The One with Cheese and Chocolates

Kraft sold its pizza business to Nestle and bought Cadbury.

Read this transcript to learn why Warren Buffett opposes the dealS.

On selling the pizza business:

1. Kraft sold the (frozen) pizza business at $3.7 bn, but net of tax will receive only $2.5 bn.

2. The pizza business earns 280 Million pre-tax income on $2.1 bn in sales which has been growing over the years.

3. He thinks that giving up $ 280 million in earnings in exchange for $ 2.5 bn is a bad deal for the seller. We can infer that paying $2.5 bn for $280 million is a GOOD deal for the buyer (ie PE of around 8.9x).

On buying the chocolate business:

1. Kraft stated that they are paying 13x EBITDA

2. Buffett told the interviewer that DEPRECIATION IS A VERY REAL EXPENSE. (i believe he meant capital expenditure to keep the business in place)

3. There will be about 1.3 bn in restructuring charges.

4. Part of the ''currency" used for this transaction is Kraft's undervalued stock. Thus they are acquiring Cadbury at more than 13x EBITDA based on intrinsic value of stock.

(the above two paragraph of numbered points were extracted from the transcript, the following is my analysis... ...proceed with care, cuz this author is famously careless)

"So, the actual multiple, if you look at the value of the Kraft stock, is more like 16 or 17 and they sold earnings at nine times. So, it's hard to get rich doing that. And I've got a lot of doubts about the deal."

From the above statement, we can reverse engineer what may approximate Kraft's intrinsic value per share.

Let us just convert all the deal details available at Kraft's website into USD.

840 pence per Cadbury share for 500 pence in cash and 0.1874 New Kraft Foods Shares

at the exchange rate of 1.63 USD/GBP

840 pence = 13.69 USD ----(1)

500 pence = 8.15 USD ---- (2)

0.1874 Kraft shares at $29.58 = 5.54 USD ----(3)

Check: (1) = (2) + (3) , therefore balance

Since Kraft's statement states that at the current deal price, it is acquiring at 13 x EBITDA, then

13.69 / EBITDA = 13

EBITDA = 1.0533

Mr Buffett said that Kraft is paying at least 16 x EBITDA based on kraft's intrinsic value, thus value of deal at

16 x EBITDA = 16 x 1.0533 = 16.853 USD ----(4)

0.1874 Kraft shares = (4) Less Cash component (2) = 16.853 - 8.15 = 8.703

Intrinsic value of 1 Kraft share = 8.703/0.1874 = 46.44

Compare this to the closing price of 29.58, no wonder Buffett is against the deal as (I think) he believes that the company is selling at 35% discount to intrinsic value!

However, I would like to add that Kraft is expected to earn around $2 per share. Is Kraft worth 23x PE based on share price of 46.44? Of course PE is a super shorthand to estimate value. However, i find this an interesting exercise as this is one of the few times in recent years that Buffett 'reveals' his estimation of intrinsic value.

Also note that for 2008, on 3 bn in net profit, almost 4bn of operating cashflow is generated and CAPEX (with growth) is about 1.3 bn. So maintenance CAPEX maybe way less than 1.3 bn, with free cashflow exceeding net income, which means that EPS multiple maybe a lousy way to estimate value to the long term owner.

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Actually I don't quite know who I wrote the above post for, cuz most friends who read this blog will probably stop at the first line. haha. So I wrote it mostly for myself, to remind me that Price does NOT equal Value, and that smart people may do things that are not too smart things, and that I must not fall prey to over-enthusiastic promoters (however well intended they might be).

Also any readers who find errors in my reasonings or calculations, please tag or comment to set me right.

Tiger IPO

Tiger Airways is launching an IPO to raise up to $246.8 mil dollars. A fellow SMU friend emailed and asked if we should subscribe to this IPO, here's my take on it. After scrolling through the 300 over pages of prospectus available on SGX homepage.

The following discussion assumes that you intend to buy and hold Tiger Airways for at least 5 years and beyond.

Should you decide to subscribe, please consider the following;

1. The airline industry is insanely competitive. Few airlines company makes accounting profit, much less generate free cash flow after capital expenditure needs.

2. The world class low cost carrier leaders are Jetblue and Southwest airlines. Both suffered terrible results over the last three years. Do you think Tiger will fare better should we face any economic turmoil in the future?

3. Financials:
(a) Income statement (pg 12 -13), the results for the past 3 years are dismal.

(b) Balance sheet (pg 14 -15), the company is in net NEGATIVE equity position

(c) Over 3.7 BN in operating lease commitment (pg 64), this is OFF BALANCE SHEET!!! So what is the 'true' financial standing of this firm? You decide.

Thought Experiment: Assuming that you can afford to buy the whole company and has to hold it in your family for the next 3 generations (without the option to sell), how much would you pay for it?

My answer is that I will not own it at any price cuz I believe this company (and most airline companies) will consume more cash than it can generate, and that my family will be worst off having this non-cash generating cow that eats way too much grass.

