Is Kraft Bidding Too Much for Cadbury?
“The object of war is not to die for your country but to make the other b_st___d die for his.”
–General George S. Patton
To paraphrase Patton, “the object of running a company is not to overpay for another CEO’s business, but to have other CEO’s overpay for yours.”
Kraft is proposing to acquire Cadbury for $16.7 billion (see Kraft’s justifying the deal here) and faces a Nov 9th deadline to put in a formal bid according to a UK Takeover Panel decision. Though no other bidder has yet to emerge, Cadbury’s share price is trading well above Kraft’s offer price, reflecting market expectations that another bidder will emerge or that Kraft will have to raise its bid to get more than a passing yawn from Cadbury shareholders.
Both companies are posturing like peacocks to make the best deal and are pulling out all the stops. Cadbury just reported interim results (here) that exceeded expectations & raised its outlook, putting pressure on Kraft, which is slated to report in early November. With a big deal on the line, it would be shocking and a strategic misstep if Kraft did not report a strong quarter. Why? Because a higher stock price means that Kraft can pay more for Cadbury.
The math: Kraft’s proposal values Cadbury at 22 times earnings and 12 times EBITDA. Adjusting earnings for the estimated cost saves ($625 million pretax) and additional interest expense ($450 million pretax) gets the multiple down to about 19 times earnings. That’s a great price for Cadbury shareholders, not so good for Kraft’s unless everything goes right with the integration and ongoing operation.
Financially, the deal is accretive to Kraft’s earnings, but accretion is a poor measure of return on investment (ROI). To get an excellent return on its investment, Kraft will need much more than $625 million in cost saves. Typically, the bidding company low-balls the cost save estimate, so that if something goes wrong (which it normally does), there is a cushion. With Cadbury, $625 million in cost saves already represents 6% of its revenues, at the high end of typical expense savings for CPG deals. As well, Kraft and Cadbury’s operations are more complementary than duplicative, making overlap minimal and casting doubt on the ability to achieve that figure without losing something on the back-end. The only way the deal works for Kraft owners is if the companies can fully leverage each other’s distribution networks. Source: company filings.
3 Things We Learned at Wal-Mart’s Analyst Meeting
Though Wal-Mart packed two days of presentations full of granular data, it’s helpful to take the view from 30,000 feet.
1. Sales performance in context. Wall Street is still unimpressed with Wal-Mart’s domestic sales performance (up a few percent). We look at it differently. It’s difficult to avoid market ups & downs when you are becoming the market. Sales for the entire U.S. retail industry will be down about 8% or $350 billion this year. Think about that number – it is kind of like locking the doors on every U.S. Wal-Mart and Sam’s Club store for a year, that’s a tremendous amount of lost sales for the industry. Taking market share while shrinking SKU’s and improving margins seems like a pretty good outcome for shareholders.
2. International: WMT is playing the long game. Acquiring and operating successfully in new markets has a steep learning curve and takes many years. Because of the difference in profitability between domestic and U.S. operations, Wall Street has some doubts about WMT’s ability to operate successfully outside the U.S. For WMT to get out of the “penalty box,” it must demonstrate that it can acquire and operate successfully in Asia – the world’s new growth engine. After extensive discussions with key managers, it looks to us like WMT is taking the appropriate steps at Seiyu (management changes, merchandising & improving price leadership) to be in a position to report improved progress over the next few years. Good news from Seiyu is a critical lever in changing investor’s view of WMT’s growth potential and thereby stopping the erosion in WMT's P/E multiple. It’s erosion of the P/E multiple (not lack of earnings growth) that has kept the stock from rising.
3. Recruiting: From Pariah to Power: In the old days, many executives viewed working for a retailer in Arkansas with all the enthusiasm of being sent to Siberia. And Wal-Mart, to use a sports metaphor, relied mainly on building from within and recruiting top “position players” in logistics, merchandising, etc. It was apparent from our meetings that Wal-Mart is now more like the USC Trojans in football, recruiting both position players and “athletes,” individuals with strong leadership, financial & management skills, and in the process creating a very deep bench with fresh energy and ideas, very necessary as the company transitions to a more global player.
Thanks Nutrisystem!
