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How to Play the Kraft Spinoff

Posted by Joe Cornell, CFA on Wed, Oct 03, 2012 @ 11:10 AM

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Shares of the slow-growing Kraft Foods Group will yield a fat 4.5% after the food giant splits on Monday. But the other half, snack maker Mondeléz, is probably a better buy.

How do you get investors to sit up and take notice of a soon-to-be spun-off stock? If you're Kraft Foods, which will spin off its slow-growth North American grocery business to shareholders on Oct. 1, you pay a big dividend.

The new Kraft Foods Group (ticker: KRFT) will offer a 4.5% yield, based on when-issued trading in the shares late last week. That's the highest yield among major food companies—most are in the 3% range—and is in line with the dividend rate on utilities and other traditional income sectors of the stock market.

Thanks to its high dividend, new Kraft most likely will have one of the highest valuations in the food group, trading for more than 17 times projected 2013 profits, compared with 14 to 16 times earnings for the likes of Campbell Soup (CPB), Kellogg (K), Heinz (HNZ), and General Mills (GIS).

With its lofty price/earnings ratio, new Kraft doesn't look as appetizing as its rivals. Kraft's payout ratio will be much higher than its food peers, which could limit dividend increases in coming years. It may be better to buy shares of Kellogg or General Mills—both yield about 3.3% and have a lower P/E and better dividend-growth prospects.

If its high valuation persists, Kraft could attract imitators in the food industry, as companies figure they can boost their share prices with an ample dividend. Consumer-staples producers tend to pay out about half their earnings in dividends, while new Kraft's payout ratio will be nearly 80%, based on projected 2013 profits.

New Kraft's dividend looks safe, thanks to the stability of its well-known brands, which help give the stock its bond-like 4.5% yield at a time when 10-year Treasury notes yield under 2% and Kraft's own 10-year debt yields less than 3%.

Kraft (KFT) is separating into new Kraft and the larger Mondeléz International (MDLZ), which will hold the company's global snacks business, including Nabisco cookies, Cadbury chocolate, and Chiclets gum. New Kraft's portfolio includes some familiar American products like Jell-O, Kool-Aid, Velveeta, Planters, Oscar Mayer, Kraft macaroni and cheese, and Kraft refrigerated cheeses. Until Tuesday, new Kraft will trade in a when-issued market with the ticker KRFTV, and Mondeléz as MDLZV . Old Kraft shares will stop trading after the split.

Mondeléz will have a more modest dividend, around 2%. In an indication of the importance of dividends in a yield-parched environment, Mondeléz has a P/E ratio similar to new Kraft's, despite a stronger growth outlook. Mondeléz looks more appealing than new Kraft.

Kraft announced the split a year ago, as a way to highlight its high-growth snacks business, following its controversial $20 billion purchase of Cadbury in 2010, a deal that angered Kraft's most prominent shareholder, Warren Buffett, the CEO of Berkshire Hathaway (BRK.A). Buffett felt Kraft overpaid, and he criticized Kraft's tax-inefficient move to sell a pizza business to fund the Cadbury deal. Berkshire has steadily sold Kraft shares. It had 59 million as of June 30, versus 130 million at the end of 2009.

Cadbury is an important part of Mondeléz, a made-up word that suggests the French word "monde," or world, overlapping "deléz," which Kraft calls a "fanciful expression" of the word "delicious."

Kraft holders will get one share of new Kraft for every three shares of old Kraft, and the old Kraft will be rechristened Mondeléz. In when-issued trading Friday, Mondeléz fetched about $26 a share and new Kraft, $45. Old Kraft traded Friday at around $41, equivalent to the value of one share of Mondeléz and one-third of a share of new Kraft.

In investor presentations recently, managements of new Kraft and Mondeléz disappointed Wall Street by projecting a lower-than-expected 2013 profit, but the positive surprise was Kraft's intended annual dividend of $2 a share. Kraft shares initially dropped on the earnings guidance, but have since recouped those losses, mostly because investors are assigning a higher-than-expected value to new Kraft, based on its lofty dividend.

New Kraft expects profit of $2.60 a share, and Mondeléz projects $1.50 to $1.55 for 2013. New Kraft and Mondeléz both fetch around 17 times 2013 estimates.

Mondeléz is targeting 5% to 7% organic annual revenue growth and double-digit gains in profit (excluding the impact of foreign-exchange moves). New Kraft is aiming for more modest "mid to high" single-digit annual earnings gains. Mondeléz's ambition is to be viewed like higher-growth consumer companies, such as Coca-Cola (KO) and Colgate (CL), rather than slower-growth food producers.

Kraft bulls like Robert Moskow of Credit Suisse like the Mondeléz story, arguing that next year's profits could be held back by a couple of special factors, including currency, and that Mondeléz's profits could rise sharply in 2014 to $1.80 a share. Joe Cornell of Spin-Off Research last week assigned a Buy rating to Mondeléz, with a $29.50 price target, about 12% above the when-issued share price. He has a Hold rating on New Kraft, with a target of $44.25.

