Kraft Reverses Course by Splitting Up Business

A mere 18 months after its acquisition of Cadbury,  Kraft (KFT) intends to split the business into global snacks and North American grocery (which is expected to be completed by year-end 2012), essentially reversing the confectionery deal. We have been quite skeptical since the Cadbury transaction was announced regarding the qualitative aspects of the acquisition--that is, personnel retention--and we believe that Thursday's announcement supports our thinking. Further, we now question the firm's ability to garner the targeted $1 billion in revenue synergies, since it will no longer be able to extend the distribution of some existing brands through Cadbury's network. From a cost perspective, because the integration was still in the early innings, we doubt the firm has realized substantial savings from the Cadbury deal that could reverse post-spin-off. However, we still think this deal could unlock some additional value for shareholders, and we intend to raise our fair value estimate slightly based on a sum-of-the-parts valuation.

Kraft's decision mirrors what we've seen from other consumer product firms over the past several months, as  Sara Lee  and  Fortune Brands (FO) have also decided to breakup their individual businesses. But in these cases, there was a strategic rationale for the deals, and we expect that Sara Lee's and Fortune's segments could be acquisition targets. In our opinion, Kraft's motivation leans more toward unlocking a higher multiple for the faster-growing snack business that was being unappreciated when combined with the more mature North American grocery brands. In addition, in Kraft's case, we doubt that either of the firm's business units will garner much interest from potential acquirers as the sheer size of the units (with global snacks' revenue at $32 billion and North American grocery's at $16 billion) makes them unlikely targets. From our perspective, following the spin-off, investors with a thirst for growth in the packaged food sector may be interested in the global snack business, while income-seeking investors may want to consider the North American grocery business as management has stated that dividend payments would be a priority for cash for the more mature grocery segment.

We assume that the global snack business could garner an EBITDA multiple of 13 times (in line with the multiple Kraft paid for the Cadbury business), while the North American grocery business could garner an EBITDA multiple of 8 times (due to the slower growth but respectable margins the segment generates). Kraft has not provided enough detail to determine a pro forma credit rating for the firm or the spun-off entities once the breakup is completed. We will complete a new credit rating analysis and provide an anticipated credit rating for the entity where the bonds will reside subsequent to the spin-off once additional information is released.

Kraft also reported second-quarter earnings and raised its full-year sales forecast to growth of at least 5% (up from 4%) and operating earnings of $2.25 per share (up from $2.20). Second-quarter internal sales grew 7.1% year over year, thanks to higher prices (up 5.5%) and increased volume (1.6%); however, the volume growth was less impressive given that the bulk resulted from the shift of Easter into the second quarter. Despite higher prices, rampant cost inflation plagued Kraft's profitability, as the gross margin contracted by 320 basis points to 35.1% and the operating margin fell 90 basis points to 13.0%. Similar to what we've heard from other consumer product firms, cost pressures are unlikely to subside, as management raised its full-year cost inflation forecast to the low teens versus high single digits previously, primarily reflecting a runup in dairy and coffee prices. As a result, Kraft expects to raise prices further; however, because consumers in developed markets are still under significant strain because of rising gas prices, lackluster wage growth, and stubbornly high unemployment levels, the strength of Kraft's brands and whether it can sustain these higher prices will be tested over the next several quarters, particularly if competitors don't follow suit.

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