Don’t Wait Through Kraft’s Drawn-Out Split

by Will Ashworth | September 7, 2011 10:27 am

Don’t Wait Through Kraft’s Drawn-Out Split

As of Sept. 6, 2011, exactly 188 out of 500 stocks in the S&P 500 were in the black year-to-date. One of them is Kraft (NYSE:KFT[1]), whose largest shareholder still is Berkshire Hathaway (NYSE:BRK.A[2]), despite selling 5.7 million shares in the second quarter. Kraft is up 10.7% YTD. Among food companies, only Unilever (NYSE:UL[3]) has done better. Will it continue? Perhaps, but here are some reasons you might want to sell just the same.

Two Companies

Kraft’s Aug. 4 announcement that it was splitting into two independent, publicly traded companies[4] appears to have added little excitement to a stock that’s been treading water since May. According to the Chicago Tribune, this type of breakup is likely to deliver shareholder value within one to two years[5].

Joe Cornell, head of Spin-Off Advisors LLC, a research firm specializing in spinoffs, believes this kind of move motivates existing management to become more growth-oriented and entrepreneurial. As separate entities, it’s easier for investors to value them. The executives operating each of the Kraft businesses will have a clearer picture of their compensation as a result. Cornell goes on to suggest the move also is necessary given the expected synergies from the Cadbury acquisition never materialized.

It seems unwise to wait 12 to 24 months for the delivery of an unquantifiable amount of shareholder value. Wouldn’t it make more sense to sell now and reconsider a year or two down the road when that value creation is more apparent?

Cadbury

It’s been 15 months since Kraft acquired 100% of Cadbury for $18.5 billion. At the time, even Warren Buffett questioned the price paid. In its second quarter 10-Q, Kraft boasted about the $750 million in annual cost savings the deal’s synergies will generate by 2013. However, to deliver on those savings, it will need to spend another $1.5 billion in integration costs, so the real price tag is $20 billion.

As I mentioned earlier, the split seems to suggest expected synergies between Kraft and Cadbury aren’t materializing and thus the split provides management with a way to take the focus off this failure. Furthermore, some analysts feel the split actually will reduce the synergies currently available to the company, producing two so-so businesses instead of one dominant one.

Kraft CEO Irene Rosenfeld herself said this before the Cadbury takeover in 2010: “We believe scale will be an increasing source of competitive advantage both in confectionary and in the food industry at large.” Now we’re supposed to believe it’s not so important? Rosenfeld and the board have major believability issues. Just look to the closing of the Cadbury plant in the U.K. for proof.

Valuation

Let’s discuss Kraft’s current valuation. Its enterprise value is 10.5 times EBITDA. While not outlandish, it’s still expensive. Using the Graham Number[6], I get a fair value of $29.50, which is below its current price of $34.08 as of Sept. 6. Looking at most of Kraft’s other valuation metrics, including price-to-earnings, they currently are trending around their five-year historical average, so any move higher would tip Kraft’s stock from fairly valued into expensive territory.

I know many investors applaud the move to split Kraft in two because it will accurately reflect the company’s true value. The fact remains, however, that it has yet to prove the Cadbury acquisition was worth $20 billion — and further, that the global snacks business will be the big winner everybody thinks it will be. Many questions still need answered. Investors waiting for the pot of gold at the end of the rainbow could be sorely disappointed.

Bottom Line

Time is money. The proposed split might not happen until the second half of 2012. The anticipated delivery of shareholder value another year or two after that means it could be 2014 before you see a bump in the stock price. It’s only worth waiting around if you’re an income investor. Otherwise, I’d move on.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

Endnotes:
  1. KFT: http://studio-5.financialcontent.com/investplace/quote?Symbol=KFT
  2. BRK.A: http://studio-5.financialcontent.com/investplace/quote?Symbol=BRK.A
  3. UL: http://studio-5.financialcontent.com/investplace/quote?Symbol=UL
  4. splitting into two independent, publicly traded companies: http://www.sec.gov/Archives/edgar/data/1103982/000119312511209127/dex991.htm
  5. deliver shareholder value within one to two years: http://articles.chicagotribune.com/2011-08-05/business/ct-biz-0805-kraft-breakup-20110805_1_spinoffs-joe-cornell-kraft-shares
  6. Graham Number: http://en.wikipedia.org/wiki/Graham_number

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