Tuesday, January 19th, 2010 - Cadbury (CBY, Financial) agrees to sell itself to Kraft (KFT, Financial) for $11.07 billion in cash and 15% ownership of the combined company.
Wednesday, January 20th, 2010 - CNBC’s Becky Quick interviews Kraft’s largest shareholder - Warren Buffett - and asks him what he thinks of the deal:
Buffett
I feel poorer…in the last two weeks there’s been two things that caused me to feel poorer. They sold a very fine pizza business and they said that they got 3.7 billion for it. But because it had practically no tax basis they really got about 2.5 billion. So they sold a business for 2.5 billion that Nestle (NSRGY) is willing to pay 3.7 billion for. Now can Nestle run it that much better than Kraft? I doubt it. But that business was sold for 2.5 billion (and) earned 280 million pre-tax last year. So they sold that…right around 9 times pre-tax earnings.
Now they mention paying 13 times EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) for Cadbury but they’re paying more than that. For one ting EBITDA is not the same as earnings. Depreciation is a very real expense. But on top of that they’ve got 1.3 billion they’re going to spend in terms of rearrangements of Cadbury. They’ve got 390 million of deal expenses. They are using their own stock - 260 million shares or something like that - (which) their own directors say is significantly undervalued. When they calculate that 13 (times EBITDA) they’re calculating Kraft at market price not at what their own directors think the stock is worth. So: the actual multiple if you look at the value of Kraft stock is more like 16 or 17 and they sold earnings at 9 times. It’s hard to get rich doing that.
Why Buffett Hates Kraft Selling its Frozen Pizza Business
Kraft sold its frozen pizza business - brands like DiGiorno and Tombstone - to get more cash to offer Cadbury shareholders. Buffett hates the deal. Here’s why:
Why Buffett Hates Kraft Issuing New Shares
A share of stock is like a slice of pie. The more slices you cut the less each person gets. Issuing new shares is bad for investors when they get nothing in return - like when a CEO takes a lot of stock options. The pie stays the same size and each slice gets smaller.
But when one company buys another using stock two things happen:
What Kraft Buying Cadbury Means for Berkshire
Warren Buffett’s Berkshire Hathaway (BRK.B, Financial) is Kraft’s largest shareholder.
Kraft’s sale of its pizza business changes some things for Berkshire:
When Kraft sold its pizza business it cost Berkshire more than $100 million. Berkshire owns 9.4% of Kraft. If Kraft’s pizza business is worth the $3.7 billion Nestle paid Berkshire’s slice of Kraft lost $348 million in business value and gained $235 million in cash. That makes Berkshire $113 million poorer.
I wrote in another article that Kraft was worth something like $37.84 a share. It’s an arbitrary number. Read the article if you want to know the reason behind it.
Otherwise take my word for it and assume Kraft is worth close to $56 billion.
As part of the deal Kraft is setting aside 15% of the new company for Cadbury shareholders. This means Kraft is selling something like $8.4 billion of its own business to Cadbury shareholders. Berkshire owns 9.4% of everything Kraft owns - so that’s like Berkshire giving up a business worth $790 million.
Think of it this way:
What Kraft Investors Are Giving up to Get Cadbury
Cadbury’s 2008 “underlying profit from operations” was $1.03 billion.
That means Kraft investors are paying more than 20 times Cadbury’s pre-tax profits.
Kraft says it’s paying 13 times EBITDA. Buffett says Kraft is paying more like 17 times EBITDA. And I say Kraft’s paying more than 20 times pre-tax profits.
Who should you believe?
A lot of the difference comes from how we value Kraft stock. The press always uses the market price. Investors - like Buffett - who are forced to sell part of the old business to buy the new business think in terms of intrinsic value.
And that’s why Warren Buffett hates the Cadbury deal.
Wednesday, January 20th, 2010 - CNBC’s Becky Quick interviews Kraft’s largest shareholder - Warren Buffett - and asks him what he thinks of the deal:
Buffett
I feel poorer…in the last two weeks there’s been two things that caused me to feel poorer. They sold a very fine pizza business and they said that they got 3.7 billion for it. But because it had practically no tax basis they really got about 2.5 billion. So they sold a business for 2.5 billion that Nestle (NSRGY) is willing to pay 3.7 billion for. Now can Nestle run it that much better than Kraft? I doubt it. But that business was sold for 2.5 billion (and) earned 280 million pre-tax last year. So they sold that…right around 9 times pre-tax earnings.
