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Geoff Gannon
Geoff Gannon
Articles 

Warren Buffett Bought Kraft Stock at $33 a Share - Should You Buy it at 29?

January 12, 2010 | About:
Tuesday, January 5th, 2010 - Warren Buffett’s Berkshire Hathaway announces it will vote “no” on Kraft’s proposal to issue 370 million new shares.

Kraft’s CEO wanted to use the new shares as ammo in her hostile takeover of Cadbury. Buffett shot her down. Why?

Because Kraft’s stock is too cheap.

Here’s what Buffett wrote:

“What we know with certainty…is that Kraft stock, at its current price of $27, is a very expensive ‘currency’ to be used in an acquisition. In 2007, in fact, Kraft spent $3.6 billion to repurchase shares at about $33 per share, presumably because directors and management thought the shares to be worth more.”

Buffett also bought Kraft around $33 a share. Page 15 of last year’s annual letter to shareholders shows that Berkshire’s 130 million plus shares of Kraft cost $33.24 a piece.

What Does Buffett See in Kraft?

1. Brands that will never be duplicated.

· Kraft products are in more than 99% of American homes

· The company has 9 brands with more than $1 billion in sales

· And 40 brands started before 1910

2. A dominant competitive position.

· 80% of Kraft sales come from products with the #1 market share in their category.

· And 50% of sales come from categories where Kraft’s market share is more than twice that of their nearest competitor.

3. Good margins.

· On average, Kraft turns 7.7 cents of each sales dollar into free cash flow.

· Kraft’s U.S. Groceries - its salad dressings, barbecue sauces, Cool-Whip, Grey Poupon, and Jell-O - have the same profit margin as Google (GOOG).

· The company’s cheeses have margins equal to Heinz (HNZ).

4. Managers focused on the right things.

· Kraft sends most of its free cash flow straight to shareholders in the form of a $1.16 a share dividend - giving the stock a dividend yield of 4%

· In 2007, the company started buying back gobs of its own shares - giving each shareholder a bigger slice of the same pie

· They’re cutting costs

· And restructuring foreign businesses to look more like the American business

The 4 Questions Warren Buffett Asks Before Buying a Stock

Those are good reasons for any investor to buy Kraft. But Warren Buffett has four specific questions he asks before buying any stock:

1. Does he understand the business?

2. Does it have favorable long-term prospects?

3. Is it operated by honest and competent people?

4. And is it priced very attractively?

Does Kraft Pass Warren Buffett’s Test?

No.

It fails question number 4.

At least it would if Buffett’s four questions had stayed exactly the same as they were in 1977.

Question #4 - “Is it priced very attractively?” - is the reason Berkshire sometimes holds off buying any stocks at all. Buffett is always on the lookout for great businesses and he usually finds them. But he can’t always find them at the right price.

The Warren Buffett of 1977 wouldn’t buy Kraft, because that Warren Buffett only bought super cheap stocks. Today Buffett has to settle for slightly cheap stocks because there simply aren’t enough super cheap stocks to soak up all of Berkshire’s cash.

To solve this problem Buffett lowered his standards and changed question #4 to:

Is it pricedvery attractively?

Kraft passes this test. That’s why Buffett bought it.

Should you?

What is Kraft Worth?

Warren Buffett values companies according to something he calls owner earnings:

“…we consider the owner earnings figure, not the GAAP (Generally Accepted Accounting Principle) figure, to be the relevant item for valuation purposes - both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes's observation: ‘I would rather be vaguely right than precisely wrong.’”

So what’s the vaguely right earnings number for Kraft?

My guess is $1.85 a share.

It’s a somewhat arbitrary number. But only somewhat.

If you take Kraft’s free cash flow from 2000 through 2008 and adjust it for the number of shares out today you get $1.75 a year in free cash flow. If you take the last three years as a short-term average you get $1.73 a share.

Kraft’s sales are higher now than they were in those years. If you slap Kraft’s historical free cash flow margin of 7.7% on the today’s sales you get $2.07 a share in free cash flow.

(This assumes sales will be down 6% from last year but doesn’t adjust for the sale of the pizza business.)

