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Two is Better than One: Analyzing the Kraft Foods Breakup
Kraft Foods Inc., which built itself up over the course of more than a century to become the largest food manufacturer in the U.S. and the second-largest in the world behind Swiss behemoth Nestle, spun off its North American grocery division on October 1st. Under terms of the tax-free transaction, each Kraft Foods shareholder received one share of the new company, Kraft Foods Group (KRFT), for every three shares of Kraft Foods stock held. Kraft Foods then changed its corporate name to Mondelez International (MDLZ), and began trading on the NASDAQ under the symbol MDLZ, rather than the old KFT. It now consists primarily of the overseas snacks operations, and is headed by Kraft Foods’ former CEO, Irene Rosenfeld.
The two separate public entities have very distinct growth profiles and agendas that make them suitable for different types of investor accounts. The surviving company, Mondelez International, is the larger and sexier of the two, with some of the best fundamentals of any participant in the food processing industry, while Kraft Foods Group ought to be the more stable, cash-rich business.
In fact, Mondelez will probably be able to generate annual earnings growth in the double digits (on organic revenue advances of 5%-7%) over the long haul, thanks to its exposure to the attractive snack and beverage categories (approximately 90% of the top-line mix comes from these thriving segments), and to its significant presence in emerging international countries (e.g., Brazil, China, Mexico, and Russia). The only other multinational consumer goods outfit that appears to rival Mondelez when it comes to developing market exposure is beverage giant Coca-Cola (KO - Free Coca-Cola Stock Report); Nestle, by contrast, seems to be lagging.
Mondelez, meanwhile, with world-class brands like Cadbury, Milka, Jacobs, LU, Nabisco, Oreo, Tang, and Trident in its portfolio, also has extensive distribution capabilities that should support market-share gains going forward. (Aggressive infrastructure investments have long been a priority, but the company greatly enhanced its distribution capacity when it acquired French biscuit maker Lu and British confectioner Cadbury in 2007 and 2010, respectively.) And Mondelez has plenty of opportunities to boost efficiencies, especially at the Nabisco biscuits unit, where new streamlining initiatives and improvements to the supply chain, from manufacturing to sourcing and logistics, ought to lead to big cost savings. This, along with restructurings in the beleaguered euro zone and hard-won economies of scale in the firm’s developing footprint, augurs well for margin expansion as we head toward mid-decade.
From a financial standpoint, Mondelez looks to be in pretty good shape, too, with decent cash flow, $4.6 billion in cash on its books (as of mid-2012), and a manageable debt-to-capital ratio in the 30% range. This should allow the company to develop new products and continue paying a modest dividend. Defensive-minded investors looking for income would be better served to look at Kraft Foods Group, however. That newly independent food concern, being led by CEO Tony Vernon and marketing well-known consumer products like Velveeta cheese and Planters peanuts, will likely have a stronger balance sheet once it eliminates certain liabilities owed to Mondelez. And it ought to focus more on cutting costs, boosting productivity, and generating free cash flow than on maximizing its bottom line.
Like one-time parent Altria Group (MO), Kraft Foods Group will probably return most of its profits to shareholders in the form a generous dividend, initially expected to be $2 a share on a yearly basis. Yet, the company should still be able to eke out some respectable earnings growth as it makes its way in the U.S. food industry, which is rather mature and has not fared especially well in this difficult macroeconomic environment. (Volume growth has been virtually nonexistent for most domestic food makers of late.)
Indeed, we envision share-net increases in the mid-to-high single digits for Kraft Foods Group, as the company steps up marketing spending, places a greater emphasis on product innovation, and streamlines its cost structure. Notably, the firm’s profitability metrics generally fall short of those of its peers at present. But the margin gaps should narrow over time, as Kraft Foods Group rationalizes its manufacturing base, drives efficiencies across its supply chain, and reins in its SG&A expenses. And these productivity gains should create a virtuous circle, whereby the company continues to invest in its brands, solidify its market positions, and up its dividend payout. Accretive acquisitions are a possibility, as well, as Kraft Foods Group tries to further bolster its cash flow by playing the role of consolidator in the packaged food space.
In sum, Mondelez International and Kraft Foods Group represent two very different investment vehicles. Mondelez is a growth-oriented company, poised to leverage its powerful slate of brands in developing regions around the globe. And Kraft Foods Group is a defensive, U.S.-based company, with a more consistent business that ought to be less affected by shifts in the economic landscape. At the moment, KRFT shares, trading at about a 4.5% dividend yield, look a bit more attractive, even though they offer only limited appreciation potential out to 2015-2017. Mondelez stock, by contrast, seems richly valued at the current quotation. Indeed, long-term investors wishing to get into that quality name, which, we believe, deserves to trade at a higher P/E multiple because of the firm’s superior earnings prospects, would do well to wait for a lower entry point.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.