Is Kraft A Legitimate Deep Value Stock?

| About: The Kraft (KHC)


Kraft's inclusion in the Magic Formula screens looked suspicious.

The stock is not worthy of inclusion on a deep value screen.

Although not substantially undervalued, there does appear to be upside in the stock.

One stock that has been in the official Magic Formula® (MFI) screen for the past month or so has piqued my interest: Kraft (KRFT).

The MFI screens, particularly the $50 million screen, are usually reserved for deep value stocks. Usually you find stocks in here suffering serious adverse business developments [Liquidity Services (LQDT), NeuStar (NSR), etc.], operate in out-of-favor industries [Apollo Group (APOL), Strayer Education (STRA), etc.], have volatile and difficult-to-predict future prospects [PDL BioPharma (PDLI) comes to mind], or are just simply cheap quantitatively [Cisco (CSCO), Coach (COH), et al).

Kraft doesn't seem to meet those descriptions. The company operates in one of the most stable and predictable industries around: packaged foods. Kraft is suffering no material adverse business developments, enjoys immense competitive advantages in the form of scale and brands, has a reasonably good balance sheet for the industry, and pays a 3.7% dividend yield.

So why the 12.5 P/E ratio, vs. a 16.3 for former parent Mondelez (NASDAQ:MDLZ), a 15.9 for ConAgra (NYSE:CAG), or a 20.8 for Unilever (NYSE:UL)? Is Kraft really an overlooked value play here?

Pension Effects Muddying the Accounting Waters

A little sleuthing reveals the reason for the apparent disconnect in valuation.

Kraft inserts the valuation effects of its pension plans directly into its income statement, embedded within the cost of sales and selling, general and administrative (SG&A) line items. This has a significant effect on operating earnings and earnings per share, effects which most screeners do not (and cannot) take into account.

For example, in 2013, Kraft inserted $1.56 *billion* dollars of pension gains into these two line items. In 2012, a much less robust year for the market, that figure was just $223 million. See how this affects gross margin, operating margin, and earnings per share:

Metric 2013 w/ pension 2013 wo/ pension
Gross Margin 37.6% 32.7%
Operating Margin 25.7% 17.2%
EPS $4.53 $2.60
Click to enlarge

Comparing Apples to Apples

As you can see, that's quite a difference! Screeners - including the Magic Formula screener - would use the 2nd column, while for competitors, screeners are effectively using the 3rd column, as pension effects are not really operating metrics and simply muddy the accounting waters.

At the most basic level, comparing P/E ratios, we see that Kraft's comparable P/E ratio is actually ($56.86 / $2.60) = 21.9, which is actually well above most of its competitors. Also, backing out pension effects makes Kraft's gross and operating margins much more comparable to its competitors.

In a nutshell, we can answer the core question of the article right now: Kraft is NOT a legitimate deep value stock, and in truth probably should not be in the Magic Formula screens at present.

What Is Kraft Really Worth?

While we are here, let's dig into what the stock is worth.

Kraft is a great business, as we mentioned before. As North America's 4th largest food and beverage company, with 2 brands (Kraft and Oscar Meyer) selling over a billion dollars a year (and over 25 that generate $100 million plus), and accounting for 4-6% of all grocery sales, Kraft has excellent competitive advantages. Food is a largely recession-resistant industry, so cash flows are stable and predictable. Kraft's goals are to increase earnings and dividends in the mid-single digit range annually - an achievable target.

These facts also make Kraft a relatively easy stock to estimate. Assuming about 5% cash flow growth, discounting at a low rate, and setting a market average valuation assumption, I get a target price of $61 for Kraft. That represents about 11% upside from current prices.

That's not too bad considering the conservative nature of the stock.

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. I have no business relationship with any company whose stock is mentioned in this article.