Like I said: arbitrary.

But averaging the three figures and taking $1.85 a share as your owner earnings is the vaguely right approach.

Yes - you can substitute $1.75 or $1.73 or $2.07 or anything in between if you want. No one will smite you for it. The important thing is putting some numbers in and taking some emotion out.

This eternal stream of cash flow from Kraft stock needs to be compared to something if we want to put a dollar value on the shares.

I’m going to use the yield on investment grade corporate bonds - 4.89% - which means inverting the yield (1/0.0489 = 20.45) and multiplying Kraft’s owner earnings by that number.

Which is a fancy way of saying each share of Kraft is worth its owner earnings times the price people are willing to pay for each dollar of corporate promises.

Right now investors are willing to pay $20.45 per dollar of corporate promises they believe.

Kraft stock promises $1.85 in owner earnings.

That promise should be worth $37.84 a share.

Right?

Maybe vaguely.

It depends on a lot of things. The biggest is the quest for Cadbury - a subject I’ll take up tomorrow.

About the author:

Geoff Gannon



Rating: 4.3/5 (37 votes)

Voters:

Comments

gurufocus
Gurufocus premium member - 9 years ago
GuruFocus note:

We welcome back columnist Geoff Gannon for his contributions!
tkervin
Tkervin - 9 years ago    Report SPAM
My cost basis for Kraft is about $26. My thinking was fairly simple. When I can buy a stock that is a significant holding of Buffett's at a better price than Warren paid........I will make money more times than not........
kidchoi
Kidchoi - 9 years ago    Report SPAM


This is an excellent analysis, I will add to my position.
batbeer2
Batbeer2 premium member - 9 years ago
Thanks for the analysis. I just took another look at the KFT balance sheet with inflation in mind.... currently, let's say a dollar of equity gets you 1.5 dollars of sales.

So now it's 2020 and a dollar get's you about half the ammount of groceries you got n 2010. All things being equal, KFT sales double, current assets double, COGS.... etc. What does NOT double is the intangibles and the long term debt. What is the ROE, ROA etc. now ? You get some interesting results.

Imagine having to compete against something like that..... you will have problems. Unlike most competitors, Kraft needs very little extra equity to grow in an inflationary environment. Any excess cash is for shareholders. A scenario like that will see KFT with less competition and higher dividends in 2020.

What they do not need is more intagibles aka Cadbury.

Where is that dividend growth guy ?
Michael Baun
Michael Baun - 9 years ago    Report SPAM
Bottom line is that chocholate labeled Kraft would not sell unless it sold at 5 cents a pound._
Michael Baun
Michael Baun - 9 years ago    Report SPAM
Bottom line is that Cadbury has quality brand recognition for chocholate that Kraft does not have for cheese. Buffet paid too much for Kraft, He is saying he will vote against the purchase because of this. I don't believe this for a moment. I believe this is Buffet's strategy to drive the price down and then vote yes.
buffetteer17
Buffetteer17 premium member - 9 years ago
A couple of tweaks to the analysis. Investment grade corporate bond yield, as indicated by Moody's Seasoned Baa Corporate Bond Yield is actually around 6.4% right now. The long term average for this is around 7.5% [source: http://research.stlouisfed.org/fred2/data/BAA.txt]. Inverting this 7.5% yield gives a present value of $13.33 per dollar of yield. Of course, bond yields don't grow over time, but it seems reasonable that Kraft's free cash flow would grow, so it makes sense to pay a premium for a growing income stream compared to a fixed stream. Say the stream grows by 2.5%/year. The present value of this stream is 1/(yield_rate-growth_rate) = 1/5% = $20. Okay we're right back where Geoff started almost, with a $1 of yield worth ~$20 today for a stable, slow-growing company.

What's the point of this exercise? Geoff's $20.45 today per dollar of yield was a number more-or-less plucked from the air (although I'm sure he could justify it if pressed), but I wanted to demonstrate it has a quite solid basis.
cm1750
Cm1750 - 9 years ago    Report SPAM


For almost all wide moat businesses, using normalized FCF/(r-g) is a great 10 second way to get to a DCF value. Buffetteer uses the corp bond rate for r, but using cost of equity is more applicable as the bond rate is for a lower risk security as it has seniority in the capital structure and the exact cash flows to be received are much more certain, as it is stated in the bond indenture.

