As Kraft Splits, Watch the Pieces, but Wait

 | Sep 21, 2012 | 9:00 AM EDT  | Comments
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Kraft Foods (KFT) will soon be splitting into two focused components: Kraft Foods Group (KRFT) and Mondelez International (MDLZ). Splits, by their very nature, entail some short-term dislocations, in both the corporate and investor arenas. Kraft's will be no exception, and therein might lie an opportunity.

Kraft Foods Group will be the mature, $19 billion U.S. grocery operator. Mondelez will be the faster-growing, $34 billion company with an international focus. The split will be effective after the close on Monday, Oct. 1. The record date for the shareholder split was Wednesday Sept. 19. When-issued shares began trading on Monday, Sept. 17, under the temporary tickers KRFTV for Kraft Foods Group and MDLZV for Mondelez International.

Kraft Foods Group will be the largest U.S. consumer packaged goods manufacturer, with well-known brands such as Kraft, Oscar Mayer and Maxwell House. The company is expected to grow revenue at 1% to 3% per year and earnings at 5% to 8%.

During its recent September road show, management reduced guidance by $0.20 to $0.25 a share because of higher pension expenses and higher operating costs of being an independent public company again. Analysts and investors are comfortable with the upcoming 2013 earnings guidance of $2.50 per share.

To investors' surprise, management guided to a $2 annual dividend. At the recent when-issued share price of $46.45, Kraft Foods Group will have a 4.3% dividend yield, compared with an average of less than 3.5% for the consumer packaged industry as a whole. From the perspective of a price-to-earnings multiple, Kraft is trading at 18.6x 2013's projected EPS estimate of $2.50, which places Kraft's valuation multiple at a 2 to 3 point P/E premium to the consumer packaged goods group.

Management expects to continue to raise the dividend in the upcoming years. We expect Kraft Foods Group to increase dividends in line with its long-term growth rate at 6% to 7% per year because of acquisitions, margin improvement opportunities, acquisitions and stock buybacks.

Mondelez International will be the faster-growing global snacks business, led by such iconic brands as Cadbury, Nabisco and Trident. The company is expected to grow revenue more than 5% per year and earnings at double-digit levels, since 44% of revenue comes from the faster-growing emerging markets of Asia, Latin America and the Middle East/Africa.

Management recently reduced guidance by $0.05 to $0.10 per share to $1.50 per share in 2013, because of higher pension expenses, negative foreign-exchange conversion ratios and higher operating costs of being an independent public company again.

There was some disappointment with this guidance, and the company might be in the penalty box for a bit until operating performance turns around. The dividend is expected to be modest, since Mondelez is expected to be a premier global growth company. Free cash flow will be primarily reinvested in growth, rather than returning capital to shareholders.

At the recent when-issued share price of $26.31, Mondelez is trading at 17.5x 2013's projected EPS. This valuation level places the company at a 2 to 3 point P/E discount to the premium consumer packaged goods firms such as Hershey (HSY) and McCormick (MKC), but at a premium to the overall packaged food group.

Notwithstanding their favorable attributes, we would take a wait-and-see approach for both Kraft Foods Group and Mondelez. In each case, we believe that the near-term advent of the split could be a selloff as each company's investor base undergoes some gyrations. A pullback of 5% to 10% in Kraft Food Group's price would make it very appealing for the dividend-oriented side of the barbell.

For Mondelez, we would get interested to include it in the growth-oriented side of the barbell if we saw the P/E multiple move down to the 14-15.5 range.

Historically, split-ups have been a good way to enhance shareholder value, but over the short term they can bring dislocations, uncertainty and on occasion stock price weakness. Entry points and valuations count, and at current levels we would not be buying either piece quite yet. But both pieces bear watching, and either could become interesting into possible weakness.

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