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Using a Value Line Report: The Kraft Foods Split – January 27, 2012
Regardless of one’s feelings about the plan, it appears that Kraft Foods (KFT – Free Value Line Research Report on Kraft) is going to separate into two distinct entities: a global snack company and a mature, domestically focused grocery business. The global snack business (the growth-oriented part of Kraft’s business), as it is currently envisioned, will contain brands such as Oreo, LU Biscuits, Cadbury, Trident, and Tang. The grocery business (what one might call the company’s “cash cow”) would include iconic brands like Kraft macaroni and cheese, Oscar Mayer meats, Philadelphia cream cheese, Jell-O, and Maxwell House. (The extend of the currently combined entity’s business can be seen in the Business Description section of the Value Line report.)
Based on the nature of the two operations, it is likely that the grocery business would take on a greater relative percentage of the company’s debt, though management’s goal is to maintain investment grade credit ratings for both concerns. The grocery group would be managed to deliver reliable growth in line with industry averages and free cash flow, and would likely pay a dividend. The snack business is much larger than the grocery business, expected to have annual revenues of around $32 billion, compared to grocery’s $16 billion, and would be focused on growth.
The current Kraft Foods traces its roots back through several major acquisitions, the last of which was the apparent impetus behind the current plans. In fact, the Cadbury purchase, the last major addition, is still in the process of being integrated. Interestingly, one of the company’s largest shareholders, Warren Buffet, was not a big fan of the deal. Still, the takeover created an even larger player in the food space with both stable and growing businesses, and leading positions in many market categories around the world. The prospects for the new Kraft were quite rosy, particularly since the Cadbury business lines broadened the company’s exposure to foreign markets—particularly those considered to be emerging economies. The logic of breaking into two is that each entity now will have a management team that is more focused than would have been possible based on the size and complexity of the combined entity.
The stock’s performance over the past 12 months or so is a clear indication of the market’s approval of the pending breakup. The Graph clearly shows an improvement since about the third quarter of 2011, and the Total Return box to the bottom right of the Graph shows that the shares advanced 22.6% over the trailing 12 months through December 2011, while the broader market fell 5.9%. The company’s relative valuation has increased, as well. For 2011, as displayed in the Statistical Array, the stock’s relative P/E ratio was 0.95, indicating that it was trading at a slight discount to the market. As of late January, the relative P/E had increased to 1.05—a slight premium. While the total change may appear small, it suggests a shift in investor sentiment toward the stock, which hasn’t had an above market valuation since it was spun off as its own company—which occurred in 2001.
Assuming that the intended split is viewed favorably, investors should be asking themselves if the advance is overdone or if, as the company expects, the split will unlock material shareholder value. If the former is the case, selling the stock would make sense. If the latter is the outcome, however, now could still be a good time to buy shares.
Value Line’s Justin Hellman thinks now is a good time to buy the issue. In the Analyst Comment, he notes the company’s recent success, the potential for continued advances, and the fact that he believes the separated entities will have higher multiples as stand-alone companies.
A premium valuation isn’t hard to believe for the growth-oriented foreign snack business. This company will have material exposure to many fast-growing markets around the world, including Brazil, Russia, India, and China. That could easily justify a higher P/E multiple. For the domestic business, however, a market-like valuation seems more likely than a premium one, as this business is largely mature and will be operating in a mature market.
That said, one business being afforded a higher valuation than the other doesn’t mean the split is a bad idea. It simply suggests that investors would own a “cash cow” type company and a “growth” company. Thus, the end result of the split could still be a net positive if the P/E of the “cash cow” company doesn’t fall too much from where the combined entity’s P/E is today. This is a reasonable outcome.
So, at the end of the day, investors in today’s Kraft will own two very distinct entities, both of which will be solid companies in their own right. And, if the logic above holds, buying the combined company today could be well worth the investment, if management continues to execute as well as it has of late.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.