Now they mention paying 13 times EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) for Cadbury but they’re paying more than that. For one ting EBITDA is not the same as earnings. Depreciation is a very real expense. But on top of that they’ve got 1.3 billion they’re going to spend in terms of rearrangements of Cadbury. They’ve got 390 million of deal expenses. They are using their own stock - 260 million shares or something like that - (which) their own directors say is significantly undervalued. When they calculate that 13 (times EBITDA) they’re calculating Kraft at market price not at what their own directors think the stock is worth. So: the actual multiple if you look at the value of Kraft stock is more like 16 or 17 and they sold earnings at 9 times. It’s hard to get rich doing that.
Why Buffett Hates Kraft Selling its Frozen Pizza Business
Kraft sold its frozen pizza business - brands like DiGiorno and Tombstone - to get more cash to offer Cadbury shareholders. Buffett hates the deal. Here’s why:
- Kraft’s shareholders lost $1.2 billion to the IRS.
- Nestle paid $3.7 billion in cash for the pizza business.
- But Kraft only got $2.5 billion.
- The other $1.2 billion went to the IRS - because almost all of the price was recorded as profit.
- If Kraft had given the pizza business to its shareholders they would have owed zero dollarsin taxes.
- Kraft knows how to avoid this kind of tax. It spun off Post Cereals to avoid paying taxes.
- The reason Kraft’s shareholders lost $1.2 billion to the IRS is because Kraft was in a hurry to buy Cadbury and wouldn’t wait to do a deal in a way that cost less in taxes.
- Nestle paid $3.7 billion in cash for the pizza business.
- Kraft sold its pizza business for a cheap price.
- Nestle paid $3.7 billion.
- Last year the pizza business earned $280 million before taxes.
- That means Nestle bought the pizza business to yield 7.57% before taxes. That’s more than investment grade corporate bonds (6.16%) and a lot more than AAA bonds (5.24%). Bond interest doesn’t grow. The frozen pizza business’s earnings do.
- Kraft got $2.5 billion in cash. Giving away $280 million in earnings for $2.5 billion in cash means Kraft needs to find something that pays 11.20% a year to make up its loss. If the pizza business grows the yearly return needed to make up the loss of today’s income and tomorrow’s growth is a lot more than 11.20%.
- Nestle paid $3.7 billion.
Why Buffett Hates Kraft Issuing New Shares
A share of stock is like a slice of pie. The more slices you cut the less each person gets. Issuing new shares is bad for investors when they get nothing in return - like when a CEO takes a lot of stock options. The pie stays the same size and each slice gets smaller.
But when one company buys another using stock two things happen:
- The pie gets bigger.
- And that bigger pie is cut into more slices.
What Kraft Buying Cadbury Means for Berkshire
Warren Buffett’s Berkshire Hathaway (BRK.B, Financial) is Kraft’s largest shareholder.
Kraft’s sale of its pizza business changes some things for Berkshire:
- Berkshire loses its slice of Kraft’s pizza business.
- Berkshire gains its slice of the cash Kraft got from the sale of its pizza business: $235 million.
When Kraft sold its pizza business it cost Berkshire more than $100 million. Berkshire owns 9.4% of Kraft. If Kraft’s pizza business is worth the $3.7 billion Nestle paid Berkshire’s slice of Kraft lost $348 million in business value and gained $235 million in cash. That makes Berkshire $113 million poorer.
I wrote in another article that Kraft was worth something like $37.84 a share. It’s an arbitrary number. Read the article if you want to know the reason behind it.
Otherwise take my word for it and assume Kraft is worth close to $56 billion.
As part of the deal Kraft is setting aside 15% of the new company for Cadbury shareholders. This means Kraft is selling something like $8.4 billion of its own business to Cadbury shareholders. Berkshire owns 9.4% of everything Kraft owns - so that’s like Berkshire giving up a business worth $790 million.
Think of it this way:
- Berkshire owns 9.4% of Kraft.
- After the deal goes through Berkshire will own 7.99% of Kraft.
- 1.41% of Kraft is worth about $790 million.
What Kraft Investors Are Giving up to Get Cadbury
- $11.07 billion in cash.
- $8.35 billion worth of Kraft stock.
- $1.3 billion to restructure Cadbury.
- $1.2 billion in taxes to sell the pizza business.
- $390 million to get the deal done.
Cadbury’s 2008 “underlying profit from operations” was $1.03 billion.
That means Kraft investors are paying more than 20 times Cadbury’s pre-tax profits.
Kraft says it’s paying 13 times EBITDA. Buffett says Kraft is paying more like 17 times EBITDA. And I say Kraft’s paying more than 20 times pre-tax profits.
Who should you believe?
A lot of the difference comes from how we value Kraft stock. The press always uses the market price. Investors - like Buffett - who are forced to sell part of the old business to buy the new business think in terms of intrinsic value.
And that’s why Warren Buffett hates the Cadbury deal.
