by Jerel H Novick Kraft is the world’s second largest drink and food manufacturer. They have a strong international portfolio of brands (Ritz, Oreos, Kraft Cheese, A1 Steak Sauce, Jello). They are currently working aggressively to restructure/realign their business and increase their global footprint. They are getting rid on non-core brands and slow growth brands (sold Very Fine Juices, hot cereals, Minute Rice, Milk-Bones and Post Cereals, bough the Danone Group’s biscuit business). More transactions are on the way. The expectation is that several small brands will be packaged together. The end result is to end up with a company is made up primarily of brands that are #1 or #2 in market share in their category.In the attached model, I assumed a return to modest sales growth of 3% in ’07, 4% in ’08 and 5% thereafter. EBIT margin compression will continue for the next two years as pressure remains on commodity price. As Kraft is today I see a target valuation of $38.Ralcorp (RAH) is buying Post for $2.6 bill (9x EBITA 2.5x sales). RAH is a private label food producer with a market cap of $1.5 bill with a 27% of their sales and 20% of income from cereals (51% and 65% after the merger). Post is the #3 cereal maker. The cereal sales have been growing by Post has been stagnating due to their heavier mix of sugary kid’s cereals, lack of distinction in family/health cereals and mature brands (Grape Nuts). Buying Post gives RAH a higher margin business (23.5% Post EBIT margin vs. 6.9% for RAH). EBIT margin for the new company is expected to be in the neighborhood of 12-13%. Cost savings are expected to be 2-4% cost savings to the combined company by leveraging economies of scale in purchasing and production. This is will also give RAH more pricing power with grocers by controlling more shelf space. It is expected to be immediately accretive to earning for $0.44-$0.68 making 2008 EPS about $4.00. As part of the Post sale, Kraft shareholders will get 0.4 of RAH for every KFT share they hold. KFT shareholders will own 54% of the new company. There are no collars on the deal. So it is not clear how many shares RAH will be issuing and how many KFT will be retiring. RAH is currently trading at 17x forward earning of $3.51. With continued commodities pressures I would expect the multiple to cheapen to 16x on the new company. On a simple multiple basis I would value RAH at about $64 (currently at $60).I think buying Kraft gives us exposure to a major food company that is retooling them for a tougher operating environment. Splitting-off Post to Ralcorp should unlock additional value to shareholder. The potential mix of Kraft and Ralcorp to the portfolio would give us exposure to both the branded and private label segments of the Consumer Staples segment. Continued pressure on commodities and grocery prices may have cause some consumers to shift temporarily to private label brands.
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