Despite increased debt load from the Cadbury deal, Morningstar's Dave Sekera thinks that Kraft's copious free cash flow will keep bondholders safe.
Jeremy Glaser: How sweet will Kraft's Cadbury purchase be for bondholders? I'm Jeremy Glaser with Morningstar.com.
Joining me today is Senior Analyst, Dave Sekera, to take a look at Kraft and where bond opportunities may lie. Dave, thanks for joining me.
David Sekera: Thank you, Jeremy.
Glaser: So first off, how did Kraft's acquisition of Cadbury impact your thinking about the firm's financial strength?
Sekera: Well, as you would expect, they did incur a lot of debt and they increased leverage very substantially in order to acquire Cadbury. So, pro forma for the acquisition leverage went up to about 4.3 times from 3.4 times prior to the acquisition. There was pretty good increase in leverage in the consumer product space.
However, it does put them in pretty good position as they now have distribution channels in the emerging markets that they didn't have access for. So there should be a lot of synergies that we should see in expanded growth margin opportunities.
Glaser: What are some of the other aspects of Kraft that make you feel better about the financial health of the company?
Sekera: Sure. Kraft itself, you have to remember is the largest in North America, the second largest in the world itself. They have a number of brands, which each produce over $1 billion worth of sales in and of themselves. Company produces a huge amount of free cash flow. We expect the company is going to use a very substantial portion of that free cash flow in order to repay debt. And in fact, over our forecast period, we believe that should come back down to three times over the next five years.
Glaser: Certainly this deal was not wildly popular among all investors; Warren Buffett, in particular, voiced his concerns. What are some of the potential pitfalls for Kraft with this transaction?
Sekera: Sure. As with any large acquisition of this size, there are always potential integration issues that we could see. However, we'd really foresee that those are going to be more short-term in nature rather than long-term business issues. Things we'd probably be most concerned about from a rating aspect, it would be if we were to see any kind of gross margin deterioration. As commodity prices keep going up, if we don't see that they have the pricing ability to flow those through to the consumer, we could see gross margin pressure.
We also see a lot of encroachment in the private-label space coming into their markets. So if they had spend a lot more on promotional marketing in order to offset what we're seeing in the private labels that could impact their margins as well.
Glaser: Given all of this, where does your credit rating shake out?
Sekera: We came out a BBB minus. We would caution that is the lowest investment grade rating, but we do see over time, if the company does pay down cash or does pay down debt as we would expect with their free cash flow, there could be some upside potential over the next couple years.
Glaser: Is Kraft's debt trading around that low investment grade level or does it look like there's some opportunity for investors to grab some extra spread?
Sekera: For being in the consumer product space, it does look attractive to us right now, especially in the 7- to 10-year maturity range. On an option-adjusted spread basis, you probably pick about 170 basis points over treasuries by way of reference right now, could probably get 4% to 4.5% yields as compared to the underlying Treasury bond, which I think this morning was just inside 3%.
Glaser: All right, great, Dave. Thanks so much for joining me today.
Sekera: Thank you, Jeremy.
Glaser: For Morningstar.com, I'm Jeremy Glaser.
