Profit By Thinking Like an Owner
It’s a fair question: Is Warren Buffett right?
He isn’t always, of course. Buffett beats himself up each year in his annual letter to shareholders, spelling out exactly what he flubbed up.
On Tuesday the famed Oracle of Omaha sent out a different kind of letter.
In it, Buffett, speaking as chairman of Berkshire Hathaway (NYSE: BRK-A), said it could not support Kraft’s (NYSE: KFT) takeover bid for British chocolate maker Cadbury (NYSE: CBY). Berkshire, which owns 9.4% of Kraft’s stock, is the company’s largest shareholder.
Buffett’s reasoning for voting no: The financial details of the deal weren’t clear, and he wasn’t willing to hand Kraft CEO Irene Rosenfeld a blank check. Buffett especially didn’t like that her bid involved stock, which he thinks is undervalued and thus an “expensive” currency to make an acquisition with.
It amounted to a stunning no-confidence vote in Rosenfeld, and I expect she’ll lose her job over the Cadbury deal sooner or later. (Never undertake an acquisition your largest shareholder hasn’t signed off on, Irene.) But while Buffett is right when he says the details aren’t known — they aren’t — it’s his assertion that Kraft is undervalued that bears scrutiny. Is it?
As the largest U.S. manufacturer of branded food items, Kraft brings in a ton of revenue. Its top line totaled $42.2 billion in 2008 and nearly $30 billion in the first nine months of 2009. What counts, of course, is how much of that revenue it gets to keep. Kraft’s margin, currently at about 7.8%, puts it squarely behind General Mills Inc. (NYSE: GIS), which has managed a net profit equal to more than 9.0% of its revenue for the past 10 years. On the other hand, customers are willing to pay a premium for Kraft products, and it shows up in the bottom line, which is usually twice as robust, percentage-wise, than competitor ConAgra Foods, Inc. (NYSE: CAG).
Kraft is an industry leader with a modest profit margin and the potential to grow into a more profitable business. Buffett could use this to bolster his case.
The most common valuation yardstick is the earnings multiple, which is sometimes called the price-to-earnings ratio. Kraft trades at 14.5 times its trailing 12-month earnings. That’s significantly less than the broader S&P 500, which sells for 24.7 times earnings, and it’s a little less than Kraft’s historical average of almost 16 times earnings.
Given a 2010 earnings forecast of $2.17, Kraft is likely fairly valued at about $32 a share. By this metric, the shares may or may not be considered undervalued so much as they have about +11.5% upside for 2010, about the same as the historical long-term average for the overall market.
Net Asset Value
Investors can assess value using other methods. One favored by value investors like Buffett is “book value.” Book value is the “net worth” of the company if the assets are sold and the debts are paid. Most companies have a market capitalization that is several times its book value. In fact, the aggregate price-to-book ratio of the S&P 500 is 2.28. Kraft’s is 1.99.
Again, there’s some upside, but it is hard to make a case for the shares being significantly undervalued. If Kraft’s price-to-book value was to match the S&P’s, the shares would trade for $31.96. That’s roughly the aforementioned $32 and roughly equal to the market’s likely gain for the year.
Buffett has absolutely no intention of selling Kraft for a short-term gain. He thinks of himself, rightly, as an owner of the business and, as such, he is geared toward long-range results. That’s why he doesn’t want to give away stock in the Cadbury deal: Those shares could return far more over time than it would cost to borrow the money to finance the acquisition.
Kraft has sterling credit and could borrow billions easily, and relatively inexpensively. Berkshire has the cash and the credit to finance any deal on God’s green earth. I think that’s what Buffett is hinting at: And, to be fair, he did give himself an out, saying he could change his mind if the terms evolved in such a way that “the offer does not destroy value for Kraft shareholders.”
If there’s any hope for Rosenfeld to survive — to say nothing of close the deal — she’d better get on a plane to Omaha, take a meeting with Warren, and discuss how they can finance a deal using cheap cash instead of the stock that Buffett holds dear.
For investors looking to leverage this opportunity for their own account, the path is clear: Be like Buffett. Buy Kraft shares and hold on to them for the long-term. Its leading market position gives it value no other company has, its profit has room to grow, and, if the above financial assumptions prove true, the worst you’ll do in the short term is match the market (and collect a handsome 4.0% dividend).