Kraft Food and Cadbury Merger PDF

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Merger Model and Assessment of Kraft Food's acquisition of Cadbury UK...

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Overview of Kraft Food and Cadbury Kraft Foods is the second largest f&b corporation headquartered in United States and was incorporated on December 10, 1923 by Thomas H. Mclnnerney. Started off as a door to door cheese business, Krafts expanded into other confectionary items through many takeovers to achieve success (Smith 2009). It is second in terms of sales and popularity in the confectionary industry with annual revenues of $42 billion, operating in more than 150 countries (Kraft 2008). Cadbury, on the other hand is the second largest confectionary business based in the UK and started with the manufacturing of tea, coffee and later chocolate in 1984. In 1969, the company merged with Schweppes to form the international confectionary and beverage company called, Cadbury Schweppes and later in 1989 after purchasing Trebor Bassett, forming the UK confectionary subsidiary “Cadbury Trebor Bassett” which was renamed to Cadbury UK in 2009 at the time of listing on the London Stock Exchange. Both companies are multinational operations with activities in both developed and developing countries. Cadbury however is a market leader in the UK and Ireland’s confectionary where consumers have a liking for British chocolates which contains vegetable oil as opposed to continental cocoa fat which is used by Kraft i.e., therefore having a better market share than Kraft in such markets. Rationale of Kraft and Cadbury Merger The falling confectionary industry, just like many other sectors, during the recession gave rise to consolidation of the industry on the back of potentially creating and achieving a competitive edge and economies of scale. Kraft saw Cadbury as a potential target due to its resilient performance during the recession which led to a proposal and ultimately the takeover of Cadbury by Kraft. The initial offer from Kraft for acquisition of Cadbury at USD 16.3 billion or 740p per share (300p in cash and 0.2589 new shares in Kraft shares i.e., representing 31.1% premium over Cadbury’s trading price of GBP 5.68) was outright rejected in August 2009, resulting in company’s share price to skyrocket to GBP 7.83 i.e., surpassing Kraft’s offer price. Shortly after the initial offer, Kraft proposed another bid at USD 17 billion with the same terms as the first offer in November 2009. The closing price reflected the bid valuation of Cadbury at 710p which was lower than the share price of 761p then on the day and was rejected again. In January 2010, Kraft submitted a revised offer of 840p (500p in cash and 0.1874 new shares in Kraft shares i.e., representing 48% premium over Cadbury’s trading price. Valuing Cadbury at GBP 13 billion at EV/EBTIDA of 16.25x of 2009 EBITDA) that was ultimately supported by the Cadbury board. Advantages and disadvantages of the merger for Kraft For Kraft it was the biggest cross-border acquisition for the year giving Kraft a foothold in the fastest growing chewing gum segment of the industry and helping it boast portfolio of over 40 confectionary brands each having the ability to yield annual sale of USD 100 million. Cadbury would profit from Kraft’s extensive distribution network around the globe. Cadbury had been vulnerable to a takeover ever since it demerged its US soft drinks business. This high takeover bid was an attractive opportunity to do away with such a fear. A combined Kraft and Cadbury would significantly expand the global reach of both businesses and create synergies worth in the region of USD 625m. The disadvantages of the takeover entailed high debt issues and employee layoffs. The high debt position of Kraft further worsened with the takeover as funds were borrowed to pay the Cadbury shareholders a higher yield. Financial overview and analysis of the acquirer and the target With the market share of 2.5% of the F&B industry in 2009, Kraft had net revenues of USD 40.38 billion in 2009 which compared to the previous year was lower by 3.7% and as such represented a growth at a CAGR of 5.3% since 2005. The decline in revenues is primarily explained by the volume decline observes across every segment and unfavorable currency losses which resulted in lost revenue amounting USD 1.89 million. Cadbury on the other hand, at GBP 5.98 billion recorded a net revenue growth of 11% in 2009 over the prior year and a five years CAGR of 8.7% i.e., primarily boosted by the Vision in Action program launched by the company in 2007 which targets a the year-onyear organic growth of the company between 4% - 6%. The operating income of Krafts in 2009 grew by 43.7% to USD 5.5 billion and was primarily driven by cost efficiencies achieved in the direct costs and exit costs which were reduced following Restructuring Program started in 2008. For Cadbury, the biggest slice of operating costs belongs to cost of sales which involves ingredients, labor, utility and depreciation costs – with 60%, (GBP 2.870 million) 12% more than in the previous year (GBP 2.870 million), followed by administration expenses with 21% (GBP 1.110 million) 1% more than in 2008 (GBP 1.098 million).

