Tuesday, January 5th, 2010 - Warren Buffettâs Berkshire Hathaway announces it will vote ânoâ on Kraftâs proposal to issue 370 million new shares.
Kraftâs CEO wanted to use the new shares as ammo in her hostile takeover of Cadbury. Buffett shot her down. Why?
Because Kraftâs stock is too cheap.
Hereâs what Buffett wrote:
âWhat we know with certaintyâŚis that Kraft stock, at its current price of $27, is a very expensive âcurrencyâ 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.â
Buffett also bought Kraft around $33 a share. Page 15 of last yearâs annual letter to shareholders shows that Berkshireâs 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 Kraftâs 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.
¡ Kraftâs U.S. Groceries - its salad dressings, barbecue sauces, Cool-Whip, Grey Poupon, and Jell-O - have the same profit margin as Google (GOOG).
¡ The companyâs 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
¡ Theyâre 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 Buffettâs Test?
No.
It fails question number 4.
At least it would if Buffettâs four questions had stayed exactly the same as they were in 1977.
Question #4 - âIs it priced very attractively?â - 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 canât always find them at the right price.
The Warren Buffett of 1977 wouldnât buy Kraft, because that Warren Buffett only bought super cheap stocks. Today Buffett has to settle for slightly cheap stocks because there simply arenât enough super cheap stocks to soak up all of Berkshireâs cash.
To solve this problem Buffett lowered his standards and changed question #4 to:
âIs it pricedvery attractively?â
Kraft passes this test. Thatâs why Buffett bought it.
Should you?
What is Kraft Worth?
Warren Buffett values companies according to something he calls owner earnings:
ââŚwe 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: âI would rather be vaguely right than precisely wrong.ââ
So whatâs the vaguely right earnings number for Kraft?
My guess is $1.85 a share.
Itâs a somewhat arbitrary number. But only somewhat.
If you take Kraftâs 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.
Kraftâs sales are higher now than they were in those years. If you slap Kraftâs historical free cash flow margin of 7.7% on the todayâs sales you get $2.07 a share in free cash flow.
(This assumes sales will be down 6% from last year but doesnât 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.
Iâm going to use the yield on investment grade corporate bonds - 4.89% - which means inverting the yield (1/0.0489 = 20.45) and multiplying Kraftâs 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 Iâll take up tomorrow.
Kraftâs CEO wanted to use the new shares as ammo in her hostile takeover of Cadbury. Buffett shot her down. Why?
Because Kraftâs stock is too cheap.
Hereâs what Buffett wrote:
âWhat we know with certaintyâŚis that Kraft stock, at its current price of $27, is a very expensive âcurrencyâ 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.â
Buffett also bought Kraft around $33 a share. Page 15 of last yearâs annual letter to shareholders shows that Berkshireâs 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 Kraftâs 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.
¡ Kraftâs U.S. Groceries - its salad dressings, barbecue sauces, Cool-Whip, Grey Poupon, and Jell-O - have the same profit margin as Google (GOOG).
¡ The companyâs 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
¡ Theyâre 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 Buffettâs Test?
No.
It fails question number 4.
At least it would if Buffettâs four questions had stayed exactly the same as they were in 1977.
Question #4 - âIs it priced very attractively?â - 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 canât always find them at the right price.
The Warren Buffett of 1977 wouldnât buy Kraft, because that Warren Buffett only bought super cheap stocks. Today Buffett has to settle for slightly cheap stocks because there simply arenât enough super cheap stocks to soak up all of Berkshireâs cash.
To solve this problem Buffett lowered his standards and changed question #4 to:
âIs it priced
Kraft passes this test. Thatâs why Buffett bought it.
Should you?
What is Kraft Worth?
Warren Buffett values companies according to something he calls owner earnings:
ââŚwe 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: âI would rather be vaguely right than precisely wrong.ââ
So whatâs the vaguely right earnings number for Kraft?
My guess is $1.85 a share.
Itâs a somewhat arbitrary number. But only somewhat.
If you take Kraftâs 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.
Kraftâs sales are higher now than they were in those years. If you slap Kraftâs historical free cash flow margin of 7.7% on the todayâs sales you get $2.07 a share in free cash flow.
(This assumes sales will be down 6% from last year but doesnât 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.
Iâm going to use the yield on investment grade corporate bonds - 4.89% - which means inverting the yield (1/0.0489 = 20.45) and multiplying Kraftâs 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 Iâll take up tomorrow.
