Buffett Is Wrong on Kraft, It Isn't Undervalued

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 |  Includes: CAG, CPB, GIS, HRL, K, MDLZ, PEP, SFD, TSN, UN
by: Bennington Investment Ideas

Warren Buffett made headlines yesterday regarding stocks held by Berkshire Hathaway (NYSE:BRK.A). In particular, he has refused to write down the value of his approximately 97 million shares in Kraft Foods, Inc. (KFT) despite holding an unrealized loss of around $150 million. His assertion is that he believes the stocks are undervalued and that he intends to continue to hold them until they recover. While there are technical accounting rules about requirements for valuing assets like securities, management has very wide discretion in taking impairment charges to assets. I'm not actually interested in the details of the accounting rules and requirements - that is for BRK.A to work out with the SEC.

To me, the more interesting question is whether or not KFT could be viewed as undervalued.

Analysis

The first approach to viewing fair value is to quickly assess other comparable company valuations. KFT is categorized as a major diversified food company and is described below:

Kraft Foods Inc., together with its subsidiaries, manufactures and markets snacks, confectionery, and quick meal products worldwide. The company offers snacks, including cookies, crackers, salted snacks, and chocolate confectionary; beverages, including coffee, packaged juice drinks, and powdered beverages; cheese, including natural, process, and cream cheeses; and grocery, including spoonable and pourable dressings, condiments, and desserts. It also offers convenient meals, including primarily frozen pizza, packaged dinners, lunch combinations, and processed meats. Kraft Foods markets its products primarily under various brand names, including Kraft, Oscar Mayer, Philadelphia, Maxwell House, Jacobs, Nabisco, Oreo, Milka, and LU. The company, through its subsidiary, Cadbury Plc, also offers chocolate products under the Cadbury Dairy Milk, Flake, Creme Egg, and Green & Black's brands; gum products under Trident, Dentyne, Hollywood, and Bubbaloo brands; and candy products under the Halls, Cadbury Eclairs, Bassett's, and The Natural Confectionery Co. brand names. It sells its products to supermarket chains, wholesalers, super centers, club stores, mass merchandisers, distributors, convenience stores, gasoline stations, drug stores, value stores, and other retail food outlets. The company was founded in 2000 and is based in Northfield, Illinois. Kraft Foods Inc. operates independently of Altria Group Inc. as of March 30, 2007. - Yahoo!Finance on KFT

At a high level, the following companies are also involved in similar businesses to KFT:

KFT Comparables

Ticker Name Focus Market Capitalization ($ Millions) Revenue ($ Millions) Dividend Yield
KFT Kraft Foods Inc. Diversified 54,652 49,207 3.7%
TSN Tyson Foods, Inc. Focused 7,482 28,430 0.8%
CAG ConAgra Foods, Inc. Diversified 10,383 12,079 3.9%
SFD Smithfield Foods, Inc. Focused 4,058 11,203 0.0%
PEP PepsiCo, Inc. Focused 102,397 57,838 3.0%
UN Unilever NV Diversified 87,059 61,171 3.1%
HRL Hormel Foods Corporation Focused 7,468 7,221 1.8%
GIS General Mills, Inc. Diversified 23,207 14,797 3.1%
K Kellogg Company Diversified 19,581 12,397 3.0%
CPB Campbell Soup Company Diversified 11,194 7,676 3.5%
Click to enlarge

Data is provided by Zacks.com services.

The first observation is that companies clearly have differences in Price-to-Sales ratios ranging from 0.3x for TSN to 1.8x for PEP. Factors that can impact this from a valuation perspective are profitability and capital intensity. These two factors would help get towards a free cash flow assessment. The next screen will look at the above companies with the exception of TSN and SFD which have more focused business strategies across key metrics. From a valuation perspective, I'll also focus on Enterprise Value to account for different leverage structures.

Enterprise Values

Ticker Name Market Capitalization Debt Cash Enterprise Value
KFT Kraft Foods Inc. 54,652 28,760 2,600 80,812
PEP Pepsico, Inc. 102,397 24,900 6,370 120,927
UN Unilever NV 87,059 13,160 3,950 96,269
GIS General Mills, Inc. 23,207 7,050 566 29,691
K Kellogg Company 19,581 5,900 444 25,037
CPB Campbell Soup Company 11,194 3,120 325 13,989
CAG ConAgra Foods, Inc. 10,383 3,240 545 13,078
HRL Hormel Foods Corporation 7,468 350 650 7,168
Click to enlarge
Data is provided by Zacks.com services for market capitalizations and Yahoo!Finance for Cash and Debt.