Cash flow forecast assumptions and analysis Kraft – it is assumed that the revenue of the company will grow at a CAGR of 2% year on year from 2010 onwards i.e., in-line with the projections (of USDA till 2019) of an economic recovery from global financial crisis and recession, an increasing in household income and a slow population growth in developed countries against developing countries. The company’s cost of sales as percentage of sales is maintained at the 2008 level at around 67% over the forecast period. Considering the commodities as a result of recession would increase in 2010, the cost efficiencies achieved by the company in 2009 are therefore ignored for the valuation purposes. Operating costs are projected to increase by 3% year on year. due to Kraft Foods’ need of investing more in advertisement, mainly in developing markets, as well as in R&D, to develop new products and flavors to enlarge its range of products to stay ahead the of competition by satisfying the most demanding needs on developed markets. Also, G&A costs are going to increase due to the necessity of business expansion, mainly in developing markets. Projected capex of the company is estimated by analyzing company’s historical capex to sales ratio and applied to the projected net revenues and depreciated in-line with the historical trends. The interest cost relating to the company long and short term debt is estimated based on the historical effective interest rate of 6.5%. The projected net working capital of the company was estimated based on the historical working capital days and trends.

Kraft Foods Valuation The valuation of the company has been carried out by applying Discounted Cash Flow (DCF) method and the market comparable approach. The approach used in determining the intrinsic value of the company based on the DCF is Free Cash Flow to Firm (FCFF) which resulted in an Enterprise Value of USD 70.7 billion i.e., corresponding to an EV/EBITDA multiple of 12.87x, and an Equity Value of USD 54 billion (or USD 36.4 per share); corresponding to a P/E multiple of 25.6x, based on the EBITDA and Net Profit of the company as at 31 December 2009. Under the market comparables approach, EV/EBITDA, EV/Sales and PE multiples of a select peer group as at the valuation date are considered. DCF based valuation

Weighted Average Cost of Capital (WACC) - Kraft The Weighted Average Cost of Capital (WACC) of Kraft was calculated using the US 10 year Treasury bond with the yield to maturity (YTM) of 3.8%. The unlevered beta of the global food processing industry sourced from Damodaran’s website has been considered to compute the levered beta by applying the company’s target debt equity structure and the company’s historical effective tax rate of 31.5%. The equation used to find the levered beta of the company is as following:

Where: βL= levered beta, βu = unlevered beta, Tc = Tax rate, D/E = debt to equity structure of the company. The risk premium of 4.5%, represent the risk premium of the US market and comprises a default probability of zero basis points. In order to arrive the market cost of debt of 5.8%, a default spread of 2% was added to the assumed risk free rate i.e., 3.8%. The default spread assumed, is based on the company’s credit rating by Moody’s at the time (Baa2) – a rating which has be ascribed a default spread of 2% by Damodaran on his website.

Kraft Foods – Market Comps analysis and valuation

Summary of market comps based valuation

Price offered for share exchange was around 12.5% lower than the Median valuation of Kraft i.e., implying undervaluation of Kraft’s shares.

Conclusion Kraft’s median price per share arrived at after taking into consideration various valuation methods and approaches suggest that the price offered for Kraft’s shares to Cadbury as means of partial payment for acquisition is understated by around 12.5% i.e., which may have severely damaged the long term prospects of Kraft and its brand equity.

