The Rational Walk
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Rosenfeld Defends ‘Transformational’ Cadbury Acquisition September 16, 2010

In an exclusive interview today on Bloomberg  Television, Irene Rosenfeld, CEO of Kraft Foods, strongly defended the company’s acquisition of Cadbury which closed earlier this year.  Ms. Rosenfeld believes that investors who remain skeptical regarding the acquisition will eventually be won over as projected synergies appear in financial results.  Skeptical investors include Warren Buffett who opposed the acquisition and “felt poorer” based on the terms of the deal.  Mr. Buffett has reduced Berkshire Hathaway’s stake in Kraft in the months since the Cadbury acquisition closed.

Ultimately, executives respond to incentives.  In Ms. Rosenfeld’s case, her compensation plan rewarded her for pursuing and closing the Cadbury acquisition despite using questionable tactics to fund the deal including disposing of a profitable pizza business in a very tax inefficient manner.

Here are a few excerpts from the interview:

On the Acquisition of Cadbury

“We are as excited today about the Cadbury acquisition as we were when we made the initial offer. It is transformational for the company. It sets us up on a very different growth trajectory both in terms of the categories for which we participate, higher growth categories like snacks, the opportunity to have a broader geographical footprint, particularly in developing markets and opportunities to have more participation in faster growing immediate consumption trade channels.”

On Winning Back Investors

“I think a number of our investors have some skepticism about the synergies assumptions that will come as a result of combining the two companies. I believe that one of the core competencies of Kraft has been our ability to generate synergies as we have combined companies we bought. “ “I think the challenge is just as we deliver the synergies, I think our investors will continue to feel good about the company.”

On Warren Buffett’s Objection to the Acquisition of Cadbury

“We set out a strategy to transform the company in terms of the categories in which we participate, in terms of the geographic footprint, and Cadbury is a critical piece of that puzzle as I had laid it out for all of our investors. We believe that this would set us up on a new growth trajectory. Warren Buffett has said on many occasions that he is concerned about synergies, he’s a little skeptical about the ability to generate synergies and when a company makes an acquisition, he buys two cards, one is a congratulatory card the other is a sympathy card. I feel quite comfortable that we will receive a congratulatory card in the not too long of period of time.”

On whether Rosenfeld has talked to Buffett Since Acquisition

“I have contact with Warren as I do with all of our investors. I understand that he liked our pizza business. We liked our pizza business very much but as we look at our long-term growth strategy, and the opportunity to expand it beyond North America, we made the decision it did not belong in our portfolio long term.”

“I have enormous respect for Mr. Buffett as I do for all of our investors. I understand there is skepticism about our ability to realize value from a combination of Kraft and Cadbury and I think time will tell, as we deliver against the targets we have laid out, I think we will make our case quite clearly.”

The full interview appears below.

For RSS Feed Subscribers, please click on this link to view the video.

Disclosure: No position in Kraft. Author owns shares of Berkshire Hathaway.

Berkshire Hathaway Reduced Kraft Position During First Quarter May 17, 2010

Buffett Kraft

Warren Buffett was highly critical of Kraft’s acquisition of Cadbury throughout the takeover process.  It is therefore not entirely surprising to learn that Berkshire Hathaway cut its stake in Kraft by nearly 23 percent during the first quarter. It is not common for Mr. Buffett to openly criticize managers so it was all the more notable to hear him say that the deal made him feel poorer, particularly due to the “dumb transaction” involving the sale of Kraft’s pizza business to fund part of the acquisition.

In a 13F Filing with the Securities and Exchange Commission this afternoon, Berkshire reported holding 106.7 million shares of Kraft as of March 31, 2010 compared to nearly 138.3 million shares on December 31, 2009.  In addition to the sale of Kraft shares, Berkshire liquidated shares in several other companies and added to positions in three companies.  No new positions were initiated during the quarter.  Let’s take a brief look at the Kraft sale and other transactions revealed in today’s report.

Why Sell if Kraft is Still Undervalued?

The reason we stated that the sale of Kraft shares was not “entirely surprising” is due to Warren Buffett’s longstanding preference for dealing only with managers who can be trusted to exercise good business judgment.  With wholly owned subsidiaries, Mr. Buffett is looking for good operational managers who can run their businesses well but he handles all capital allocation personally.  This is not the case with minority stakes in public companies.  Mr. Buffett quite clearly believes that Kraft CEO Irene Rosenfeld is incompetent in capital allocation, although he has said that she is a capable operational manager.

What makes the size of the reduction somewhat surprising is that Mr. Buffett still believes that Kraft is undervalued on a component part basis.  According to several accounts of notes taken at the Berkshire Hathaway annual meeting (for example, click on this link for The Inoculated Investor’s notes), Mr. Buffett quite clearly stated that Kraft is undervalued.  The implications of a large sale is that the degree of undervaluation may not represent enough of a margin of safety to protect against future incompetence in capital allocation.  Of course, Berkshire continues to own a large stake in Kraft even after the sales during the first quarter.