One week before trumpeting a new distribution agreement with Wal-Mart (press release), Nutrisystem (NTRI) granted Chief Marketing Officer Chris Terrill 60,000 shares of restricted stock (filed here on September 28). Though the shares vest over 4 years, the stock is up a cool $6.00 to $21.69 since the announcement, which is a nice $360,000 gain, (on paper, anyway) for Terrill, who was named chief marketing officer in June. Source: footnoted.org
Remarkable Graph of Target Store Openings
The interactive map of Wal-Mart’s store openings got tons of hits from our readers back in February (see it here). Now, the folks at FlowingData have added an interactive map of Target store openings since its inception. Source: FlowingData
Quote of the Day:
“We believe employment agreements help mitigate the economic hardship associated with unexpected termination.”
Well, employment agreements like these sure do. We saw this in the Clorox proxy statement filed this month. $1.5 billion of Clorox’s $5.5 billion of sales are to Wal-Mart. The comment is perhaps untimely in light of the backlash rippling through the country over executive pay. The millions of dollars that named officers would receive upon termination or a change in control will go a long ways towards “mitigating their economic hardship.” According to the plan, a named officer that is “unexpectedly terminated” would receive two times salary plus 150% of annual incentive compensation along with a few other minor perks.
Clorox is an excellent company; however, it is disheartening to see the board set low hurdles for compensating executives. We couldn’t help but notice the low hurdle to achieve 100% of target for the “economic profit” metric for annual incentive compensation. Theoretically, “economic profit” is a 50% factor in awarding bonuses, with sales growth accounting for the remaining 50% weighting. According to the 2009 proxy, to reach 100% of target, “economic profit” would have to be $359 million, which is below 2008’s economic profit of $363 million.
The other interesting item we noticed in the company’s financial footnotes was that the company maintains investments in low-income house partnerships. The partnerships develop and operate low-income housing rental properties. The company’s ownership is not entirely philanthropic; the investments provide the company with low-income housing tax credits. Though the benefit to Clorox is nominal, tax credits are more valuable than tax deductions as the credits provide a dollar-for-dollar reduction in federal income taxes while a tax deduction only provides a deduction in taxable income. Source: Company filings.
Local blogs of interest to the vendor community
Here’s a few blogs we’ve come across that may be of interest to you our readers. I’m sure there are some we haven’t discovered yet. If you have an appealing blog or newsfeed, tell us.
NewMarket Builders and also here
And, MorningNewsBeat.com is a national blog, but highly recommended.
Two Things We Learned About Sugar
It’s no secret that sugar prices have hit an all-time high due to supply constraints, principally in India. Both the 10-year chart here and a 25 year chart here tell the story. Suppliers of sweetened snack-foods and beverage makers are in the crosshairs. Two years ago, Cott, a private label beverage maker that counts Wal-Mart as its largest customer, saw investors squash its stock as sugar prices spiked at the same time that Cott was caught between the big boys as they traded blows for shelf space in the midst of industry-wide declines in volumes for carbonated beverages. Two things you might not know about sugar:
Warren Buffett has recounted the story of Coca-Cola, which went public in 1919 at $40 per share, but was halved the next year as investors feared that high sugar prices would crush its earnings. That turned out to be a great time to buy the stock. We are not saying that Cott is the next Coca-Cola, but there’s a difference between a permanent change in business fundamentals and re-occurring commodity price swings. Coke turned out to be a pretty good investment over the next 90 or so years for investors.
And going way back to 15th and 16th centuries in England: Smiling at others became popular as a social norm thanks to Tudor aristocrats who smiled to show off their blackened teeth as proof that they “were rich enough to rot them on costly sugar.” Source: The Art of Conversation, Catherine Blyth
They Said It
On trying to fix the economy quickly: “You can’t produce a baby in 1 month by getting 9 women pregnant.”
–Warren Buffett
“You can’t have a world where 50% of the people are dieting and 50% of the people are starving if you want stability.” –John Shelby Spong
Have a thought or comment? Give us a call or email.
Scott Alaniz, CFA
Joe Chumbler, CFA
Rogers (479) 657-6940
Information in this report has been obtained from sources that we believe to be reliable. Boston Mountain Money Management does not guarantee its accuracy or completeness and assumes no responsibility for actions taken with respect to information contained herein. The authors held a position in Wal-Mart Stores at the time of this newsletter.
