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Some food for thought on Philip Morris' $8 billion Kraft IPO
Analysts mixed on long-term prospects of stock
Kathleen Pender

Tuesday, June 12, 2001

Philip Morris is hoping its partial spin-off of Kraft Foods this week -- in what will be the second-largest initial public offering ever -- will raise about $8 billion in cash and remove the smell of tobacco from its food business.

The company will probably achieve its first goal. But on the second, Philip Morris will be about as successful as the restaurant that tries to separate food from cigarettes by roping off a nonsmoking section.

After the IPO, which is expected to be priced tonight and begin trading tomorrow, Philip Morris will still own 84 percent of Kraft's stock and control more than 97 percent of its voting rights.

Here's why: Philip Morris is selling 280 million to 308 million Class A Kraft shares to the public. Class A shares have one vote each. After the offering, Philip Morris will still own 49.5 percent of Kraft's Class A shares and 100 percent of Kraft's Class B shares, which have 10 votes each.

Although the spin-off may shield Kraft shareholders from Philip Morris' legal liabilities, investors who have avoided the tobacco-maker on moral grounds will probably avoid Kraft as well.

"Kraft isn't going to be in our portfolio anytime soon," says Amy Domini, president of the Domini Social Equity Fund, which won't invest in tobacco and other businesses it considers ethically challenged.

She says Kraft would violate her fund's 50 percent rule, which excludes companies that are more than 50 percent owned by a banned company.

The California Public Employees Retirement System is in the process of divesting tobacco stocks, following instructions from its board, which wanted a smoke-free portfolio. The giant pension fund has looked at Kraft but hasn't decided whether it wants to own it, a CalPERS spokesman says.

For investors who don't consider social criteria, does Kraft make sense?

Maybe, if you could get it at the offering price -- expected to range from $27 to $30 per share.

At a midpoint price of $28.50, most analysts and professional investors consider Kraft slightly overvalued or slightly undervalued compared with other big food companies.

But at a price greater than $30 per share, Kraft becomes a harder sell.

William Leach of Banc of America Securities is one of the few analysts commenting on Kraft. (Most analysts can't talk because nearly all of Wall Street is underwriting the megadeal).

"At $28.50, the shares would appear to be valued at 17.3 times estimated 2001 cash earnings per share of $1.65, and 9.9 times estimated 2001 EBITDA (earnings before interest, taxes, depreciation and amortization). That compares to our food group average of 18.3 times cash EPS and 10.8 times EBITDA," he says.

Even though Kraft looks a tad undervalued, Leach rates the stock "market perform" or neutral. He expects it to hit $33 within a year, a solid but unspectacular gain.

"This is not a double-your-money idea. This is not Krispy Kreme," he says. "This is the world's second-biggest food company" after Nestle.

In the United States, Kraft is No. 1, and that is precisely what attracts some investors.

"There has been a refocus on brand and quality in the IPO market. And Kraft is one of the premier brands here and abroad," says Steve Tuen, an analyst with IPO Value Monitor.

In its prospectus, Kraft boasts that it has seven brands that each generate more than $1 billion in annual sales -- Philadelphia, Nabisco, Oscar Mayer, Kraft, Maxwell House, Jacobs and Post.

Tuen admits that most of these brands are "mature, but there's enough of a discount there to warrant purchasing the stock."

Merrill Lynch analyst Leonard Teitelbaum says Kraft doesn't lookundervalued at all.

"This thing is coming out on the high end of my comfort zone," he says.

At $30 per share, he says Kraft would sell for 24 times this year's expected earnings compared with a price/earnings ratio of 18 for the food group.

"If we look at an enterprise value-to-EBITDA, the food group is selling at about 7.4 times and Kraft is coming closer to 10," Teitelbaum says.

Some people say Kraft deserves a premium valuation because it is a market leader that can increase profits at a faster rate than revenues.

"From 1996 to 2000, it had improved its gross margins, operating margins and EBITDA on a steady basis," says Melanie Hase, an analyst for the IPO Plus fund.

During the next three years, the company expects revenues to grow to 3 to 4 percent annually, and net earnings will grow 18 to 22 percent per year -- largely because of cost savings resulting from its December 2000 purchase of Nabisco, Hase says.

Also, Kraft will use the proceeds from its IPO to repay money it borrowed from Philip Morris to buy Nabisco, and that will reduce its interest costs.

But Banc of America Securities' Leach says Kraft's earnings projections are overly optimistic, considering that Nabisco accounts for only 17 percent of its revenues.

He says Kraft expects its cash earnings to grow 15 percent annually during the next few years, compared with less than 5 percent historically. Leach says 9 percent is a more likely target.

Some analysts say Kraft will trade at a discount to its full value because of its lack of voting control and the "tobacco taint."

"We believe that investors are likely to apply a 5% to 10% discount on Kraft's equity to reflect tobacco-related risk," writes analyst Romitha Mally of Goldman Sachs. "In the worst-case scenario, if Philip Morris Companies . . .

go bankrupt owing to tobacco liabilities, it could be forced either to sell its Kraft shares in the open market or transfer its shares to litigants, which could create significant overhang."

In the prospectus, Philip Morris admits that a forced sale of its Kraft stock is possible. But "because Kraft Foods Inc. and its subsidiaries are separate corporations that have not engaged in the business of manufacturing and selling cigarettes, we believe that the risk that our assets could be attached to satisfy these liabilities is remote."

Of interest to income-oriented investors, Kraft expects to pay an annual dividend of 52 cents per share. At a share price of $28.50, that's a 1.8 percent dividend yield -- compared with 1.3 percent for PepsiCo, 1.2 percent for Quaker Oats and 2.6 percent for General Mills.

"Ultimately, it's going to be slow, plodding and predictable," says Kyle Huske, market analyst with IPO.com. "For a lot of people, that will be appealing."

http://sfgate.com/cgi-bin/article.cgi?f=/c/a/2001/06/12/BU137635.DTL

This article appeared on page C - 1 of the San Francisco Chronicle