing is likely to be out of whack.

I do not think KFT’s existing management which made this offer knows what is growth or value to shareholders. We investors need to understand that real growth or value means increased return on capital. Putting the company under huge debt for 2% top line growth is not a wise decision. What this does is (1) it generates enormous fees for investment bankers; and (2) C-suite officers get brownie points for building large global companies. These managers and investment bankers will not structure a deal which includes a clause for scheduled payments depending upon how the deal works out over a period of time. They take their fees and run. KFT shareholders are getting a raw deal.

To me, it is immaterial whether KFT increases its dividends or not, it is immaterial whether this acquisition goes through or not. KFT management has shown lack of vision by going after and overpaying (or over offering) for 2% revenue growth.

Disclosure: No position in any of stocks discussed in this post.

Comments

[User 489287:]

You bring up some good points, not to mention that at its current share price it is still well below it IPO offering price of $31 or $32 dollars. How long ago was that, it has been years not months.

Sep 21 05:23 PM

[Teak:]

KFT was spun out of MO at $31.66 a share by my calculations (it was never stated what the price was) on 31 March 2007. Now it hovers around mid-$26 price range.

I bought more shares of KFT one year after spinoff hoping that it would continue as a divdend-payer. Author makes strong points, however, that maybe Ms. Irene has empire-building plans so need to rethink my investment with this company.

Sep 21 08:53 PM

[User 489429:]

excellent point about only 2% projected growth with 16B dollars.

Sep 22 06:42 AM

[User 489430:]

great perspective on this offer. if this deals goes through, this will be another one of those where investment bankers will laugh to the bank, CEO will leave after two years with fat pay checks, and shareholders will remain lurched ...... there is literally no accountability left in US companies....

Sep 22 06:46 AM

[User 489431:]

yeah investment bankers will take their commission and fees and run. they don't care where it really affects the shareholder value. same way CEO will take credit and in two years go somewhere else... that's been the story of corporate america...

Sep 22 10:21 AM

[Rinki Cote:]

I don't think author understand this in proper context. on relative terms the 2% improvement w.r.t to 9% is more than 22% increase due to the acquistion. what about the global footprint it will gain, how can that be valued? that is why you need investment bankers to understand the and quantify such value. BTW 2% growth in confectionery business is huge...

Sep 22 10:26 AM

[David Van K...:]

Kraft's bid for Cadbury can only be seen as a good deal for Kraft shareholders through a very long-term lens, and even at that, it is speculative. In the short term, as the author has pointed out, the negatives are a frozen dividend, relatively small EPS growth, and apparent overpayment for the acquisition.

I believe (as does famed investor Peter Lynch) in figuring out a stock's "Story." If you can't explain why to buy a stock in a few sentences that a child could understand, don't buy it. With this offer, Kraft has twisted its Story around so that it is now not understandable. For any investor, but especially for a dividend investor, that is a huge red flag. A reliable dividend-paying and dividend-raising company has been transformed into...what? Happily, I don't own Kraft in my dividend portfolio. If I did I would sell. Its reasons for being there have vanished.

Sep 22 10:28 AM

[Dividend Tree:]

Hello David,

I would agree with you; its a long term speculative.

"A reliable dividend-paying and dividend-raising company has been transformed into...what?", this say it all. Thanks for your comment.


On Sep 22 10:28 AM David Van Knapp wrote:

> Kraft's bid for Cadbury can only be seen as a good deal for Kraft
> shareholders through a very long-term lens, and even at that, it
> is speculative. In the short term, as the author has pointed out,
> the negatives are a frozen dividend, relatively small EPS growth,
> and apparent overpayment for the acquisition.
>
> I believe (as does famed investor Peter Lynch) in figuring out a
> stock's "Story." If you can't explain why to buy a stock in a few
> sentences that a child could understand, don't buy it. With this
> offer, Kraft has twisted its Story around so that it is now not understandable.
> For any investor, but especially for a dividend investor, that is
> a huge red flag. A reliable dividend-paying and dividend-raising
> company has been transformed into...what? Happily, I don't own Kraft
> in my dividend portfolio. If I did I would sell. Its reasons for
> being there have vanished.

Sep 22 10:36 AM

[realold:]

I was an enthusiastic owner of KFT until this offer. I sold all of my shares. To me, this offer has completely changed the nature of the investment from conservative growing dividend to super speculative. It tells me that either KFT management is out of their minds, or, they are expecting a world of hurt in future years and decided to do something desperate. Either way, I am reluctantly out of here.

Sep 22 10:53 PM