Kraft Foods Vs. Mondelez: Which Should Investors Pick After the Split?

In the financial world, corporate execs use a variety of tactics to stimulate the creation of shareholder wealth.  One of the most undocumented and underappreciated methods is the stock spin-off.  Occurring when a large company wants to free its most entrepreneurial departments from an administrative glut, the spin-off organization is usually swifter and smaller in size, though this is not always the case.  Kraft Foods (NYSE: KFT) announced last year that it would split up its North American grocery and global snack businesses, keeping the former under its control, and renaming the latter Mondelez International with the ticker MDLZ.  This move will be completed by December 2012.

As is the case with most splits, each company will have its own CEO, Board of Directors, and departmental structure.  Unlike most examples, however, the newly created Mondelez is the larger operation, as it is estimated to be worth $32 billion.  Kraft Foods’ North American grocery outlet, meanwhile, is worth half that at $16 billion.  Aside from the distinct differences between KFT and MDLZ that will be discussed below, it’s worth looking at the historical performance of spin-off stocks.

Since the recession, we’ve seen break ups between ConocoPhillips (NYSE: COP) and Phillips 66 (NYSE: PSX), ITT (NYSE: ITT) and Exelis (NYSE: XLS), and Tyco (NYSE: TYC) and Covidien (NYSE: COV) to name a few.  For more about the bullish potential of Conoco.   Historically speaking, spin-offs have: (1) outperformed the market, (2) been underrated by the Street, (3) been undervalued immediately following the split, and (4) have been directed by highly motivated leaders with a fresh take on managerial tactics.  Using the past 45 years of market data, these newly formed subsidiaries have outperformed the market by an average of 19.4 percent in the twelve months following the spin-off date, according to the empirical studies of Purdue faculty members McConnell and Ovtchinnikov.  Moreover, they found that this return is amplified 24 months following (24.4%) and 36 months following (26.32%) the spin-off.

Aside from this pragmatic reasoning, there are a few other factors that should make investors giddy about Mondelez.  As mentioned above, MDLZ is a $32 billion business, and is expected to be a low-margin, high-growth stock.  Much like its name, which means ‘delicious world’ in Spanish, the company will focus on fine-tuning its existing snack products to appeal to the world marketplace.  Upon its inception, Mondelez will possess four $1 billion brands: Oreo, Milka, Cadbury, and Trident.  In 2011, this fab four achieved a global growth of 12 percent, led by sales in China (+30%) and Brazil (+15%). MDLZ will also be able to focus on developing products to specific regions of the world; for example, it is already developing a heat-resistant chocolate that can be safe from melting in hot climates.  Moreover, the company is also testing different flavors of its Oreo and Ritz crackers for distribution in different markets.  Income investors can take solace in the fact that MDLZ is also expected to offer a dividend yield between 2 and 3 percent.

Kraft Foods’ North American grocery, meanwhile, gives investors what MDLZ does not – lower growth with higher margins.  KFT will be keeping its Nabisco, Oscar Meyer, Philadelphia, Planters and Tang brands, though it’s worth noting that all of these products are artery clogging.  See, KFT does not currently offer any health food options, though management is preparing a few new lines post-split.  Currently, execs are most excited about Planters NUTrition peanut butter, which is currently in R&D.  This line of peanut butter will contain nuts and fruits, while costing nearly 50 percent more than its traditional spread.  It is believed that consumers will pay a premium for healthy goods, a view supported by the success of grocers like Whole Foods (NASDAQ: WFM).

On the downside, Kraft’s North American grocery outlet is facing quite a few economic headwinds, including: (1) lower-priced private label competition, (2) higher commodity costs, (3) higher fuel costs, and (4) efficiency losses following the split.  If KFT is only relying on a healthy peanut butter to drive away these worries, it will be a sad state of affairs.  Aside from this, the company may consider its beverage division – that which is responsible for Capri Sun, Crystal Light and MiO – to be its ace in the hole.  Currently, the company’s beverage sales account for only 1 percent of the U.S. market share, though they have grown by over 10 percent each year since the recession.

While valuation metrics include MDLZ in their computation, its worth noting that shares of KFT are essentially fairly valued, with a P/E ratio (18.9X) right on its 10-year historical average (19.0X), and close to the industry average (21.3X).  Moreover, it currently trades at a PEG ratio of 1.4, which is above competitors like Nestle SA (NASDAQOTH: NSRGY.PK) and Unilever PLC (NYSE: UL), but below Sara Lee (NYSE: SLE) and General Mills (NYSE: GIS).  Bears may point to moderate earnings and revenue growth in the first quarter of 2012, though it’s worth noting that sales volume stayed relatively flat, as price markups were implemented across the board.  This is not a particularly desirable combination for long-term prosperity.  Additionally, free cash flow has shrank by almost 30 percent post-recession, though investors have paid no mind, as KFT currently sports a P/CF ratio (14.3X) above the industry average (14.1X) and its own 10-year historical average (14.2X).

All in all, it would be wise for growth hunters to consider buying into Mondelez immediately following the split later this year, while Kraft is more of an uncertain investment at the moment.  One strategy that may prove useful is pairs trading, by going long MDLZ and short KFT.

Disclosure: The author has no holdings in the stocks mentioned in this article and has no plans to initiate any positions within the next 72 hours.  He does, however, have the intention of rating these stocks on, a social media website where investment ideas are shared openly and free.

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