Munger always jokes that he has never seen Warren do a DCF, when I think Warren really just plugs in a normalized FCF to that formula with some asset adjustments.

Any mediocre analyst can do lots of detailed spreadsheets, but 90% of the real investment value is identifying those businesses with sustainable long-term cash flows and buying them at a discount.

Using 1/(r-g) and plugging in 9.5% for r and figuring with 1-2% unit growth, 3% pricing power and maybe 0.5% of operating leverage will give you a fair FCF multiple of about 22x - if you can buy such a business for around 13x, you have Graham's 40% discount to intrinsic value. Ideally, you can buy a business for 13x that can grow FCF 8% for 30+ years so fair value is 67x. However, most investment professionals only look out maybe 3 years when valuing a company.
kidchoi
Kidchoi - 9 years ago    Report SPAM


Cm - how do you arrive at 9.5% for the cost of equity for KFT?

Based on using the simple FCF yield method (FCF/r-g) then, PFE appears to provide even more bang for the buck. The FCF yield is quite high, even with patent expirations factored in.

Comments on PFE or other high yielding FCF stocks? This is all Berkowitz always emphasizes.
cm1750
Cm1750 - 9 years ago    Report SPAM


Cost of equity (Ke) of 9.5% is used for 2 reasons:

1) The historic stock "real" market return is 6.5% based on data from GMO etc. If you add 2.5-3.0% for inflation you get 9.0-9.5% nominal returns. If KFT etc. is fairly priced, one would expect a market rate of return.

2) Investing in equities is riskier than investing in Treasuries. If you can get 3.75% from 10-yr T-bonds, you want a premium for holding riskier stocks. McKinsey said the equity risk premium for the market is 4.75% so the Ke today should be about 8.5%. Given the 10-yr T-bond is artificially low (would anyone seriously lock up money for 10 years at 3.75%?), I use a more normalized 4.5-5.0%. So adding the risk premium on normalized 10-year rates gives you about 9.5% so the Ke is consistent with reason #1.

Remember, using 1/(r-g) is best used for a wide moat company where you can reasonably project FCF for 10+ years - the "g" is the perpetual growth of FCF. Guessing perpetual growth for companies in rapidly changing industries is a fool's game, but it works for stocks like PEP, KO, PG, PM, JNJ etc.

Berkowitz does look at FCF yield as this is the return you get assuming zero growth if you own the whole company - like a bond. Conversely, if you pay 10.5x FCF for a company (9.5% Ke with zero growth), then investors realize it will have 3% growth, the stock should move to a 15.4x P/FCF, giving you a 46% return.

PFE is an especially good deal if you think it can grow FCF 3-4% for a long time - given my lack of expertise in pharma, I just worry given many drug companies have faltered with pipeine issues. What I do know is that people will be buying JNJ products (JNJ has fantastic consumer brands and a smaller exposure to medical). With JNJ at $64.50 and 2010 FCF of roughly $4.85, the market only assumes 2% perpetual growth at its current 13.3x P/FCF. Given the company has grown FCF by 11% since 2000 and 8% since 2005, I would be willing to take that bet. I think that JNJ is like WMT - its valuation was too high 5-10 years ago and now the P/FCF has compressed so it should return to delivering strong investor returns over the next 5-10 years. Fortunately, investors ignore it as the stock has done nothing, without realizing that the P/FCF now provides a good entry point.

One of the reasons that blue chip stable companies are undervalued vs. the overall market is that most quality companies can theoretically grow FCF forever at 3.5%+ (inflation + tepid unit growth) and should trade at a minimum 16.7x FCF using 1/(9.5% - 3.5%). However, some large cap blue chips are below this base threshold while lower quality companies are trading at higher multiples. If you are a trader trying to make a 20% return in 6 months, long-term value does not matter. But for a long-term investor, the question is this: Would you rather pay a 16.7x FCF multiple for a JNJ, PEP etc. vs. some lower-quality company if you had to hold it for 10 years? At least you are pretty sure of getting 9-10% from the quality stalwarts. So the risk/return is definitely in favor of the blue chips.

