Raw Deal for Kraft Shareholders

dealRecently, Kraft Foods not only froze its dividends, but also attempted an acquisition of Cadbury (CBY). Dividend Growth Investor presented a very good argument to support his decision of holding off a new position in KFT. Certainly, one would tend to believe that KFT coming from the stable of Altria Group (MO) would show dividend friendliness. Its management would understand the real meaning of value or growth. However, recent actions of freezing dividends, stopping share repurchasing, and attempting an acquisition belies the common school of thought.

I had presented stock analysis for CBY and observed that it is good dividend growth company. CBY is an international dividend achiever has been raising its dividends for last 11 years. The most recent dividend increase was in February 2009. Investors holding CBY shares are hedged against international growth, dollar fluctuations, and emerging markets. In addition, it continues to maintain its leadership position in confectionery business with its unparalleled reach across the global, multiple brands, and diversified revenue streams. Therefore, CBY knows its market positioning and brand potential.

In my view, overall KFT’s offer was a good for CBY shareholders and they should take the money and run. But the inclusion of KFT stocks in the bid offer is what I think makes CBY as undervalued. CBY is much bigger global brand than KFT, for which KFT needs to dole out cash (and not its shares). Accordingly, CBY rejected the first bid offer hoping to stoke competitive bidding from Nestle and Hershey. This is a good scenario for CBY and its shareholders.

This leaves KFT in a very intriguing position. KFT acquisition seems to be driven by its quest to become more competitive to Mars, inorganically get into higher profitability business, and expand into emerging markets. KFT made an offer worth USD 16.7 billion which includes cash and stock component. It will have to increase proportion of cash in its bid offering or raise the offer all together. KFT shareholders are being motivated by the statistics that their revenue growth will increase to 5%+ (instead of 4%+) and earnings per share will grow 9% to 11% (instead of 7% to 9%). If I were KFT shareholder, I would question these projections and its implications. Do I really want to spent USD 16.7 billion, probably more, to get this 2% additional growth in EPS? In a nutshell, management is saying, we cannot increase shareholder value organically, or give us USD 16 billion for inorganic growth of 2%?

Furthermore, KFT already has close of USD 25 billion of debt on the books. The acquisition of CBY will add financing debt and CBY’s existing debt. I would tend to assume that the total combined debt will easily go beyond USD 30 billion. Therefore, two or three years down the road  the value preposition or growth projection that KFT management is showing is likely to be out of whack.

I do not think KFT’s existing management which made this offer knows what is growth or value to shareholders. We investors need to understand that real growth or values means increased return on capital. Putting the company under huge debt for 2% top line growth is not a wise decision. What this does is (1) it generates enormous fees for investment bankers; and (2) C-suite officers get brownie points for building large global companies. These managers and investment bankers will not structure a deal which includes a clause for scheduled payments depending upon how it works out over a period of time. They take their fees and run. KFT shareholders are getting a raw deal.

To me, it is immaterial whether KFT increases its dividends or not, it is immaterial whether this acquisition goes through or not. KFT management has shown lack of vision by going after and overpaying (or over offering) for 2% revenue growth.

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