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Gene Marcial's Stock Picks

Marcial: Pros Bet Cadbury Will Melt for Kraft

How to play the Kraft Foods (KFT) vs. Cadbury (CBY) takeover chess game?

With American Depositary Receipts (ADRs) of Cadbury easing from 52.66 a share on Oct. 22 to 50 on Nov. 12, this is a chance for investors to grab some of the U.K. company. Some pros are betting big bucks that Cadbury will succumb to Kraft's persistent efforts to buy the leading maker of chocolate, gum, and candy. Kraft is one of the world's largest branded food and beverage companies.

On Nov. 13, Cadbury's stock inched up to 51. Cadbury bulls believe the intrinsic worth of the stock is 56 to 59 a share.

It's likely Cadbury's stock may slip again as Kraft continues to take its time before raising the ante in its cash-and-stock bid of £7.14 for each ordinary share, or 47.44 per ADR. Cadbury Chairman Roger Carr called the unsolicited bid "derisory" as he and the board swiftly rejected the offer.

Kraft CEO's "Ultimate Deal" Don't be puzzled by the way Kraft seems to be pence-pinching in its quest. The endgame is to win Cadbury—at not so steep a price. And some pros believe Kraft will emerge victorious.

"It is the ultimate deal of her [Chairman and CEO Irene Rosenfeld's] career if she wants to push forward Kraft's global reach and much-needed expansion," says Kevin Dreyer, a consumer staples industry analyst and portfolio manager at GAMCO Investors (GBL), which owns nearly 1% of Cadbury's stock.

"Cadbury is a company that Kraft desperately wants not only because of its fast-growing confectionery products but [because of] its geographic fit," Dreyer points out. Among Cadbury's brands: Trident, Dentyne, Halls, and Cadbury.

Cadbury has a big share of the markets in the 60 countries in which it operates, with Britain, Ireland, the Middle East, and Africa accounting for 31% of total revenues, the U.S. and Latin America 27%, Asia-Pacific 25%, and Europe 17%.

What has disappointed investors is Kraft's decision to stay with the original buyout price it offered in September, and worst of all, the implied price is now lower because of the decline in Kraft's stock price.

Prospects for a Sweetened Offer "While we are somewhat surprised Kraft did not increase its bid, we view this offer as a means to continue the process toward a negotiated transaction," says Dreyer. The offer equates to 11.6 times his 2009 estimated earnings before interest, taxes, depreciation, and amortization (EBITDA) for Cadbury, and 10.6 times his 2010 EBITDA forecast.

Dreyer believes Kraft will ultimately sweeten its bid for Cadbury, whose "private market" or intrinsic value he puts at 59 per ADR, or about 13 times EBITDA before corporate expenses. He notes that previous deals in the industry were done at about 18 times EBITDA, including the acquisition of Wrigley by Mars on Oct. 6, 2008, for $80 a share in cash.

So Dreyer believes Kraft will likely boost its offer to at least £8.50 per ordinary share, or 56 per ADR, which he figures would be more in line with the company's intrinsic value.

As early as Jan. 21, 2009, Dreyer had recommended Cadbury as a possible target of Kraft because of its strong brands, leading position in the global confectionery industry, and significant exposure in emerging markets,

Rival Bidders? Although Dreyer expects other companies, including Nestlé (NESN.DE) and Hershey (HSY), may go after Cadbury, Kraft would be the most logical buyer, he argues.

Are there other bidders in the wings? Possibly. Kraft wants to "smoke out" other potential bidders before it makes its final move, says Jonathan Feeney, analyst at Janney Capital Markets, who rates Cadbury a buy. Kraft wants to make sure, he says, that there are no other bidders out there.

"Right now, we expect Cadbury's bankers and management to try to attract another bidder or make a counterproposal to shareholders," to make a case for an increased value for the company, he adds. There's at least a 50% chance that no other bidder will step up to the plate, he says.

Feeney is convinced Kraft wants the acquisition badly because it needs the strong growth Cadbury represents. And why would Cadbury agree to being acquired? Feeney says Cadbury has radically cut costs and divested a major line of business (it spun off its Dr. Pepper unit in 2008), and now faces global competitors, including Mars, which is more than twice its size. He puts Cadbury's worth at 56 a share.

Bidding Process Could Drag Out "Kraft has the financial flexibility to raise the offer for Cadbury," says David Tovar, analyst at Bank of America Merrill Lynch (BAC), who says the bidding process could drag on through March.

Kraft's "disciplined bid" recognizes the very low probability of a competing bid surfacing, says Christopher Growe of investment firm Stifel Nicolaus (SF). This tactic may work, he says, but a "sweetened offer could guarantee sealing the deal."

Buying Cadbury would "fast-forward" Kraft's plan to build a larger emerging-market presence and "would no doubt offer an infrastructure in these key countries, including India, China, and Eastern Europe, that would take years to build on its own," says Growe.

In sum, there is a consensus view among analysts that Cadbury would be greatly helped by hooking up with a global company such as Kraft. So far, of the five Wall Street analysts who follow Cadbury, three recommend buying the stock and one rates it a hold. (Bank of America's Tovar has withheld any rating pending the outcome of the tussle between Kraft and Cadbury.)

If the bulls are right, Kraft may come in with a definitive bid for Cadbury that could hit the sweet spot for savvy investors.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.
Marcial writes the Inside Wall Street column for BusinessWeek. In 2008, FT Press published the book Gene Marcial's 7 Commandments of Stock Investing.

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