Given GMO's 7-year asset class forecast just came out, let's see their conclusions (figures include inflation of 2.5%/year).

U.S. large cap - 3.8% IRR

U.S. small cap - 3.0% IRR

U.S. high quality - 9.3% IRR

Int'l large cap - 7.2% IRR

Int'l small cal - 7.1% IRR

So it seems GMO agrees that large cap blue chips are fairly priced as one can expect normal market returns of 9-9.5%. This is much better than other U.S. stocks. The best part is that finding these 9-9.5% IRR stocks is not tough - just buy a basket of JNJ, PG, PEP, WMT, PFE, XOM, CSCO and take a 7 year nap. For more active investors, you can hold these stocks and then sell out-of-the money covered calls and puts on these stocks when the market reaches extremes.
benethridge
Benethridge - 9 years ago    Report SPAM
Excellent analysis, but I have to question your question:

"Given the 10-yr T-bond is artificially low (would anyone seriously lock up money for 10 years at 3.75%?)"

I do not agree that this bond is "artificially" low. Apparently, quite a few people are seriously locking in at this rate. I mean, the T-Bond market is a voting machine, like all other public markets, right?

If we go into a second long recession or depression (i.e. a 10 year deflation scenario), that will have been the smart money, and the hypothetical equity risk premium the rest of us "bought" will have been lost, and might not be gained back for a very long time...perhaps even 25 years or so, if history rhymes.

I personally would bet against the T-bonds same as you, and I would bet on the basket of stocks you show. After all, we'll get almost the T-bond yield in just the dividends... but we could be very, very wrong.

My point is that rejecting the T-bonds as artificially low is not a no-brainer.

cm1750
Cm1750 - 9 years ago    Report SPAM
You have a good point about Treasuries potentially working out OK - I just think the risk/reward is not in your favor with 10-year T-bonds (3.75% yield). I think Fuss at Loomis Sayles and Bill Gross at PIMCO also share this view.

Remember, bonds have 4 basic compenents (MILD) - Maturity risk premium, Inflation premium, Liquidity premium and Default risk premium. Assume the Maturity risk premium is 0.4% and inflation is 2.5% over those 10 years. I assume the last 2 factors are zero for treasuries. Given the massive U.S. money printing and projected deficits, potential for higher energy/material prices etc., that 2.5% inflation assumption may be low.

Even if you demand no maturity premium, you still are locked into a security that will, in 80-90% of likely scenarios, provide zero real returns assuming a fed/state tax of 33% (after-tax 2.5% return). Worst case is inflation jumps and you suffer a significant capital loss on the bonds.

Alternatively, you can buy Philip Morris [or insert other blue chip dividend stock here]. You are paying 13x FCF (7.7% yield). PM has pricing power of inflation or better (raised prices 8% recently with a related minimal drop in volume) so FCF growth should overcome any drag of inflation's effect on the DCF discount rate, assuming zero volume growth and zero operating leverage. Plus you get a nice tax-advantaged (for now) 4.7% yield.

In the conservative base case, PM has zero volume growth (despite increased demand from emerging nations), raises prices 3% per year with no operating leverage, but continues its dividend and using excess cash flow for its accretive buyback program. With no P/FCF expansion, one should get roughly pre-tax 9% returns over 10 years (4% capital appreciation + 4.8% dividend). After all long-term capital gains and dividend taxes, about 7%. Unlike treasuries, you beat inflation and you are not capped at a 3.75% nominal return (assuming hold to maturity).

Maybe Goldman should lever up 40:1 and short 10-yr treasuries, using the proceeds to buy a basket of blue chip dividend paying stocks. :-)
benethridge
Benethridge - 9 years ago    Report SPAM
Regarding treasury risk/reward: I agree. Given our government's monetary policy, I think there is a far greater chance that we will go in to hyper-inflation or stagflation than into a long depression. T-bonds would then have been a horrible choice.

Do you think that, over the long-term, those blue chip dividend stocks would protect me from such inflation? I've studied it some, but I don't yet see how they do or don't.

