Kraft Foods Inc. or Cadbury PLC: Which is the Better Business? And Which is the Better Stock?

Some investors think Cadbury is a better business than Kraft because the Cadbury name is high class and the Kraft name isn’t. That’s crazy. As a rule: the world’s greatest brands aren’t prestigious - they’re familiar.

Cadbury’s most prestigious brands are in chocolate. But the company’s best brands - and its brightest future - are in gum.

Why Cadbury is a Better Business Than Kraft

1. Cadbury gets more cash from each dollar of stuff it sells.

· Cadbury’s CFFO - Cash Flow From Operations - margin was 13.27% over the last three years.

· Kraft’s operating margin is just 10.08%.

2. Cadbury has better margins than Kraft in both good markets and bad.

· The best market for both companies is the Americas. Cadbury has a 16.93% operating margin - Kraft: 14.37%.

· Europe is the worst market for both companies. Cadbury has a 9.90% margin - Kraft just 6.34%.

3. Cadbury is in the gum business.

· Gum is the fastest growing part of the confectionary business.

· Worldwide gum sales have grown faster than the overall economy.

· It’s easier for foreign gum brands to take market share than it is for foreign makers of chocolate or other foods.

Why Kraft is a Better Business Than Cadbury

1. Kraft keeps more cash from each dollar of sales than Cadbury.

· Kraft’s free cash flow margin - what’s left after building all the factories and buying all the equipment it needs - is 6.75%.

· Cadbury’s free cash flow margin is only 4.42%.

2. Kraft dominates more of its markets than Cadbury does.

· Some of Kraft’s brands - like Jell-O and Cool-Whip - are one brand markets. Shoppers don’t think of them as brands with substitutes but as separate products all their own - kind of like WD-40.

· Cadbury’s best categories are gum and chocolate. Mars - which now owns Wrigley - is bigger in both categories.

· Kraft’s best market is its home market. Cadbury doesn’t break out its British results. But its performance on the European mainland is much worse than its performance in the U.S.

There’s nothing wrong with doing better in foreign markets than at home. The problem is that Cadbury’s competitors share its growth prospects.

The countries where Cadbury expects to gain market share are countries where Cadbury’s competitors expect to gain market share. The countries where Cadbury is investing are countries where its competitors are investing.

Kraft dominates a boring market: the United States. Cadbury has a foothold in a lot of exciting markets. It will face more straight up fights than Kraft.

And unlike a century or two ago - when many of Kraft and Cadbury’s brands started out - the battle for market dominance will be fought by well-funded, well-organized multinationals.

Kraft or Cadbury: Which is the Better Business?

Kraft dominates more businesses. But Cadbury is in better businesses. Cadbury gets more cash from each dollar of stuff it sells. But Kraft keeps more.

So which is the better business?

If I had to choose I’d choose Cadbury for three reasons:

1. It’s better to be #2 - or 3 or 4 - in a good business than #1 in a not so good business. About 80% of Cadbury is gum and chocolate. Those are good businesses. Cadbury will do well in them even if Mars does better.

2. It looks like Cadbury has more untapped pricing power than Kraft. Cadbury says it’s going to improve margins. The easiest way to do that is jack up prices. People like chocolate better the more you charge them for it.

3. And most importantly: Cadbury already has better (cash) operating margins than Kraft. All Cadbury needs to do to throw off a ton of free cash flow is cut capital spending to the bone.

Which Company Has to Put More into its Business?

Investing is about what you get for what you give. Cadbury gets more - percentagewise - out of its business than Kraft. But Cadbury also puts more into its business than Kraft.

Does Cadbury have to put more into its business than Kraft? Or does it simply choose to?

If Cadbury wants to grow quickly, it probably has to. A lot of Cadbury’s growth is in frontier markets. It takes more cash to grow sales in these countries than in long settled markets like the U.S. and Europe.

What if Cadbury Stopped Putting So Much Back in the Business?

It could give a lot more cash to shareholders by paying a bigger dividend and buying back stock. But it wouldn’t grow as fast.

Which would investors prefer? Cash or growth?

My guess is growth. But the math says different.

Cadbury has been sinking so much cash into its business that it needs to grow sales 3% a year faster than Kraft to make this reinvestment pay off for its shareholders.

Cadbury’s capital spending - close to 9% of sales - is over 300 million GBP (British Pounds) more than Kraft spends on the same amount of sales.

Even if Cadbury cuts capital spending to Kraft like levels next year - which it won’t - those 300 million pounds of burnt cash leave a big hole.

How big?

My favorite measure of the price investors are willing to pay for cash is the yield on the best (U.S.) corporate bonds. Right now that’s 4.87%.

Invert that 4.87% (1/0.0487 = 20.53) and you see that it takes a river of cash flowing at a rate of almost 15 million pounds a year to replace 300 million pounds spent today.

(300 million / 20.53 = 14.61 million)

With a free cash flow margin of 10% it would take another 146 million pounds in sales each year to fill that gap.

For Cadbury that’s close to 3% of sales.

Does that Mean Cadbury’s Growth Isn’t Worth It?

No.

In theory: sales growth - especially in new markets - will bring fatter operating margins and a better competitive position. All this means tons more free cash flow year after year.

In reality: I have my doubts. The biggest is that Cadbury has competitors - like Mars - that see the same market data and probably read it the same way.

Cash from operations depends on things like advertising and pricing. And advertising and pricing depend a lot on what the other guy does.

Cadbury will grow. But will it grow fast enough and profitably enough to make up for all this spending?

Cadbury’s management says it will. They’re already promising mid-teens operating margins, better cash conversion, and capital spending that’s almost half of what it is today.

If that happens - and Cadbury’s growth doesn’t slow - the added investment will pay off.

Kraft or Cadbury: Which is the Better Stock?

Kraft and Cadbury are two very different stocks with very different strategies.

Kraft’s best bet is to buy back stock. Cadbury’s best bet is to grow the business in countries with fast growing economies.

But Kraft’s bid has the potential to screw up both companies.

Cadbury is a speculative stock till a deal gets done. You can judge it as a business. But there’s no point.

A share of Cadbury is just a piece of paper. It’s worth whatever Kraft or Hershey is willing to pay.

Investors won’t block a deal even if it’s a bad one. So I can’t recommend buying Cadbury stock.

Kraft is a more interesting situation. It’s cheap.

But there’s a chance it’s about to do something stupid - like sell a lot of itself to buy Cadbury.

The best thing for Kraft shareholders would be if Hershey offered to buy Cadbury.

A serious offer from Hershey would be a buy signal for Kraft.

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