Kraft / Buffett / Cadbury: A Sad Reflection of Executive Mismanagement

by: Amit Chokshi, CFA

Since September 2009, Kraft (KFT) has been pursuing an acquisition of UK-based Cadbury (CBY). KFT has essentially been the only legitimate buyer for CBY as competitors such as Hershey (NYSE:HSY) and Ferrero have not been forthcoming with any real bids. Nestle (OTCPK:NSRGY) recently expressed interest which prompted KFT to consider raising its offer, but once KFT's largest shareholder, Warren Buffett, stepped in and voiced his concern about KFT's issuance of shares to finance the deal, Nestle began to back away. In response, CBY's Todd Stitzer has now clearly overplayed his hand, hoping to entice HSY to stretch its finances to combine with CBY. The actions by both KFT, CBY, and HSY have been reflective of the sad state of executive management, particularly in light of discussions regarding management "talent" in recent media reports.

I have expressed a view that KFT could be an attractive holding in 2010. On a recent appearance on Bloomberg Radio, I outlined why KFT could be an interesting addition to a portfolio in 2010 highlighting the company's cheap valuation, dominant market positions, and attractive dividend. I also indicated that shares could be depressed due to concern regarding the issuance of KFT shares to finance the CBY deal and believed that investors may have been overestimating KFT's willingness to overpay. Since that interview on December 30th, 2009, KFT announced it would use $2.2B it received from selling its North American frozen pizza business to Nestle to increase its cash portion of its bid for CBY. CBY rejected this bid as well.

However, KFT's main stumble was management's desire to issue as many as 370MM KFT shares to help finance the CBY deal. This is where Buffett, whose Berkshire Hathaway (NYSE:BRK.A) owns 9.4% of KFT, stepped in to voice his concern. What's particularly sad is that KFT management would consider financing a deal with this much stock given its current valuation. One look at KFT stock since it was spun-off from Altria Group (NYSE:MO) in 2001 illustrates that KFT shares are still below its initial spin off price and, more importantly, just about 30% above its all-time low of roughly $21-$22. At its current price, KFT is valued at roughly 9.0x EV/EBITDA and about 13.0x rather visible 2010 earnings. For a dominant company with leading brands and an attractive dividend yield, KFT looks cheap across many measures yet management is willing to dilute existing shareholders in its pursuit of CBY. Even more laughable is that KFT management was comfortable having KFT execute a share repurchase at higher levels yet finds it fitting to issue shares at current depressed levels.

Many M&A studies demonstrate that M&A destroys shareholder value, primarily due to the acquirer overpaying for the target. By stretching for CBY, KFT appears willing to go down this path. What is more worrisome for KFT shareholders, however, is that most of the value created by a KFT/CBY combination would be due to cost synergies. It's likely that KFT's bankers are modeling aggressive cost synergies to entice KFT to overpay for CBY. Unfortunately, if this deal is consummated, then KFT management must actually execute. It's in these situations when investors unfortunately discover that the extent of management "talent" is usually limited to firing rank and file employees to pursue those savings and little else.

Fortunately for KFT shareholders, Buffett stepped in to bring management back in line. However, what is really disheartening is that Buffett HAD to step in. Without his interference, KFT management would continue on, excessively diluting existing holders in pursuit of CBY. Executives of a company like KFT shouldn't need a shareholder to point out the obvious, to point out that while KFT was willing to repurchase shares at higher prices, it is now willing to sell shares on the cheap, particularly when the deal can be financed with cheaper debt. It's an even sadder comment that KFT's investment bankers haven't taken corporate finance 101 to differentiate between the cost of debt and equity.

With KFT potentially reined in, CBY's CEO Todd Stitzer is now fumbling around in order to preserve the roughly 50% gain in CBY stock tied to KFT's offer. Nestle has indicated it now has little interest, prompting Stitzer to reach out to HSY and hope that HSY in combination with Ferrero can salvage a deal. Rather than work for CBY shareholders, Stitzer worked for himself. Miraculously after the KFT bid, CBY management unveiled brand new growth and profit targets...targets that were significantly above where CBY had been performing in recent years. Rather than work in finalizing and closing a deal with KFT, Stitzer bluffed for too long and now there is a strong likelihood that CBY shareholders could face the prospect of a sharp price drop if KFT and CBY do not merge.

HSY management and its trust should also be viewed curiously by shareholders. A first year finance student could determine that HSY is in no position to effect a transaction with CBY yet management has hired bankers to tell them this, or worse attempt to convince them to pay for CBY in a financing scheme that would leave the company in a precarious financial position. HSY squandered a chance to sell to Wrigley (WWY) for $89 a share in 2002 and now is trying to increase its risk profile in chasing CBY.

In summary, the actions by KFT, CBY, and HSY management all clearly demonstrate that the "talent" executive management teams attempt to portray is no more than an illusion. Unfortunately, until government bodies such as the SEC actually allow shareholders to have a larger voice in determining who runs a company and what that person is paid, investors will be perpetually frustrated with overpaid, misaligned management.