Ben
cm1750
Cm1750 - 9 years ago    Report SPAM


I have seen conflicting studies on stocks and inflation. I think WEB has said that equities are good during inflationary environments.

IMHO, the key is pricing power. Profits increase if you have the ability to raise prices at the same or at a higher rate than costs. If you sell a "must have" product, this is more likely. Think PM/MO, AAPL, garbage landfill owners (RSG, WM), cell tower companies such as CCI, AMT, SBAC (inflation escalators in long-term contracts) etc.

Given WEB owns "price makers" that have the power to raise prices over time, that may be his rationale for not fearing inflation.
batbeer2
Batbeer2 premium member - 9 years ago
-EDIT- this was meant for the movado thread.

Nice pick; I like it. At first glance:

Book: Intentory is less than one year of selas and in this case I think it may be valued at close to cash. The book value is quite hard so this provides some downside protevtion.

Earnings: They have been spending record ammounts on capex recently. I will need to look into this to find out what they have been spending it on, but if one normalises capex a different picture emerges. Given that this compnay has grown over the past decade, normalising capex is not unreasonable.

Management: They have returned ~110m of cash to shareholders while growing at a fair clip (booth revenue and book value). ROE is decent without leverage. This is a rare combination to find. looks well managed.

I will look into this one some more, i may find something to poke at, but at first glance, great opportunity.

extramiler
Extramiler - 9 years ago    Report SPAM
I don't understand the comment that Kraft has the same margins as Google?? Google's net margin is about 20%, roughly 3x Kraft's ~6-7%.

Geoff Gannon
Geoff Gannon premium member - 9 years ago
Kraft’s U.S. Groceries - its salad dressings, barbecue sauces, Cool-Whip, Grey Poupon, and Jell-O - have the same profit margin as Google (GOOG).
gurufocus
Gurufocus premium member - 9 years ago
Thanks!
Sivaram
Sivaram - 9 years ago    Report SPAM


Good to see you back writing articles Geoff. If you want a topic for your next article, I wouldn't mind hearing your thoughts on Buffett's purchase of Burlington Northern Santa Fe. It looks like a ridiculous deal and wonder what you think of that.
dealraker
Dealraker - 9 years ago    Report SPAM
Good writing. And I'll wager with anyone on this board that both Buffett's BNI and KFT purchases will do better than Mr. Market from the exact time they were purchased.

While the focus is on what Buffett does wrong is always trendy....well, it is always trendy for the narcissi crowd.
expectingrain
Expectingrain - 9 years ago    Report SPAM
I think the real story here is that Geoff Gannon is going to be writing for gurufocus.com (hopefully a lot!) I used to read his blog pretty regularly. He didn't post much but when he did it was absolutely value investing gold. Very happy you're here, Geoff- here's a good research idea-- tobacco leaf stocks UVV and AOI. Right up your alley- both are severly underfollowed in the analyst community.
grandpagates
Grandpagates - 9 years ago    Report SPAM
This is a watershead thread. KFT puzzled me for many years. I could never figure out why WEB bought KFT, so I did not. Even knowing that WEB said "the really great [investment] moves bring a collective yawn". And this one is a yawner. The 5-year average ROE is a mere 9%. Gag me with Velveeta!

OK, so the answer is moats. Even knowing that WEB said recently that every few years he tells his CEOs of the company he owns, roughly "don't worry about this quarters profit necessarily, build your moats" (my rough recollection). I always thought of moats as simply guaranteeing that you would be around in the future, but cm1750 has turned the light bulb on. Moats mean that you profit on humdrum growth - the kind of growth WEB has been speaking of for BNI (railroads will carry more goods in the future because of more people in the US) and for some of the home related businesses he owns (there will be more people in the future). So in essence, it gives you a higher PE because it affects the DCF calculation.

Okay, and relooking at the ROE ... it seems to be rising. The direction is much more important than the actual value, just like the KO ROE was rising just before WEB bought it.

So after years of puzzling, I can see that KFT is quintessential Buffet, and my yawning is morphing into "animal spirit" greed!

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