Kraft's value

The legendary investor has been accumulating shares of Kraft[KFT] ever since it was spun-off from Altria. It now represents over 7% of his portfolio and with the stock down since the Oracle purchased his stake, is it time for value investors to take a bite?

Kraft is the largest U.S. food company and the second largest after Nestle. With food and beverage brands including Kraft, Nabisco, Oscar Meyer, Post, Maxwell House, Philadelphia, Jello, and Oreo, Kraft has strong customer loyalty as evidenced by its #1 market share position in over 70% of its categories. Kraft has marketing and/or distribution channels in over 155 countries and is the second largest food producer in the world behind Nestle. In early September, Kraft offered $17 billion for Cadbury, the British confectionary giant.

Kraft stock has fallen over 8% since the announcement as the markets are anticipating that Kraft will overpay for Cadbury. The proposed consideration price reflects a 1.9x multiple on the consensus FY10 sales estimate and 11.5x the consensus FY10 EBITDA. The 11.5x forward EBITDA multiple pales in comparison to the roughly 16-17x that Mars paid for Wrigley. Kraft wants to buy Cadbury to have greater access to the global confectionary markets which are fast growing and offer higher margins.

Furthermore, the transaction would buttress Kraft’s presence in emerging markets. Buffett, who has a 10% stake in Kraft, has stated that the company had already offered a “full price” for the British chocolate maker. He raised doubts over whether Kraft had enough shareholder support to raise its bid significantly. Speaking recently about the takeover battle, Buffett said: “Any time you’re in a takeover, the animal spirits run high and all of that, but Kraft has the disadvantage of using an undervalued stock.”

So how undervalued is Kraft? At current prices, Kraft is trading around 12x 2010 earnings, 8.6x 2010 EBITDA and pays a 4.5% dividend. Additionally the company should generate over $2 billion in free cash flow and offers a solid 12.4% return on equity, something that Buffett has cited time and time again in his shareholder letters as the right metric to judge a business.

Buffett bought his stake in Kraft as he expects it to benefit from the current environment and recent actions of its turnaround plan. Top line growth is expected to improve over time as Kraft increases its marketing spend as well as reaps benefits from its R&D. Furthermore, margins will benefit from declining commodity costs. At the current offered price, the transaction is expected to result in an 8% increase EPS by 2012. If Kraft were to increase the price by an additional 25% and use cash to finance the majority of the deal, the transaction could be as much as 9% accretive. Of course, there is a possibility that Nestle and/or Hershey make an offer for Cadbury. Earlier in the decade, Cadbury and Nestle offered to buy Hershey but were rebuffed as the Hershey did not want to cede control of the American brand. If Kraft is successful in its bid, expect the stock to remain under near term pressure, however this could offer patient investors a sweet deal.

Given the revenue and cost synergies, Kraft management sees a successful acquisition accelerating its growth prospects. Management argues that a successful acquisition, at the proposed price, would increase its long-term annual EPS growth potential to 9-11% from 7-9% and organic revenue growth to 5%+ from 4%+.

Furthermore, as Buffett has consistently argued, investors should look at the private market value of the business and take the long term view. With its consistent cash flow generation, strong brand presence, attractive valuation and growth prospects, Kraft offers value investors a tasty treat.

=> Kraft is a strong brand and one of the corporation that can benefit in recession because more people prefer dining at home instead of eat out. On the other hand, its historical sales growth trend is around 5% which may not be attractive.
=> Bilibala do agree that Kraft is under value. Its "normal" price should be about $37, plus 5% growth every year since 2007, one should expect it to rise close to $50 in 2012 (assume no dividend pay out), 92% return in 3 years, not a bad deal.