Cadbury financial statements and analysis Cadbury – it is assumed that the net revenues of the company will grow at a CAGR of 5% year on year from 2010 onwards i.e., in-line with the expectation of economic recovery in the Europe and the company’s focus on the emerging markets; where the confectionaries sector grew by 12% in 2008 (compared to only 3% in the developed market) and accounted for 69% of Cadbury's revenue growth in the first half of 2009, up from 60% for the full year in 2008. The company’s cost of sales as percentage of sales is maintained at the 2009 level at around 54% (compared to 53% in 2008) over the forecast period. The assumption of maintaining the costs at the higher levels achieved in 2009 is consistent with the rationale provided for Kraft i.e., the commodity prices which as a result of recession would increase in 2010. Operating costs are projected to increase by 5% year on year, in-line with the increase in the net revenues. This may seem as an aggressive assumption when considering the historical growth trend which depicts around 1% growth in operating costs compared to a net revenues CAGR of around 13% achieved during the same period. However, in order to sustain the growth in the emerging markets where the confectionary market is highly fragmented due to many smaller and local competitors, Cadbury would need to invest in marketing to continue to promote its products and improve its distribution channels. Projected capex of the company is estimated by analyzing company’s historical capex to sales ratio and applied to the projected net revenues and depreciated in-line with the historical trends. The interest cost relating to the company long and short term debt is estimated based on the effective interest rate of 8.3% in 2009. The projected net working capital of the company was estimated based on the historical working capital days and trends.

Cadbury Intrinsic Value Calculation The valuation of the company has been carried out by applying Discounted Cash Flow (DCF) method and the market comparable approach. The approach used in determining the intrinsic value of the company based on the DCF is Free Cash Flow to Firm (FCFF) which resulted in an Enterprise Value of GBP 10.7 billion i.e., corresponding to an EV/EBITDA multiple of 13.2x, and an Equity Value of GBP 9.3 billion (or GBP 6.0 per share). Under the market comparables approach, EV/EBITDA, EV/Sales and PE multiples of a select peer group as at the valuation date are considered. DCF based valuation

Weighted Average Cost of Capital (WACC) - Cadbury The Weighted Average Cost of Capital (WACC) of Cadbury was calculated using the UK 10 year Guilt with the yield to maturity (YTM) of 4.1%. The unlevered beta of the global food processing industry sourced from Damodaran’s website has been considered to compute the levered beta by applying the company’s target debt equity structure and the company’s historical effective tax rate of 28.0%. The equation used to find the levered beta of the company is as following:

Where: βL= levered beta, βu = unlevered beta, Tc = Tax rate, D/E = debt to equity structure of the company. The risk premium of 4.5%, represent the risk premium of the developed market and comprises a default probability of zero basis points. In order to arrive the market cost of debt of 6.1%, a default spread of 2% was added to the assumed risk free rate i.e., 4.1%. The default spread assumed, is based on the company’s credit rating by Moody’s at the time (Baa2) – a rating which has be ascribed a default spread of 2% by Damodaran on his website.

Cadbury – Market Comps analysis and valuation

Price offered acquisition of Cadbury shares by Kraft seems significantly overvalued i.e., by 50% compared to the median valuation of the company.

Conclusion Cadbury’s median price per share arrived at after taking into consideration various valuation methods and approaches suggest that the price offered by Kraft’s at GBP 8.4 per share for acquisition of Cadbury is at a significant premium of 50% which is above the typical 20% - 30%. While, Cadbury’s attractive confectionery segment which is a high margin and faster growth businesses than some of Kraft’s packaged food lines such a cheese, can add to the overall value of Kraft, the acquisition of Cadbury would also allow Kraft to expand its operations into faster growing markets such as India i.e., where Kraft virtually had no presence.

