Philip Morris and Kraft

Question 1 Why is Kraft a takeover target?

Solution

As expressed by the Kraft Chairman, Mr. John Richman, “Kraft has an outstanding record of profitability and growth. It is a great company with great traditions, great brands and a great future”.

The statement highlights the underlying performance of a company, which is under a takeover threat from Philip Morris. The takeover bid presents significant opportunities for Kraft (target), Philip (the acquirer) and the food industry as discussed below:

Kraft (Target)

• Focussed on core business: Kraft business strategy was focussed only on division i.e., food industry, such a strategy helped the company to completely focus on one line of business and maximize on the diverse and rewarding opportunities.
• Strong financial and business performance: Kraft’s focus on an all-food strategy is directly reflected in its strong financial and business performance as highlighted below:

• Company’s focus on all-food strategy and consumer’s increasing demand for food related products has resulted in high sales growth as reflected in revenue CAGR which has increased from 7% to 27%.1
• Profit margin has been consistent around 30% and have been on an upward trend since 1983.
• Key business divisions have contributed positively to the growth for Kraft, for e.g., operating profit margin for US consumer food has increased from 10% to 13% from 1982 to 1987. Also, it is worth highlighting that Kraft shows an operating profit margin of 13% in its U.S. Consumer Food segment, the strongest one, which is above the average of 11.44% of the industry

• Increasing shareholder value: Kraft’s strategy of balancing short-term returns and continued investment for long-term growth has generated positive returns for shareholder value i.e., 20% over the past 5 years at compounded annual rate. Also, considering the Return on Equity, which has doubled from 12.6% in 1982 to 25.8% in 1987 and have outperformed all the major indexes Food index (12.5% in 1997), S&P 500 Index (11.8% in 1987), reflects that shareholder’s investment in Kraft has generated high returns compared to market
• Undervaluation by stock market:  Food industry has been undergoing significant changes and companies have experienced undervaluation particularly companies which sacrifice short-term profit in order to invest in long-term growth.  Therefore, Kraft was no different, operating in the food segment, has been facing the same challenges, for e.g., the stock price decreased from 49.38 to 48.25, with its P/E ratio decreasing from a value of 16 to 13 (19% devaluation). As the stock market doesn’t translate the true value of the company it becomes vulnerable to hostile takeovers at lower offers.
• Increased financial exposure: Kraft has been experiencing significant decline in liquidity as cash has decreased from 16% to 9%, long-term debt ratio rises from 5% to 16%, from 1986 to 1987.  which makes Kraft more vulnerable to a take over or a restructuring.

Philip Morris (Acquirer)

• Diversification into food business: Philip Morris has been diversifying its portfolio since 1969 focusing on brewery, food processing among others, however, the acquisition had mixed results for Philip. Thereafter, the company is now majorly focused on diversifying out of tobacco business given decreasing consumption in US and moving to the food business, hence takeover of Kraft fits well as it complements the food portfolio of Philip Morris, thereby improving synergies on both costs such as operational efficiency and revenue through product expansion and majorly because the acquisition would strengthen Morris’s position as it would then become the largest food company in the world. 

Food Industry

• Leveraging M&A for growth opportunities: Given high past and expected growth in the food industry, major players in adjacent industries which are focussed on consumer goods such as beverages  are looking to acquire players in food industry to capture the growing pie of the market. As a result, large companies backed by strong performance are fishing for high growth companies in the food and beverage sector (F&B). As evident in the latest 3-5 years, F&B industries have experienced big ticket-size acquisition with high premium of around 35-40%, hence, with the increasing activity in M&A, Kraft one of the fastest growing company is experiencing a takeover, given the significant synergies that Kraft can provide to an acquirer.

Question 2: How did the stock market assess Philip Morris' $90 per share bid for Kraft?

Solution: Philip Morris bid of $90 per share for Kraft was undervalued by investors as the stock price of Kraft post the bid (Oct 18th) increased by $28, a massive increase of 47%, as shown in the chart below. Also, post one-week of bid (Oct 24th), the stock was trading in the range of $95-102, an increase of ~65%. Clearly, the stock price movement of Kraft reflected that the bid by Philip Morris was undervalued at $90