While Kraft Foods (KFT) and General Mills (GIS) have strong brands, macro headwinds and high inflation continue to limit value creation. I earlier argued that Kraft's breakup into two different businesses - a high-growth global snacks unit and a high-margin domestic grocery unit - would drive stock appreciation by enabling investors to better appreciate their respective value. Although the stock went up nearly 13% since the article was first published, the S&P 500 went up by more than double that, indicating investor uncertainty in the food products industry. Competitor General Mills, on the other hand, skyrocketed 85.4%. At this point, I believe that more risk than reward exists for both firms.
From a multiples perspective, Kraft is the more expensive of the two. It trades at a respective 19.8x and 14.3x past and forward earnings, while General Mills trades at a respective 15.4x and 14.2x past and forward earnings. The former trades at the high end of peers; the latter, at the low end of peers. Although both companies offer high dividend yields and low betas, greater costs and a lack of exposure to high-growth regions are limiting upside. Gross margins for General Mills are around 360 basis points greater than they are for its competitor. In addition, General Mills is less leveraged with net debt at only 30.1% of market value versus 43.1% of market value for Kraft.
Both firms may be overvalued, but solid quarterly earnings and strong brands make a short play quite risky. At the third quarter earnings call, Kraft's CEO, Irene Rosenfeld, noted strong performance:
"Q3 was another strong quarter within a very challenging macro environment. We continue to have good momentum in all geographies on both the top and bottom lines. On the top line, consumers are responding favorably to our investments in new products and in better and more effective advertising. This has been a powerful combination. It's enabled us to take the necessary pricing to offset unprecedented increases in raw material costs, while delivering solid volume mix and market shares.
On the bottom line, we grew our underlying operating income at a double-digit rate, both in the third quarter and through 9 months. We did this by effectively managing our input costs through pricing and productivity while leveraging overheads and driving integration savings."
Although the firm thinks that it is fueling demand for North American grocery through marketing, I view this effort as throwing dollars at a source that is fundamentally weak. The economies of United States and Europe continue to stagnate and much greater opportunities exist in penetrating emerging markets - a core advantage that Kraft has over its competitor. Fortunately, Kraft has a strong global snack business: global biscuits and chocolate notably grew by 9% and 8%, respectively y-o-y.
The firm also erred in acquiring Cadbury PLC with shares. The company earlier repurchased shares for $33 and it then proceeded to sell them for $27, effectively sending a bad message about shareholder value. Accordingly, the company has received pressure from activist hedge funds Trian Partners and Pershing Square, in addition to Warren Buffett.
Consensus estimates for EPS are that it will grow by 12.4% to $2.27 in 2011 and then by 11.5% and 10.7% more in the following years. Assuming a multiple of 17x and a conservative 2012 EPS estimate of $2.49, the rough intrinsic value of the stock is $42.33. This implies 17.1% upside and does not make it an attractive investment at the current moment. With that said, strong brands -Trident, Cracker Barrel, Cool Whip, Kool-Aid, Nabisco, Oscar Mayer, Wheat Thins, Easy Cheese, and Cadbury PLC, among others - present strong fundamentals and substantial risk in shorting the stock.
General Mills' brands include Cheerios, Chex, Cinnamon Toast Crunch, Yoplait, and Pillsbury, among others. Consensus estimates for its EPS are that it will grow by 5.2% to $2.61 in 2012 and then by 8.4% and 8.5% more in the following two years. Assuming a multiple of 16x and a conservative 2013 EPS estimate of $2.79, the rough intrinsic value of the stock is $47.73. This implies 17.9% upside and, like what I wrote for Kraft, does not make it an attractive investment at the current moment. Going long on the market overall and shorting these two stocks is, accordingly, an investment that some may consider. My recommendation, however, would be to not take this strategy and instead invest in a different sector entirely.