So do continue taking Tiger as we now know that the fleet is at a youthful 2.4 years (but depreciated over 23 yrs!!!). It is also likely that we are not overcharged when we buy our air tickets looking at the almost non-existent gross margins :)

Meanwhile hear the father of business strategy, Michael Porter, talks about competitive advantage and the terrible economics of the airline industry.

Suit Up for the 100th episode!!!

Can't wait!!!

The Daily Show

One of the best show in a while!

The best time in American history and George Lucas interviewed.

Managing Oneself

Re-read this classic article by Peter Drucker - Managing Oneself. I was first introduced to me in my Management of People at Work course. Sometimes I think that the value of some courses in SMU simply lies in the prof introducing students to awesome articles.

Drucker urged his readers to answer some of these questions; What are my strength and values? Where do I belong? How do I learn?

He also urged cross disciplinary learning. It is no good if a technical guy (e.g. engineer/accountant) don't know anything about human behavior, or that a HR manager know nothing about how technical guys work.

On Ideas vs Execution

"...he believes that ideas move mountains. But bulldozers move mountains; ideas show where the bulldozers should go to work."

On learning and its problems
"Schools everywhere are organized on the assumption that there is only one right way to learn and that it is the same way for everybody. But to be forced to learn the way a school teaches is sheer hell for students who learn differently."

To Jie Chao (Drucker is speaking to YOU!): "But most people, especially highly gifted people, do not really know where they belong until they are well past their mid-twenties. By that time, however, they should know the answers to the three questions: What are my strengths? How do I perform? and. What are my values? And then they can and should decide where they belong."

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Wishing all my readers a great New Year ahead of you!

Avatar

Go watch AVATAR. Please watch it in 3D. It makes a difference, as the world of the Na’Vi comes alive in our cinema.

Official Avatar Movie

There are times where technology steals the story line, yet sometimes proper use of technology enhances story telling. I would declare UP my favorite movie of the year, followed by Avatar and District 9. Watching Alvin and the Chipmunks tonight...don't think it will post a challenge to the 3 listed movies.

This review by New York Times on Avatar is worth reading.

The plot is simple enough, and it reminded me and my friends of the plot of The Last Samurai combined with Pocahontas. I half expected (neh...hoped for) Colors of the Wind to be played when the scene sweeps though the enthralling forest on Pandora. Also, it follows the classic hero's journey quite closely...thanks to Baby Chao who introduced me to Joseph Campbell.

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Had a awesome 4 hours discussion session with some E.y.E pple yesterday. Really enjoyed the dedication to learning shown by Jason, Eric, Darryl and Jin Wen.

I'd like to comment on a few key learnings:

1. There is a link between Return on Invested Capital and the range of Price to Book ratio a company sells for. Company earning high ROIC will rarely be available for low PB. Investors do recognize there is some intangibles at work that create return on capital over cost of capital.

2. For asset heavy industry, do look out for off balance sheet items and capitalize operating lease before calculating ROA or other ratios as different financing method will create HUGE difference.

3. Value of Growth

(a) Growth creates value for shareholder only when ROIC > WACC. When return is less than cost, you are destroying value.

IMAGINE:

I can borrow $100 at 5% interest (WACC) to purchase a T-bill yielding 3% (ROIC). EVERY 100 dollars investment LOSES 2.

If i can GROW this to a 100,000 dollar business, I will be losing 2,000 due to this growth!

The challenges we face with equity analysis is that both WACC and ROIC are hard to estimate. However, we just need to be roughly right, and if the spread is wide enough, it should satisfy us.

(b) Estimating free cash flow

In some of the spreadsheets for cash flow projection, depreciation expense added back is less than the capital expenditure and projected into infinity. Should this be the case, the analyst is expecting Return on Asset to increase over time and the company can do more with less!

Example:

Given that

Return on incremental asset = 10%

Net Profit margin = 20%

If incremental sales is 100, then Net profit is 20 and Need of additional asset is 200.

Assume net profit = operating cashflow, then,

Operating Cashflow ---- 20

Add back dep ----- xxx

Capital Expenditure ---- (200)

It is most likely that the to grow, free cash flow will be negative. Only in the very rare case of super high return on asset (e.g. due to very high asset turnover or profit margins) can a company grow quickly without huge investment in fixed asset.

Furthermore, working capital charges is a real charges. If your growth is partly due to expansion in Account Receivables, you are not making cash profit. Worse still, there are some companies out there that incur debt at the corporate level and lend to customer to buy their own things? This should only be considered sales with Alice in Wonderland accounting.

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After reading about investing and doing it for about 6 years, i can simply say that I learnt not to get easily conned by snake oil peddlers.

“[A] respect for evidence compels me to incline toward the hypothesis that most portfolio decision makers should go out of business — take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed. Few people will commit suicide without a push."

- Paul Samuelson

So Many Things yet So Little Time

Things on my mind:

Reflections on working with Blood Donation Drive and the challenges of sales.

My most-shiong ever ICT and the amazing platoon I serve in.

On re-reading Phillip Fisher's book and the amazing things he said in the 60s that was finally executed in the late 90s.

Some further thoughts on personal finance and the folly of spending more than you earn, albeit just a little more.

Will think harder over the next few days while i relax in Langkawi. Can't wait for Xmas eve for the caroling session.