Kraft Bid to Buy Cadbury Tastes Like Bitter Chocolate

Includes: BRK.A, BRK.B, CBY, MDLZ
by: Valuation Driven

Warren Buffett’s Berkshire Hathaway Inc. (NYSE:BRK.A), Kraft Foods Inc.’s (KFT) largest shareholder, recently indicated it would vote against Kraft’s proposal to issue 370 million shares to finance its bid for British candy maker Cadbury (CBY).

The current offer on the table is $16.5 billion in cash and stock to purchase Cadbury, which KFT’s management team believes is a smart strategic move to build a global powerhouse in snacks, confectionery, and quick meals, as well as to gain an increased exposure to emerging markets. KFT also believes that the combination of the 2 companies would allow it to achieve cost savings of $625 million annually.

Since news surfaced of KFT’s offer to buy CBY, The Applied Finance Group has pointed out that the deal would hurt Kraft's shareholders, as we believed the purchase price was too high. Berkshire’s thoughts on this deal appear to be in-line with ours, being that they refuse to approve the issuance of shares to fund this deal, unless it will not hurt KFT shareholders.

The expectations for what CBY would have to deliver to justify the proposed purchase price by KFT are very lofty and unrealistic to achieve. Kraft has made many promises about this acquisition and claims to be a disciplined buyer, but even if they achieve many of their savings goals and increase their exposure to emerging markets, it would still be very difficult to do enough to justify the price tag for Cadbury, thus hurting KFT’s shareholders (We stated in our first article). The market also seemed to agree with our thoughts on the initial deal as KFT’s shares underperformed by approximately 8% in the week after the deal was proposed.

From Cadbury’s standpoint, we disagree with their CFO who claimed that KFT’s initial offer was too low. Instead, we showed that CBY should take the money and run since its share price is being supported by the hopes that this deal will be completed. It is hard to believe that CBY’s share price will not drop if KFT removes their bid from the table.

As news of Berkshire's opposition to the currently proposed deal has had time to set in, it seems as if no deal would be the best deal for Kraft at this point. The market appears to agree with this logic, as shares of KFT outperformed the S&P 500 today by 458 bps, and CBY underperformed the S&P 500 by 403 bps, signaling that its share price has been inflated due to the hope of this deal being completed "as is."

The bottom line is that we believe that Kraft should focus on improving its existing operations to maximize shareholder value, rather than overpaying for Cadbury to "buy" growth. Soon after this deal was announced and well before the Wizard of Omaha resisted Kraft’s motion to issue new shares to finance its bid for CBY, AFG delivered valuable insights to show that this deal made no sense for the shareholders of Kraft.

image courtesy of BusinessWeek