The Bottom Line

With a 4.5% dividend yield, new Kraft's stock is more alluring for income investors than its bonds. But the better bet is Mondeléz, because of its growth potential.

Mondeléz gets 44% of its sales from high-growth developing markets, a percentage comparable to both Coke's and Nestlé's (NESN.Switzerland). Mondeléz is No. 1 globally in sales of cookies and crackers, chocolate, and candy. Current Kraft CEO Irene Rosenfeld will head Mondeléz.

In a surprising admission, Kraft's management said earlier this month that it was overly bureaucratic, had high costs, produced little innovation, and had skimped on advertising, which is important to sustaining even well-known brands. The company's last big new product was Lunchables, launched in 1988. Kraft spent 2.9% of its revenue on ads last year, versus an industry average of 4.5% and well behind leader Kellogg's 8.6%. "We must do a better job supporting our brands," Kraft declared.

KRAFT HIGHLIGHTED ITS weaknesses to emphasize the opportunity to boost its sales and operating margin, which stands at 17.1%. That's in the middle of the pack of North American food companies, but below General Mills, Heinz, and Campbell. Kraft may find it hard to raise margins while ramping up ad spending.

Other food makers face challenges, too. General Mills missed the Greek-yogurt boom, and its key Yoplait brand is suffering. The cereal business is stagnant, weighing on both General Mills and Kellogg. Campbell faces one of the toughest jobs—revitalizing its core canned-soup business.

The entire industry is grappling with the private-label challenge, as grocery chains like Kroger (KR) and Safeway (SWY)—which themselves are contending with Wal-Mart Stores (WMT), Target (TGT), and Costco Wholesale (COST)—emphasize private labels that are more profitable for them.

There isn't a lot to excite investors about new Kraft except its dividend, and Kellogg, General Mills, and Heinz may offer a better combination of yield and valuation. But for growth-oriented investors, Mondeléz could be a tastier alternative to PepsiCo, Coca-Cola, and Colgate.

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Tags: Kraft Spin-Off, KFT Spin-Off, Mondelez Spin-Off, MDLZ Spin-Off

How to Profit From a Breakup

Posted by Joe Cornell, CFA on Mon, Oct 22, 2012 @ 11:10 AM

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There's More Than One Way to Cash in on Corporate America's Latest Craze, the Spinoff.


You'd think in a sluggish economy corporations sitting on mountains of cash would try to use some of that money to buy growth through acquisitions. Lately, though, the opposite has been taking place.

Kraft just completed the sale of its global snack business to the public through a spinoff. Other giants, like News Corp., Pfizer, and Safeway have also announced plans to streamline by splintering off unwanted subsidiaries. Joe Cornell, president of research firm Spin-Off Advisors, says more than 80 companies have announced or completed splits since 2011 - double the pace from 2009-10.

Why the rush to break up? In a slow-growing world, firms are racing to make their operations more efficient. Execs also realize that pure-play firms are more easily understood and are being rewarded with higher valuations, Cornell says.

So what's the smartest way to invest in this downsizing trend?

Think Like A Value Investor

Go with the spinoff. Over long periods, beaten-down, under-appreciated stocks generally outpace the market, and what's more unloved than a business unit that gets kicked to the curb?

Once freed, "newly independent companies have more incentive to grow and more control over their capital," says John Carey, manager of the Pioneer Fund. No wonder spinoffs have risen 180% since March 2009, vs. 120% for the S&P.

Of course, there are risks: Many spinoffs start off as small enterprises, and some are jettisoned for good reason. You can reduce that risk by going with a diversified fund. The Guggenheim Spin-Off Index ETF (CSD), which invests in 24 small and midsize spinoffs, has beaten the S&P 500 by more than four percentage points a year over the past three years, mimicking a longerterm trend. Among this ETF's holdings are Cablevision spinoff Madison Square Garden and ex-Expedia unit TripAdvisor.

Play Both Sides

In Some spinoffs, the sum of the parts is worth more than the whole, says Gerry Sparrow of Sparrow Capital Management. So it can pay to hold both parent and progeny. He owns McDonald's (MCD) and its former unit Chipotle Mexican Grill (CMG). Both have whipped the S&P 500 over the past five years.

Among upcoming spinoffs, Cornell likes McGraw-Hill (MHP, pushed by shareholders to split off its textbook business, McGraw-Hill Education. He thinks the move will allow the firm's financial-services information unit, which includes the Standard & Poor's rating agency, to be more focused. and education becomes the second biggest player in the textbook biz.

Pioneer's Carey owns Pfizer (PFE), which is splitting off its under appreciated animal health unit. Zoetis, set to be the biggest veterinary drug company, saw its sales rise 18% last year. The move will allow Pfizer to focus all its energy on developing blockbuster human drugs. In other words: win-win.

Paul R. La Monica is assistant managing editor at CNNMoney. You can read his column at cnnmoney.com/thebuzz.

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Tags: McGraw-Hill Spinoff, MHP Spinoff