The first observation is that KFT carries more leverage than the other companies - Enterprise Value-to-Equity is around 1.5 for KFT and 1.25 for the other companies. The next step is compare the different valuation metrics across these companies to see where KFT ranks. One key issue to keep in mind is that KFT may have different growth prospects and risk levels that could impact the valuation metrics. For example, if KFT had the highest P/E ratio but also substantially higher growth projected it still could be undervalued on a relative basis, thus supporting Warren Buffett's argument.

Valuation Metrics for KFT and Comparables

Ticker Enterprise to Sales Enterprise to EBITDA Enterprise to OCF
KFT 1.6x 11.4x 16.5x
K 2.0x 10.5x 14.9x
GIS 2.0x 9.7x 14.7x
UN 1.6x 10.2x 14.2x
PEP 2.1x 10.6x 13.4x
HRL 1.0x 9.2x 13.4x
CPB 1.8x 8.7x 12.7x
CAG 1.1x 8.3x 11.8x
Weighted Average 1.7x 10.3x 14.3x
Click to enlarge
Data is provided by Zacks.com services

This first pass analysis shows that KFT appears to be overvalued relative to its peer group by two key metrics. On a sales basis it seems to be slightly undervalued. However, the relevance of a Enterprise Value-to-Revenue ratio is driven by profitability. Other companies may have much higher valuations if they produce larger profit margins. The table below shows the key margins for these companies.

Margin Comparison for KFT

Ticker Gross Margin EBIT Margin Net Income Margin
KFT 36.4% 11.5% 8.4%
K 42.7% 16.1% 10.1%
GIS 39.7% 17.6% 10.3%
UN NA 13.3% 10.0%
PEP 54.1% 15.8% 10.9%
HRL 17.2% 9.0% 5.5%
CPB 41.0% 17.6% 11.0%
CAG 25.4% 10.3% 6.0%
Average 36.6% 13.9% 9.0%
Click to enlarge
Data is provided by Zacks.com services

Well, the argument is not that KFT has superior margins than the competition. In fact, KFT trails all but HRL and CAG. It is necessary to dig a little deeper. The next set of comparables will focus on price ratios and will include book value which is a metric that Warren Buffett often focuses on.

Price Metrics for KFT and Comparables

Ticker Price/Book Price/Earnings PEG
KFT 1.5 13.3 1.74
K 9.1 15.7 1.71
GIS 3.8 15.2 1.84
UN 4.4 14.3 2.01
PEP 4.7 16.2 1.59
HRL 2.9 18.9 1.78
CPB 12.6 13.3 2.13
CAG 2.1 14.3 1.70
Click to enlarge
Data is provided by Zacks.com services

KFT does have superior Price/Book ratio than the other companies. It also offers the lowest P/E ((NYSE:TTM)) and one of the better PEG (Current P/E to Long term growth) ratios. However, is this enough of an advantage to offset the other arguments that could be made that perhaps KFT is overvalued? The last look, I'll take is at ROE and ROA to see how efficiently the capital at these companies is deployed.

ROE and ROA at KFT and Comparables

Ticker ROE (TTM) ROA (5 Year)
KFT 10.0% 4.7%
PEP 31.8% 15.3%
CPB 80.3% 12.1%
UN 34.6% 11.4%
K 55.9% 10.1%
HRL 18.7% 9.5%
GIS 27.6% 7.2%
CAG 20.1% 6.5%
Click to enlarge

Data is provided by Zacks.com services

Again, this is not a promising result for KFT.

Conclusion

It should be noted that any comparison to other stocks could be equally challenged based upon the views that Berkshire has expressed to the SEC:

"Berkshire management does not believe that the validity of the efficient market hypothesis as suggested by the commission can either be proven or disproven. Information made available by the issuer of a security including current results and expectations regarding the future will likely be interpreted differently by individual investors." - Berkshire CFO Marc Hamberg in letters to the SEC.

Simply because KFT seems to be relatively overvalued, does not eliminate the possibility that the entire group is undervalued and hence KFT is also undervalued.

KFT does offer an attractive dividend yield and also has substantial support relative to its book value. However, it seems that on a comparable basis, it would be hard to argue that it is undervalued. This exercise raises an interesting question around the merit of price-to-book value. On all the other dimensions reviewed above, KFT is quite ordinary, but on the book value aspect, it is superior to the other companies. The next clear step in this assessment would be to look at KFT using a free cash flow valuation model, but that will have to be another article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.