Other First Quarter Portfolio Changes

During the first quarter, Berkshire eliminated positions in Wellpoint, United Health Group, Travelers, and SunTrust Bank.  Both individually and in aggregate, these were relatively small positions for Berkshire and from the prior 13F report, it appears that the Wellpoint and United Health stakes were most likely positions controlled by GEICO’s Lou Simpson.

In addition to Kraft, positions that were reduced but not entirely eliminated include CarMax (3.4% reduction), Costco (17.5% reduction), Gannett (21% reduction), Johnson & Johnson (11.9% reduction), M&T Bank (17.2% reduction), Moody’s (3.2% reduction), Conoco Philips (9.4% reduction), and Proctor & Gamble (9.6% reduction).

Berkshire added to its position in three companies:  Republic Services (30.6% addition), Iron Mountain (11.4% addition), and Becton Dickinson (16.3% addition).

In addition to the changes noted above, the latest report shows the effect of Berkshire’s acquisition of Burlington Northern Santa Fe.  The 76.8 million shares that were held as of December 31, 2009 no longer appear on the report due to the completion of the acquisition on February 12.

Due to the widespread availability of free high quality resources for viewing Berkshire’s portfolio in real time, we are no longer providing the spreadsheet that was previously posted following the 13F release.  Instead, we suggest using Dataroma’s Berkshire portfolio tracker for basic information or GuruFocus.com for more in depth coverage.

Disclosure:  The author owns shares of Berkshire Hathaway.

Kraft’s Executive Compensation Policies Reward Value Destruction March 31, 2010

Irene Rosenfeld

Kraft Foods Inc. released its annual proxy statement yesterday which serves as timely illustration of the faulty logic that compensation committees regularly use when setting executive pay levels.  As we discussed last month, compensation policies can encourage executives to pursue value destroying mergers.  Kraft CEO Irene Rosenfeld earned $26.3 million in total compensation for 2009 with significant components granted due to “exceptional leadership” that resulted in closing the Cadbury acquisition in February.  This is the same “exceptional leadership” that resulted in Warren Buffett taking a rare public stand against the actions of a manager in which Berkshire Hathaway holds minority positions.  Berkshire Hathaway is Kraft’s largest shareholder.

“Exceptional Leadership” Rewarded

The following excerpt from the proxy pertains to Ms. Rosenfeld’s actions related to the Cadbury acquisition that justified payment of the annual incentive bonus at 130 percent of target:

Led the combination of Kraft Foods and Cadbury, which transformed the portfolio into faster growing categories and geographies.  The Committee assessed Ms. Rosenfeld’s leadership in executing on the formal bid for Cadbury in November 2009 and closing this complex deal in early 2010 as exceptional; and The Committee specifically noted her commitment to financial discipline as evidenced by maintaining our investment grade rating, accretion to cash earnings in the second full year, and our current dividend.

Led the divestitures of businesses that continue to transform the portfolio.  Divested the North American frozen pizza business in the first quarter of 2010 for $3.7 billion; and Divested several slow growth small businesses during 2009 that generated approximately $0.04 of incremental EPS.

As for Ms. Rosenfeld’s base pay, the company notes that her salary is “below the size-adjusted median of the Compensation Survey Group”.  Presumably, Kraft’s larger size in 2010 following the Cadbury acquisition will result in the company being placed into a larger peer group that will lead to higher base salary recommendations in the future which would illustrate the incentives managers have to grow the size of a business regardless of returns on incremental capital.

Pizza Business Divestiture

The bonus justification associated with the divestiture of the pizza business is particularly disingenuous because the claim that the sale raised $3.7 billion completely ignores the tax inefficiencies that Warren Buffett discussed in a CNBC Interview in January:

I feel poorer. (Laughs.) Kraft, in my judgment, well just in the past two weeks there’s been two things that caused me to feel poorer. They sold a very fine pizza business and they said they got 3.7 billion for it. But, because it had practically no tax basis, they really got about 2.5 billion. They sold a business for 2.5 billion that Nestle is willing to pay 3.7 billion. Now can Nestle run it that much better than Kraft? I doubt it. But that business that was sold for 2.5 billion earned 280 million pre-tax last year. But they sold that at less, right around nine times pre-tax earnings in terms of their own figure.

Now they mentioned paying 13 times EBITDA for Cadbury, but they’re paying more than that. For one thing, EBITDA is not the same as earnings. Depreciation is a very real expense. But on top of that, they’ve got a billion-three they’re going to spend of various rearrangements of Cadbury. They’ve got 390 million dollars of deal expenses. They are using their own stock, 260 million shares or something like that, that their own directors say is significantly undervalued. And when they calculate that 13, they’re calculating Kraft at market price, not at what their own directors think the stock is worth. 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.

