Why Kraft May Outperform Sara Lee By 36%

by: Takeover Analyst

Food producers Kraft Foods (KFT) and Sara Lee (SLE) are preferred on the Street with ratings of a "buy" or better, according to T1 Banker. Based on my review of the fundamentals, I share the Street's preference for Kraft but am more reserved about Sara Lee. Investors may consider shorting Sara Lee, while going long Kraft to benefit from the difference in returns.

From a multiples perspective, Kraft is the cheaper of the two stocks. It trades at a respective 19x and 13.6x past and forward earnings. Sara Lee, on the other hand, trades at a respective 69.9x past and forward earnings.

Investors should also consider backing Bridgford Foods (NASDAQ:BRID), which is now 29% below its 52-week high. Given that the firm has a beta of 1.42, the potential for high risk-adjusted returns in the event of a recovery is significant. J&J Snack Foods (NASDAQ:JJSF) is another smaller firm that is attractive, given that it is valued at only 17.8x past earnings.

At its fourth-quarter earnings call, Kraft's management expressed an optimistic outlook:

"Why am I so confident? It's because our businesses in every region around the world are benefiting from a virtuous growth cycle, and as a consequence, our results are outpacing our peers. In 2011, our Power Brands grew 8%. This in turn drove organic net revenue growth of 6.6%. That's a significant improvement over top line performance in 2010. Then, organic revenue rose a little over 3%, fueled by Power Brand growth of more than 6%. And we delivered those results during an unprecedented environment of economic and political unrest, as well as skyrocketing input costs.

Growth was especially strong in our global snacks portfolio. It now represents about half of our sales. Biscuits were up 9% globally, and they were up double-digits in Developing Markets. Russia and China led the way, each up about 40%. Developed Markets delivered mid-single digit growth".

Management also expressed optimism about its proposed split generating operational efficiencies. It also boosted its cost synergies estimate from integrating Cadbury to $50M. ROIC, the driver of value creation, is modeled to grow by more than 100 bps to around 10% in 2014, as net debt falls by around $3.5B. Coming off excellent momentum from 2011 when organic growth was 6%, I share confidence over the split. One risk that the company faces concerns input volatility, as evidenced by the $125M loss from commodity hedges.

Consensus estimates for Kraft's EPS forecast that it will grow by 10% to $2.52 in 2012, and then by 10.7% and 13.3% in the following two years. Assuming a multiple of 16x and a conservative 2013 EPS of $2.74, the rough intrinsic value of the stock is $43.84, implying 16.3% upside.

Sara Lee, however, carries much greater risk due to its premium. On the positive side, fourth-quarter adjusted EPS of $0.27 was strong. Coffee & Tea was able to cover elevated input costs, as sales grew 12% y-o-y. North American retail grew operating profits by 5% y-o-y, despite pricing reductions and the performance of the meat business. The spin-off will separate the global coffee & tea business from the domestic food service and meat businesses. As attractive as the split sounds, the main problem that the firm faces is from its exposure to low-growth categories and competitive pressures. Scale is critical for Sara Lee, as the softening European markets expose its vulnerability.

Consensus estimates for Sara Lee's EPS forecast that it will grow by 17.9% to $0.92 in 2012, and then by 14.1% and 16.2% in the following two years. Assuming a multiple of 16x and a conservative 2013 EPS of $1.02, the rough intrinsic value of the stock is $16.32, implying 19.6% downside.

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

Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and prospectively commissioned. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence. Always discuss investments with a licensed professional before making any financial decision. Statements made within this report may include “forward-looking statements” as stipulated under Section 27A of the Securities Act of 1933, Section 21E of the Securities Act of 1934, and the Private Securities Litigation Reform Act of 1995. Since these statements are uncertain, actual results may be materially different from those expected.