Kraft’s (KFT) Dividend Hurting Valuation

November 10th, 2010 by hackel Leave a reply »

When Kraft (KFT) released its balance sheet and income statement when reporting its fiscal third quarter last Thursday, it did so without a corresponding statement of cash flows. In its place, including during the ensuing conference call, Chairman Rosenfeld redundantly pointed to operating earnings without a single mention of cash flow, unusual given the heavy reliance by investors on the dividend. Operating earnings do not represent distributable cash flows, among other reasons, it is reported prior to interest expense, which is hefty for Kraft.

In its 10-Q, Kraft also did not provide a statement of cash flows for the 3-month period, instead providing a 9-month year-to-date report.

Thus, the need to construct a statement of cash flows, which I have done in Table 2 below.

Kraft supplied all the data necessary for such construction, with depreciation and stock-based compensation being half the six-month entry of the June 10-Q. As seen, Kraft generated just $445 MM in cash flow from operating activities during its most recently completed quarter.  Deferred income taxes would have been off in estimation by taking the balance sheet changes, but the amount would have been insignificant when taking into account the lower interim effective tax rate versus earlier quarters and lack of any large investment or financing activity.

I found it interesting that Kraft continued to sell assets ($342MM) even though total debt remained about constant. This reinforces CT Capital’s cash flow analysis of zero free cash flow being created, after dividends and interest.   I would further expect that during the coming quarter, Kraft will work its balance sheet, providing cash, but would also expect them to step up pension contributions which would overwhelm that benefit.

Table 1 below shows the effective tax rate (that is reported to shareholders) versus the cash taxes actually paid, during the past 5 fiscal years.  Kraft has historically been in a relatively high cash tax rate, which, for most firms runs below the effective rate.  Given Kraft’s interim 3rd quarter was below its prior two quarter’s effective rate, I would expect some reversal, which will slightly impact cash from operations.

Table 1: Reported Versus Cash Taxes Paid-Kraft Inc.

All in all, Kraft is being managed to pay the dividend and leverage. The current quarterly dividend requirement jumped by $92MM (or $370MM/yr.) as a result of the Cadbury acquisition, which was not met during the final quarter from operations.

It is my opinion current management has bet their careers on the Cadbury buyout, thus the strong defense of the purchase during the conference call; it is thus doubtful the dividend, a board decision, will soon be cut. However, it is difficult to suppose the firm’s prospects would not be enhanced if it were to do so. If the $370MM a year additional dividend requirement were available, Kraft’s frozen pizza business would not need to have been sold-its operating segment, convenient meals, reported over $1 billion in operating income and most likely at least half of that represented free cash flow -its cash- based return on invested capital (ROIC) was thus much great than Cadbury. No wonder Warren Buffet was upset-and so too should shareholders.

In sum, CT Capital’s cash flow work shows greater opportunities lie elsewhere than an investment in Kraft shares represents. For example, Intel (INTC) has a slightly lower yield but higher free cash flow-based ROIC and quite lower cost of capital.

Table 2: Statement of Cash Flows- Three Months Ended September, 2010

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Disclosure: No positions

Kenneth S. Hackel, CFA
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” (McGraw-Hill, 2010).


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