Merger Financial Analysis and Assumptions

Kraft Foods, at GBP 8.4/share, paid a premium of around 48% over the price Cadbury was trading at before Kraft made its first offer in August 2009. The offer price was structured as GBP 5/ share in cash and 0.1874 in Kraft shares i.e., valuing Kraft’s share at USD 29.7; assuming an exchange rate of USD 1.635 per GBP. The value of debt, given the cash constraints of Kraft and Cadbury, corresponds to GBP 9.3 billion (or USD 15.2 billion) of acquisition loan. It is further assumed, that the debt arrangement fee and equity placement fee is equal to 1% and 1.5% of the placement value and will form part of the total financing obtained. The existing bank loan of Cadbury as at 31 December 2009 stood at GBP 1.6 billion has also been assumed to be settled and replaced with the new acquisition loan. The cost of debt for the acquisition loan is assumed same as the cost of debt of Kraft’s existing debt i.e., at 6.5% and amortized over a period of 10 years. It is assumed that the book value of all the non-cash assets e.g., property, plant and equipment, trade receivables, inventory etc. represent the fair value of these assets. In practice, it is common to determine the fair value of the fixed assets and other current assets. However, as the information required to determine this is not readily available, it has therefore been ignored in the calculation. Hence, the goodwill arising as a result of the consideration paid (i.e., GBP 13 billion) and Cadbury’s net book value of GBP 3.5 billion as at 31 December 2009, is GBP 9.5 billion (USD 15.5 billion). Kraft’s pro-forma balance sheet as at 31 December 2009, after taking into consideration all of the above, is as shown in the following section. Summary of merged entity valuation and share price impact analysis

Details of the post-merger price per share and its calculation are provided in the following sections of this report.

Cadbury / Kraft Consolidation Workings

Pro-forma financial statement assumptions and analysis Kraft and Cadbury, both at the time of the transaction had a low EBIT margin relative to its peers. Kraft being the largest food company in North America and participating in high gross margin categories and Cadbury being a market leader in the UK and Ireland and controlling 10% of the global confectionary market in 2009, there is a massive upside on the EBIT that can be unlocked by restructuring direct and indirect costs (such as distribution, marketing, R&D and administrative costs), and realizing synergies from the merger of the two companies. Based on the gap between consolidated pro-forma EBIT (of 11%) and the peer group average (of 16.2%), the potential upside that can be unlocked is estimated at USD 2.5 billion p.a. For the pro-forma income statement, it is assumed that 20% of the upside potential will be unlocked in 2010 which will gradually increase to 70% by 2015; thereby improving the proforma EBIT margin from 10.6% in 2010 to around 12% in 2015. As such no other synergies on account of revenue enhancement has been assumed.

Source: Bloomberg

Based on the earnings per share analysis of the combined entity it appears that the merger will be accretive for Kraft and will create value for its shareholders, provided the company is able to expand its operating margins. Prior to approaching Cadbury in August, the trailing twelve month P/E multiple of the company was trading at around 38x compared to that of Kraft’s at 14.4x. This seems counterintuitive given that the general rule of thumb is that an accretive merger occurs when the price-earnings (P/E) multiple of the acquiring firm is greater than that of the target which then encourages a rise in the price of a combined entity.

Pro-forma Intrinsic Value Calculation The intrinsic value of the combined entity has been carried out by applying Discounted Cash Flow (DCF) method. The approach used in determining the intrinsic value of the company based on the DCF is Free Cash Flow to Firm (FCFF) which resulted in an Enterprise Value of USD 99.1 billion i.e., corresponding to a forward EV/EBITDA multiple of 15.7x, compared to Kraft’s standalone EV/EBITDA multiple of 14.4x. The Equity Value of USD 67 billion (or USD 37.9 per share) is arrived at after considering post-merger net debt position of USD 32.1 billion; which comprises the acquisition loan and Kraft’s own long and short-term borrowings. The weighted average cost of capital assumed to discount the future cash flows of the combined entity is same as that used to determine the intrinsic value of Kraft and as such no capital structure synergies which would further enhance the intrinsic value of the combined entity, have been assumed....