The market learned last Friday that Warren Buffett's Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) had taken an 8.6% stake in Kraft Foods (NYSE:KFT), making it the largest shareholder in the company.
This is hardly a surprise move for the "oracle from Omaha," as Buffett also owns large stakes in two other consumer-products companies -- Coca-Cola (NYSE:KO) and Procter & Gamble (NYSE:PG). Buffett is known to favor companies that are simple, understandable, and undervalued. Kraft certainly has a straightforward business model, so the question left to explore is whether the company is undervalued.
Organic growth accelerating
Last year, Kraft delivered 5% organic sales growth (excluding the effects of currency and divestitures). More importantly, organic sales momentum built throughout the year, improving from 3.6% in the first quarter to 6.2% in the fourth quarter. Solid.
Kraft is following a carefully designed strategy to improve product quality and grow market share. The company has been reluctant to just increase prices, preferring to accept some short-term margin hits in favor of top-line momentum. The approach is paying off, as Kraft gained or held share in businesses representing 50% of their volume in the fourth quarter. That's not stellar, but it is a marked improvement from the first quarter, when the company gained or held share in businesses representing only 38% of volume.
Restructuring to lower costs
Back in 2004, Kraft began a restructuring program to lower costs across the organization. Over the past four years, the company has reported $2.1 billion in "one-time" expenses, offset by $1.2 billion in cost savings.
This has been something of a sore point with analysts and investors. After awhile, you start to wonder whether these "unusual items" are not just part of the core business. In January, management said that the restructuring program will end in 2008 and added that it expects the company to be hitting its stride in 2009 with $1.2 billion in annual cost savings.
Cheese costs skyrocket
The company explained that barrel cheese costs (a key input commodity) have averaged around $2 since last June, one-third higher than over the past five years. This input cost pressure has put the squeeze to margins and profits, though management expects at least 4% earnings growth to $1.90 in 2008. Beginning in 2009, Kraft is targeting organic annual sales growth of 4%, with earnings per share notching 7% to 9% annual improvements.
One Fool's opinion
Is Kraft significantly undervalued? Before last Friday's 7% jump in price, the stock was trading at around $29, or 16 times adjusted trailing EPS.
I view Coke and Procter & Gamble as the best consumer-brand companies, along with PepsiCo (NYSE:PEP) and Colgate-Palmolive (NYSE:CL). These four best-in-class companies are currently trading at an average price-to-earnings ratio of just more than 22, a significant premium over Kraft.
Let's consider a scenario in which dairy costs return to historical levels. Under those conditions, Kraft would have delivered an additional $0.37 of EPS last year with simply flat gross margins. Let's also suppose Kraft delivers on its sales and earnings growth targets through 2009 and enjoys P/E expansion up to a little less than best-in-class -- say 18 to 20.
That could translate into a stock price in the range of $42 to $47 per share. Not a bad return on a stock that’s currently trading around $31, especially when you're picking up a dividend of more than 3.4% along the way.
For related Foolishness:
- Rich Smith advises that Coke is still it.
- And while Pepsi toasts international results ...
- ... Procter & Gamble is ever so predictable.
