Kraft Enters the Sell-Block

On Thursday’s edition of Mad Money, Jim Cramer issued a strict warning to investors in regards to Kraft (KFT) after its “bogus upside surprise”. While earnings did beat Wall Street expectations, that was largely due to cost cutting as revenue slipped by more than expected. He also thinks that the company has botched their attempt to acquire Cadbury (CBY) in the last few months. He ripped the company’s latest quarterly report, and added the CEO Irene Rosenfeld to his “Wall of Shame”. Of course, Cramer pulled no punches as he laid into this company and the performance of the CEO.

“… Misleading headlines. Kraft is in terrible shape. Its fundamentals are declining and the more I see I think that it is botching to take over Cadbury. ..It’s looking less and less likely to me that Kraft will be able to pull this takeover offer in a way that’s good for Kraft shareholders. Kraft’s initial bid was rejected by Cadbury and now the company has until Monday to make a formal offer given the fact that its stock has fallen since its initial bid and its disappointing results, I think that the deal is much harder to execute than it could had been and Kraft has tough conditions that simply may not allow it to pay now you have satisfy Cadbury shareholders and especially given the good results that Cadbury delivered…

I don’t think that these two necessarily mix. There’s a great article in today’s “Financial Times” about how Cadbury’s board met yesterday to discuss Kraft’s results. Here’s the sentence that jumped out at me, ‘Kraft led people to believe it would have been good results and then it did not. This could anger its shareholders they would have to be brought back on side.’ Kraft’s management now actually have to convince its own shareholders that the deal’s a good idea…

Someone needs to bear the blame of this once proud American institution and that person is none other than Irene Rosenfeld who has been Kraft CEO since June 26th, 2006. Enough time to make a difference, and at that time Kraft was at $31. The stock is off 13% since Rosenfeld took over. Things are not improving, but getting worse…We’re putting Irene Rosenfeld on the “Wall of Shame” where she belongs. Hopefully she’ll resign. The best thing for the stock.” — CNBC’s Mad Money 11/5/2009

While we understand Cramer’s gripes with the company and their CEO, we happen to see this stock from a different perspective. Cramer is probably right that the Cadbury deal may be unrecoverable, but from our perspective that is necessarily a bad thing. By our methodology, we think that Cadbury stock is worth about $45 based on current fundamentals, but the deal would certainly need to be sweetened beyond the $50-plus offer that was rejected. That means that this deal, from our viewpoint, would be a reach from a valuation standpoint and would need to yield major cost savings and synergies.

On the other hand, Kraft is experiencing some erosion to fundamentals such as sales, but earnings have continued to improve through these difficult times. Over the last two quarters, Cramer and other analysts were not worried about revenue as long as profits were better than expected. All of a sudden, wringing out cost savings is no longer a valid way to beat the street and gets labeled as bogus.

The stock has fallen out of favor with the market as is easily observable by historical valuation standards. In the past, Kraft has fetched somewhere in the neighborhood of 1.4x to 1.8x revenue per share, but even with the decline in sales numbers the current price-to-sales is less than 1x. When looking at cash earnings the stock is similarly mispriced from the perspective of the historical ranges of 13.2x to 17.6x in price-to-cash earnings. The current metric is far lower at only 10.2x. Unless you think, as Cramer does, that the stock is fundamentally broken because of the disappointing performance of their CEO, then the stock appears fairly significantly Undervalued and would be fairly valued in the mid-$30’s.

Kraft Enters the Sell-Block

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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