Kraft Hopes Two Is Better Than One

By Stephen D. Simpson, CFA | August 10, 2011 AAA

As food companies go, Kraft Foods (NYSE:KFT) has done alright over the past couple of years. Despite the controversy over the company's aggressive move to bring Cadbury into the fold, Kraft has basically matched the market, done better than rival Kellogg (NYSE:K), and kept pace with the likes of ConAgra (NYSE:CAG) and Unilever (NYSE:UL). The question now is whether a dramatic restructuring of the business is going to significantly improve growth and shareholder value, or whether it's simply a distraction to buy time for a management team that doesn't appear to earn its cost of capital.

TUTORIAL: Mergers And Acquisitions

Q2 Not as Strong as It Seems
Wall Street seemed oddly pleased with Kraft's second quarter earnings. True, the company did beat the average estimate by a healthy margin and surpassed even the high end of the range. What's more, reported growth of over 13% and organic growth of over 7% is quite good for a huge food company (Kraft is second-largest in the world behind Nestle (Nasdaq:NSRGY). Still, volume growth was less than 2% and the better-than 5% boost to price and mix was helped by a calendar artifact.

In point of fact, Kraft's top-line growth is not the issue. Margins are. Gross margin fell over three full points this quarter and operating income rose about 6% on a reported basis and 4% on an adjusted basis. All in all, then, Kraft's outperformance really was about the top line, as margin compression frittered away some of those benefits. (For related reading, see A Look At Corporate Profit Margins.)

From One to Two
By far the bigger story of the quarter, Kraft announced it is intending to split itself into two companies - one that will be focused on the global snack foods business and the other on North American grocery businesses like beverages and cheese. Based on current revenues, the snacks business will comprise about two-thirds of the current Kraft business and it will have considerably more growth than the more stable (and slow-growing) grocery businesses.

A Surprise? Apparently Not ...
It's funny how success often has multiple parents and failure tends to be an orphan. With Kraft Foods' split, it seems like analysts can't come out of the woodwork fast enough to point to some piece they wrote in the last five or six years highlighting the logic of a split. Honestly, it's just not that impressive - there's a steady pressure as a sell-side analyst to always produce some sort of content that can generate discussion (and trading revenue) and speculating on takeovers, restructurings and splits is pretty low-hanging fruit.

Even Kraft's own CEO claims that this concept has been under consideration for some time. Perhaps that will stave off the criticism that this split would seem to validate at least some of the concerns that major investors like Berkshire Hathaway's (NYSE:BRK.A) Warren Buffett had when Kraft paid so much to get Cadbury. (For related reading on Berkshire Hathaway, see Build A Baby Berkshire.)

Time Will Tell If This Works
Of course Kraft management is trying to sell this deal as a way of unlocking more value by allowing each business to focus on its own markets. The thing is, though, Kraft was run in a fairly solid fashion to begin with and it's not clear that the benefits of this "focus" will outweigh the loss of some economies of scale. Now while it may be true that the Street values the two parts more highly than the whole (the Street can be dumb in that fashion), a skeptic may not be wholly wrong in thinking that this move is also a strategy for creating a distraction for shareholders and burying issues like Kraft's low returns and less-than-fully-successful Cadbury integration.

Still, this is a move that will have major ripples. If there are in fact benefits to letting the snack business run independently, that can't be good news for PepsiCo (NYSE:PEP) and its sizable franchise. Likewise, smaller companies like B&G Foods (NYSE:BGS), Diamond Foods (Nasdaq:DMND), and Snyder's-Lance (Nasdaq:LNCE) may be seeing a lost opportunity - if big food companies decide to break up instead of selling off underperforming or non-strategic lines, that likely reduces (if not eliminates) a pretty cost-effective means of growth for these smaller players.

The Bottom Line
Perhaps it makes sense for Kraft to want to free the snacks business; it's growing faster, it's more globally competitive, and it has more potential retail outlets. Perhaps it also says something about the future on more traditional processed food manufacturing. In any case, Kraft was not terribly cheap before this announcement and until the company can prove that these companies perform better apart than together, it seems strange to pay a premium for the stock. (For related reading on mergers, see The Merger- What To Do When Companies Converge.)

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