Wednesday, April 9, 2008

Buffet's acquistion: Kraft Foods

Buffet built a big position, taking 8% ownerships cost him US $ 4 billions in Kraft Foods in 2007. This position is as big as Burlington Northern Santa Fe, but 3 times plus bigger than his Coca-Cola and American Express 20 years ago. I decided to study Kraft Foods a bit more, hoping to learn something from him. I was a little bit surprised by Kraft's so so financial performance(see charts).

Shareholders return was lagging behind S & P 500 and peers. Return on Equity was in low 10%, shareholders' equity have been growing at single digit despite of retaining more than half of the earnings, signs of poor wealth creations. Operating margin was deteriorating from mid-teens to low-teens even though it has been recovering since 2004. It was pretty hard to relate what he always preaches: great franchise, strong economic moats, great pricing power and etc. None of these fit his criteria.

Based on US$ 33/share, implied intrinsic value must be more than US $ 55 billions. He paid almost 20 times 2007 earnings and 2 times book value. We know he is a very shrewd investor, based on his track records, he will not want to add anything below 21% annual compounding return to dilute his performance. He must saw something that others don't.

Since this is a very stable business, it is relatively easier to evaluate Krafts based on future cash flows, at 10% discount rate, 8% growth rate for next 10 years and 5% as terminal rate and net margin 11%, Kraft worth US $ 33/share. However, if the management is able to improve its margin to 15%, the company worth US $ 48/share(about US $ 80 Billion), giving him 45% margin of safety. He is likely to get greater than 15% annual compounding returns over the long haul.

I supposed what attracted him could be improvement efforts by the management since 2004 begin to bear fruits, margin has been recovering despite of huge run up of commodities prices. The company is able to execute growth strategies in four area: rewire organization, reframing product categories, exploit sales capabilities and push down cost without compromising quality. Growth via acquisitions has been satisfactory, they acquired Danone for US $ 8 billions in late 2007, adding US $ 3 billions to the top line. There is also a good chance that he is banking on international sales,though currently, contribute about 20% only.

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