Kraft Foods Inc.'s (KFT) board of directors have approved the spin-off of its North America grocery business in the hope of creating more value for the company's shareholders. The decision came in earlier than expected, with plans for the spin-off first announced in August last year. The transaction will lead to two independent public companies: (1) A global snacks business under the name Mondelez International (MDLZ), comprising the current Kraft Food Europe and Developing Market segments, as well as the North American snacks and confectionery businesses, and (2) The North America grocery business called Kraft Food Group (KRFT). Shareholders will receive one share for every three held of the original company. The snack foods market is a fast growing market, whereas the grocery business is a slow one. The separation will allow the snacks business to grow faster still, and unlock hidden shareholder value. In light of strong growth potential and stable dividends payments to be expected, we recommend holding on to the two entities.
Financial Overview
Revenues of $13.3b in the second quarter took a hit due to the unfavorable currency impact and rising input prices, and came in below analyst expectations of $14b. Kraft sought to counter the impact by burdening the consumer with higher prices (by 4%). It earned 58 cents per share and 68 cents after adjusting for one-time charges. Despite the uncertain international outlook, Kraft has maintained its previous full year organic revenue growth forecast of 5% and earnings per share growth of 6%. It registered a GP margin of 37%, up from 36% last quarter. Over the years, it has maintained an average margin of 35%.
Table 1:
FY 2011 | FY 2010 | FY 2009 | FY 2008 | FY 2007 | FY 2006 | |
GP Margin | 35% | 36% | 36% | 33% | 33% | 36% |
Source: Bloomberg
Table 1 above highlights how Kraft has managed to sustain a decent margin, despite the volatility in input prices. In fact, these are signs that the marketing expenses incurred, reinvestments and promotional efforts have borne fruit.
New Entities and What to Expect
Let's first consider the global snacks business. The business will include key brands such as Oreo, Cadbury (chocolates contributed 18% of total revenue in 2011), Trident gum, Tang, Milka etc. The business is expected to generate revenues of $35b annually in light of the rapidly growing snacks business (according to estimates the global snacks food market will reach $380b by 2017). Developing markets will chip in 44% of the total revenue figure, followed by Europe's 37%, and North America's 19%. Investors should expect solid growth and definitely a capital intensive business with low dividends. The developing market provides a huge base for the snacks business with the middle class' rising disposable income. Chart 1 below shows the rising share of Europe and developing market segments combined.
Chart 1:
Click to enlarge
Source: Bloomberg and Qineqt's calculations.
The developing market, which is vital for the proposed Mondelez International business, has been steadily increasing its contribution for Kraft International. Chart 2 below shows the trend.
Chart 2:
Source: Bloomberg and Qineqt's calculations.
The grocery business, expected to bring in $18b in annual revenues, will comprise of brands such as Jell-O, Maxwell House coffee, Kraft macaroni & cheese, Miracle Whip etc. The business will witness modest growth, stable revenue, strong margins and steady dividends for its shareholders; a desirable trait in the tough economic times being faced currently.
Headwinds
Not all is great for Kraft Foods though. The company has accumulated unprecedented levels of debt ($30.25b of LTD), a large part of which was undertaken to finance Cadbury's acquisition. Moody's current rating of Baa2 (and thr S&P's BBB) on long-term senior unsecured debt means that it is just a few notches away from being classified as junk. Kraft intends to expand in the developing market and will require significant investments. All this also means that high interest costs will strain the cash flows and leave less for dividend payments. Free cash flows are currently down from their pre-Cadbury acquisition levels, but estimates provided by Bloomberg reveal that they are expected to reach new highs by 2013.
Rising commodity prices have and continue to place stress on Kraft's bottom line performance. Although the company has managed to cushion the impact by increasing product prices, there is a limit on how long the company can continue with its current policy. Cash-starved consumers in Europe and North America might eventually look for cheaper brands, whereas rising competition, coupled with high commodity prices in the developing world, will dent profitability.
With nearly 60% of revenues for Kraft being generated outside the U.S., operating results are immensely dependent on how the dollar behaves. Recent strengthening of the dollar has pushed the company to increase prices to offset the drag on revenues. The company has till yet managed to ward off the blows with various policies, but the long-term sustainability of such maneuvers is in question.
Valuations
Kraft Foods is currently trading at $41.78 and has a dividend yield of 2.77%. Analysts expect a mean intrinsic value of the stock of $44. Currently, it has the lowest yield among the competitors selected by Qineqt:
KFT | General Mills (GIS) | Kellogs (K) | PepsiCo (PEP) | |
Div Yield | 2.77% | 3.38% | 3.42% | 2.94% |
KFT | GIS | K | PEP | |
P/E | 20x | 17x | 16x | 19x |
5-yr Expected Growth | 11% | 7% | 6% | 5% |
PEG | 1.81 | 2.42 | 2.66 | 3.8 |
The stock seems attractively valued with its low PEG ratio and high 5-year growth rates. According to an article on Forbes, both Mondelez International and Kraft Foods Group would trade at premium multiples of 11 and 9 times EBITDA, respectively. We suggest holding on to both entities for their strong growth potential and strong and stable dividend payouts.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
