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

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Geoff Gannon
Jan 12, 2010
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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?


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.


Maybe vaguely.

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

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