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Kraft Breakup: Buy-Side Not Enthused


Management tells investors it will get better returns by concentrating its focus on fewer businesses. At Kraft, that just doesn't wash.

When I first heard that Kraft (KFT) was breaking into an international confection and snack company and a US middle-of-grocery store company, I yawned. Here is why.

I am no fan of conglomerates. As an inexperienced analyst, I was on a field trip to Hollywood, where Transamerica management was giving a sort of sideshow for the company's other businesses at its movie studio. I cannot remember all of the other businesses, which were financial, but they included life insurance and leasing. After the presentation I got on the bus with the other analysts to go to the next studio and heard them grumbling about the presentation. They could not understand it.

My first thought was "What on earth is the problem here?" I followed media-entertainment and all of the financial-related stocks. The presentation was fine by me. Then I looked around the bus and it hit me that there were only two other analysts from these relatively large institutions who I would see at financial conferences. Hmmmm! I guess Transamerica will never get the valuation it might deserve from our crew, whether it runs all of the businesses well or not. I never recommended the stock to my portfolio managers because of that, but I also did not keep an eye on it so that I could make money by buying it for the breakup.

Some years later I saw that the infamous Gulf & Western conglomerate had taken a first step to breaking itself up. It was still complicated, but it had The Associates, a finance company; a publishing business; and other consumer businesses, which I had started following. I remembered Transamerica and got on board with Gulf & Western. It was some of the easiest money I ever made.

The larger institutions, which tend to make the markets for the large-capitalization stocks, generally specialize by sector, which was why many of the analysts referred to above could not come to grips with Transamerica. The consumer-related stocks area is large. The medium and medium-to-large institutions generally have analysts who only follow mid- and large-capitalization consumer companies. The largest institutions generally have one analyst for consumer staples and another for consumer discretionary companies. This creates a good knowledge of the companies' businesses, generally.

An exception was with Sara Lee (SLE) spinning off its nonfood consumer businesses. One of them was Coach (COH), which is now worth more than its onetime parent and was not being given credit for its growth potential. Owning Coach from its spinoff would have made you a lot of money, and the spinoff was a good move by Sara Lee. When it was spun off, it was a relatively small-capitalization stock. Without the knowledge that professional women over the next decade were going to go wild spending money on handbags, analysts would tend not to look at the company either when it was part of Sara Lee or after the spinoff, when it became part of the purview of a small-capitalization team at most institutions. But the bottom line is this was a completely consumer-oriented situation that fell through the cracks of how institutional investment analysis is done.

Drilling down into further specialization, we have the Kraft situation. Does it make sense to split into two companies? The answer is absolutely not. Are there any analytical cracks to slip through? No. This is one of the largest and best analyzed consumer companies in the world. It is known well by all analysts who follow consumer staples stocks. When it splits up, both companies will still be large-capitalization companies followed by the very same analysts who followed the prior single company for years. The normalized earnings of both companies will be known. The present values of the future earnings streams will just be divided up into the two companies.

The way that the investment bankers probably sold this to management and the board of directors goes something like this: We can promote the higher growth international confectionary/snack food piece to growth stock portfolio managers, who are not as smart as value stock managers (which, I admit, is generally, but not always, true) and who will overvalue the earnings growth rate and its duration. A related promotion might be that the consumer staples analysts are ignorant enough that we can get them to do the same thing for the confection/snack international focused company.

Besides getting fees for investment bankers, I believe that there was allure for management, which has been under pressure from the investment community for higher earnings growth and a higher stock price. (I actually do not believe that they have done a bad job. It's just a bad food company environment.)

The reality is that estimating the long-term growth of sales and profitability of chocolate is as equally mundane a part of the analyst's job as is estimating the future of domestic cheese. These analysts have had to do it for Hershey (HSY), Cadbury, Wrigley, and Philip Morris (PM) for years. And the growth rate differential is not enough to get the higher growth company on the radar screens of growth stock portfolio managers.

Management can tell investors that it can get better returns by concentrating management focus on fewer businesses. That does not wash. Kraft is not resource constrained in any way. It has the money to pay lots of good executives to run all of its businesses in whatever manner is best for shareholders. They are all food businesses that the company has been in for years.
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