Investors in Kraft Foods (NASDAQ:KRFT) jumped up at the start of the trading week following a big upgrade from Morgan Stanley. I disagree with analysts, not seeing much potential for the shares given the difficult operating environment and the high debt position.
I would be much more cautious and stay on the sidelines, perhaps with a slightly bearish stance.
Morgan Stanley Is Bullish
On Monday, analysts at Morgan Stanley were bullish on the prospects for the food company. Analyst Matthew Grainger upgraded the rating on the stock from "Equal-Weight" to "Overweight".
Grainger raised the price target for the stock by $5 dollar towards $60 per share. The price target suggests that shares have some 12% upside potential based on Friday's levels.
Grainger notes that Kraft's shares have underperformed some 750 basis points so far this year. He furthermore notes robust productivity and restructuring efforts which support greater earnings per share visibility compared to some of its peers.
At the end of October, Kraft released its third quarter results. The company ended the quarter with $1.23 billion in cash and equivalents. Total debt stands at $9.98 billion, for a net debt position of $8.75 billion.
Sales for the first nine months of the year came in at $13.62 billion, down 1.1% on the year before. Net earnings rose by 14.9% to $1.78 billion.
At this pace, annual revenues are seen around $18.1 billion. GAAP earnings are seen at $3.58 per share or $2.1 billion. Trading around $55 per share, the market values Kraft at $32.6 billion. This values equity in the firm at 1.8 times annual revenues and 15-16 times annual earnings.
Kraft recently hiked its quarterly dividend to $0.525 per share, for an annual dividend yield of 3.8% per annum.
Some Historical Perspective
Since the spin-off of its North American grocery business in the autumn of last year, shares of Kraft have risen from the mid-forties to current levels at $55 per share. During the summer, shares touched upon highs of nearly $59 per share.
Between 2009 and 2013, Kraft Foods consolidated its revenues, increasing them by nearly a billion to an expected $18.1 billion this year. Operating earnings have been moving around the $2 billion mark during recent years.
Kraft looks appealing at first sight, and this is largely because of its high dividend; the payout ratio standing at a reasonably high 60%. This means that shareholders should mostly look for dividends for short term returns, as room for repurchases is limited with a net debt position of little over $8 billion.
While some investors were very happy with a recent arbitrator decision that Starbucks (NASDAQ:SBUX) was ruled to pay Kraft a $2.76 billion fine, they should re-read the press release. After Starbucks broke the relationship between the two firms, Kraft is eligible to receive the fee, yet Mondelez (NASDAQ:MDLZ) stands to receive all the proceeds from the ruling as agreed during the spin-off covenant.
Kraft is struggling on an operational basis, and also a bit financially. The company has failed to show growth in recent years, both in terms of revenues and earnings. The higher debt position limits the company somewhat in its operational and financial space. The reported 3.1% fall in mix/volumes for the third quarter, combined with a 1% fall in pricing are no encouraging signs.
While cost savings manage to keep earnings afloat for now, the room to keep funding revenue shortfalls by cost cutting is declining automatically. Therefore I believe the current valuation is high enough, as I don't see Kraft being able to report sustainable earnings growth for now. Combined with the high leverage, this makes me very wary, as investors are being lured into the stock for the dividend yield.
I do not share Morgan Stanley's optimism and would stay on the sidelines with a neutral to slightly bearish stance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.