December 15, 2007

Kraft:Do you follow Buffett into it?

Warren Buffett, Carl Ichan, which subsequently sold, and Beltz have all invested in Kraft Foods. This is a tremendous endorsement of some of the best investors in the world for Kraft Foods, which peaked my interest to take a look at Kraft as a value idea.

Kraft (KFT) overview (From Google Finance):

Kraft is engaged in the manufacture and sale of packaged foods and beverages in the United States, Canada, Europe, Latin America, Asia Pacific, the Middle East and Africa. The Company manufactures and markets packaged food products, consisting principally of beverages, cheese, snacks, convenient meals and various packaged grocery products. The Company operates in two segments: Kraft North America Commercial and Kraft International Commercial. It has operations in 72 countries and sells its products in more than 155 countries. In January 2007, the Company completed the sale of its hot cereal assets and trademarks. During the year ended December 31, 2006, Kraft acquired the Spanish and Portuguese operations of United Biscuits, and rights to all Nabisco trademarks in the European Union, Eastern Europe, the Middle East and Africa.

Kraft Competitive Advantage

Kraft owns several well know food brands in several food categories such as snacks, beverages, cheese and dairy, groceries, and convenient meals. The brand names are well established and have a long history, even iconic. That is definitely the sign of a strong competitive advantage for Kraft. But strong brands in the food industry, in particular, do not translate well into competitive advantage, as they do not lock consumer buying habits or entice them to buy more.

It is hard to reproduce kraft’s brands, but generics can eat into the market share of its products as consumer preference turned from brand recognition to economics and cost effectiveness. Competition from private labels almost makes food products a commodity. A consumer in an inflationary environment will sacrifice some of the taste and quality for cheaper prices of private label products.

Kraft relies on its old and established brands may be a bit too much. In today's store Kraft products lacks any differentiation from others and that is the kiss of death for any consumer business. The lack of any real differentiation in consumer minds in addition to a crowded food isles of competing products will eat into Kraft's market share. There is a tremendous variety for each food product that Kraft sells in a store. I have counted more than 20 different biscuits brands, 15 different cheese brands, and so on.

Kraft brands are old and even can be called "tired". The products lacks any newness. Most Kraft initiatives were brand extensions with no introduction of a major product for years. Kraft R&D expenditure is flat over the year and hovers around the 1.2% of sales. This is evident in the deterioration of Kraft brand name value. A recent survey by business week pegged Kraft Brand value at 3.7 billion in 2007 a decline of 5% of the previous year and behind competitors like Nestle, Kellogg's (Although Kraft has sold it cereal business) and Danone.

Cost Leadership & Distribution Network
The new CEO claims that "our scale is a competitive advantage", while discussing the acquisition of Danone's biscuit unit. However in the food or consumer industry differentiating between companies is based on marketing as oppose to costs, as manufacturing costs are similar across companies. Kraft size and its distribution network may be an advantage but it is not strong one as it is not combined with a brand presence.

Another concern is the price increases of raw material and input can not be easily passed onto the consumer without reducing Kraft market share despite of their strong brand name products. And it is passed a consumer will not be able to justify the price difference and will opt for the cheaper house brand. There is a secular trend of rising raw food prices like dairy, coffee beans and wheat, which will eat into Kraft margins. Kraft cost of sale has risen from 60% in 2002 to more than 65% on a TTM basis, and it is higher than the 6 year average cost of sales of 63%.

I concluded that Kraft lacks any sustainable competitive advantage to qualify as a Buffett like investment, which puzzles me to why he decided to invest in the company. Indeed Kraft average return on invested capital, which is a strong indication of a company's competitive position in the industry, for the last 5 years was an anemic 6.2% well below any reasonable calculation of cost of capital, which I did not attempt to do.

The company is fairly valued at this moment. Assuming a growth rate in revenue at the top of management estimates of 5% yields an intrinsic value $32 per share using a discounted free cash flow methodology. The company shares currently trade at slight premium of about 4%. The rich valuation may factor in a turn around plan, which the new CEO is undertaking, but Kraft has gone through many failed turn around in the past. You might argue it is different this time as the company is finally independent and free to leverage its operation and expand as it wishes. This could be true. However at fair value and lack of sustainable competitive advantage in my view, the company is not a value idea.

Your value seeking investor,


Anonymous said...

Buffet not only bought Kraft at a price higher than the current price, but he invested a significant portion of his portfolio -- 6.28% As to the cost of sales, all food companies are in the same boat. I would add that this is an area where Buffet has considerable experience in evaluating management and markets. Finally, seems the rise of the middle class in the bric countries provides enoumous growth potential.

Sami said...

I will give you that buffet do not make a lot of mistakes. and the fact that he placed a sizable bet is he is pretty sure of the business.

The emerging market play is valid point but Kraft is weak in its distribution in emerging markets. They have acquired some companies which have strong presence in these countries which they can leverage to grow their revenues.

Unilever is in a better position to take advantage of the emerging market story.