The Kraft/Cadbury deal might look good on the outside, but it has the potential to be soft on the inside.
In the latest news on the potential chocolate and cheese combination, Kraft Foods Inc. ( KFT – news – people ) sold one of its American pizza units to Nestle ( NSRGY.PK – news – people ) for $3.7 billion. This cash can be put toward its acquisition of Cadbury ( CBY – news – people ). Kraft has been working to sweeten its offer to Cadbury and will approach the chocolate company with a new bid before Jan. 16. (See “Cash For Cadbury, Pizza For Nestle.”)
For Cadbury, a merger would helpful.
“With cocoa having moved from 2200 metric tons to 3244 metric tons in the last year, any economies of scale through size and efficiencies would make rising commodity prices less of a factor,” says LPL Financial Chief Investment Officer Burt White. This might even allow Cadbury to better set prices in the market and undercut its competitors, he adds.
Cadbury has about 10.5% of the global confectionery market, according to recent Morningstar report. The company has grown largely through acquisitions–it has done more than 40 in the last 20 years. “Although the acquired confectionary businesses strengthened Cadbury’s global foothold, allowing these businesses to run with a high degree of autonomy, it gave the firm a bloated management structure, too many inefficient manufacturing plants and a proliferation of stock-keeping units and innovation projects that added unneeded complexity,” said Morningstar analyst Erin Swanson in a recent report.
So the company has had all these acquisitions and gained “unneeded complexity,” and it’s going to go through another merger? It might seem counterintuitive that this Kraft deal would help Cadbury. But with concerns of inflation, this might be exactly what the chocolate company needs.
For Kraft, the acquisition could alleviate pain from rising commodities prices. Kraft has been dealing with these increasing costs by raising prices across its portfolio, a recent Morningstar report says. Upping prices when consumers are already strapped for cash makes the case for buying Kraft’s products more difficult. “This is of particular concern in the cheese aisle, where the firm faces significant competition from lower-priced, private-label offerings,” Swanson said in the report.
Kraft brings to the table a company that is “still generating organic revenue and growth and divesting its less profitable lines,” says Al Frank Asset Management senior research analyst Chris Armbruster. He recommends that investors who already own Kraft hold it, if they have the patience to do so, as the company could grow to $38 a share in the next three to five years, which is his firm’s price target for the stock. The stock is currently trading at more than $28, and Armbruster considers it a buy at $23.
Besides gaining more economies of scale, there isn’t too much more upside to this deal for Cadbury, though. The Motley Fool analyst Joe Magyer says that if Kraft can’t build the support that it needs to acquire Cadbury or if it decides not to purchase Cadbury, the chocolate company’s shares will tumble. Magyer characterizes this merger as being similar to midterm elections, where lots of money is spent but the change is minimal at best.
Investors watching this situation should definitely pay attention to the price tag attached to Cadbury, Magyer says. He warns that it Kraft pays too much, the company’s shares will slide. Cadbury needs to come back with a number that will please their shareholders, but Kraft won’t be able to do much more than what it’s already said as Warren Buffett, the largest shareholder in the company, put his foot down. (See “Buffett Gets Krafty.”)
If you’re looking to invest in Kraft, you might want to wait until Cadbury has been fully integrated into the company, provided that acquisition happens. Magyer notes that Kraft has struggled with restructuring in the past and that this acquisition will like take a few years to be fully absorbed.
The only winner that Magyer is declaring in this scenario is Nestle. It gained a pizza business, and now it’s competition is preoccupied with a potential merger.
Steer clear of these companies as possible investments until a deal has been struck, or at least until you can predict the loser in this scenario, White says. The loser would be a company that makes a bid on Cadbury but doesn’t get it, such as The Hershey Co. ( HSY – news – people ) or Ferrero. “I would stay away from this situation, unless [you have] a strong feeling as to who will not be the winner of the Cadbury situation, as those stocks will likely recover somewhat on the news of not having spent a ton of money in an acquisition,” he says.
Both White and Stark & Stark shareholder Bill Singer foresee food-related companies doing well this year. “Food-related companies are often a great defensive play in lousy markets,” Singer says, adding that people always have to eat.
White likes the agriculture sector but urges investors to avoid the parts of the sector that would be hurt by rising inflation, such as supermarkets and other food manufacturers. If you want to invest in this sector, look toward the farmer, not the grocer, as when there’s rising inflation in agricultural commodities, there’s more incentive for farmers to maximize their harvests. Look toward companies that make fertilizers and farming tools.
White also likes the materials and industrial sectors, as they will benefit from rising food production. He recommends the iShares S&P Global Materials Sector Index Fund ( MXI – news – people ); its top five holdings are: BHP Billiton Ltd. ( BBL – news – people ), Rio Tinto Ltd., BHP Billiton Plc., BASF SE and Anglo American Plc. ( AAUK – news – people ). Monsanto Co. ( MON – news – people ), which provides agricultural products to farmers, will also get a boost from increased crop production, White says.
The potential deal between Kraft and Cadbury is also setting a positive tone for mergers and acquisitions in 2010. It also shows that the U.S. markets are healthy enough for such a deal to occur. Who would have thought that the fusion of a chocolate company and the firm that owns Oscar Mayer and Oreo could be so good for the markets?
A merger of this magnitude adds more validity to the recovery story. “It shows that the market is attractively priced,” White says. “Companies would not deploy capital if valuations were too high,” he adds.
Singer agrees, noting that, “as with most initial signs of thawing, this may well be a harbinger of more deals down the road.”