It appears that Kraft’s Board of Directors is content to embed misleading information regarding divestitures in the proxy statement in an attempt to justify a very rich pay package for a CEO who presided over significant value destruction leading the company’s largest shareholder to “feel poorer” as a result.  However, one can hardly blame Ms. Rosenfeld for her actions.  She knew that the executive compensation policies would reward this type of action and was only acting according to the incentives that the Board provided.

If shareholders of Kraft are looking for those to blame for the value destruction, they should note the members of the compensation committee at Kraft and vote their proxies accordingly:

The compensation committee members during 2009 were Ajaypal S. Banga, Myra M. Hart, Lois D. Juliber, Mark D. Ketchum, and Deborah C. Wright.

Alternatively, shareholder can vote with their feet by selling their shares.  If the company’s largest shareholder cannot prompt common sense corporate governance, it is doubtful that smaller shareholders could achieve better results.

Disclosure:  The author owns shares of Berkshire Hathaway which owns approximately 8 percent of Kraft common stock.

Motives Behind Value Destroying Mergers February 1, 2010

Merger Cartoon

In recent weeks, Kraft’s proposed acquisition of Cadbury has generated a great deal of interest.  When an investor with Warren Buffett’s reputation characterizes the deal as making him “feel poorer”, observers might wonder what could possibly motivate a CEO such as Kraft’s Irene Rosenfeld to pursue such a transaction.

While we cannot pretend to know Ms. Rosenfeld’s motives, there are some general observations investors can make regarding the incentive systems and motivations that make value destroying mergers and acquisitions very common.  Understanding these motives can help investors avoid situations where managements seem prone to destroying value.

Compensation Systems

In most public companies, CEO compensation is set by the Board’s compensation committee.  Usually, the base pay recommendation is made by compensation consultants who evaluate the CEO pay of companies in a “peer group”.  The peer group is inevitably made up of companies with similar revenues since this is considered to be a good proxy for the complexity of the business.

The trouble with setting base compensation by looking only at revenues is that CEOs are then given the incentive to retain earnings and pursue growth for the sake of revenue growth alone.  This can be done either through unwise internal growth or through acquisitions.

The situation gets even worse when stock options are issued to the CEO without adjusting the strike price over time for retention of earnings.  Since most options have a fixed strike price that is usually set at the market value of the stock on the date of the grant along with a ten year term, a CEO can simply retain earnings in order to boost the value of the option.  In contrast, paying dividends would reduce the value of the option.  Such option plans provide every incentive for CEOs to retain earnings even if there are no profitable opportunities for expansion of the business.

Thrill of the Deal

The day to day routine in any job can become boring eventually even in dynamic industries.  It is natural for people to seek some level of “excitement” in their jobs.  When the individual in question is the CEO, it may be more exciting to get on the corporate jet and meet other executives who may wish to “do a deal” than to attend to the routine matters of running the business.

Once a deal is underway, investment bankers and other advisors with strong incentives to see the transaction occur are brought in and create a sense of “deal momentum” that can be hard to break.  Most CEOs have risen to power by being aggressive and not taking “no” for an answer.  This is usually a healthy attribute but can lead to economically harmful deals when other psychological factors are at work and legions of advisors are pushing for the deal to occur.

Ego and Legacy

Most executives who reach the top have a healthy ego and would like to be remembered as great business leaders long after they retire.  This can be a healthy attribute and can lead to excellent performance if the energy is directed in a productive way.  However, the desire to be famous and well respected can lead to value destroying deals.  The temptation offered by doing deals that result in photos on the front page of the Wall Street Journal can be hard to resist.

Start Modifying Incentives with Compensation Reform

Of the factors discussed in this article, compensation systems are likely the easiest to modify in a way that discourages value destroying mergers and acquisitions.  By tying base compensation and bonus to per-share intrinsic value creation rather than simply looking at revenue growth, management incentives can be aligned with shareholder interests.  Stock option plans with a strike price that adjusts for retention of earnings would also be a vast improvement.  Unfortunately, there are few signs that such reforms will gain traction anytime soon.

Buffett “Feels Poorer” Based on Terms of Cadbury Deal January 20, 2010

Cadbury

If Kraft CEO Irene Rosenfeld was hoping for a public vote of confidence from Warren Buffett, she is surely disappointed this morning.  Perhaps not surprisingly based on his unusual public criticism of Kraft on January 5, Mr. Buffett says that he “feels poorer” in light of Kraft’s richer bid for Cadbury and he disagrees with the decision to shed a highly profitable frozen pizza business to provide funding for the deal.

The statement today in a CNBC interview prior the special meeting of Berkshire Hathaway shareholders clearly refutes yesterday’s Wall Street Journal article which cited an unnamed source within Kraft who indicated that Mr. Buffett was “totally supportive” of the new terms.

Mr. Buffett also comments on a number of topics including the Obama Administration’s proposed bank tax, stating that he does not believe that banks are making “obscene profits” and companies that have already repaid TARP funds should not be forced to effectively pay for bailouts at Fannie Mae and Freddie Mac.

Other topics covered include the Berkshire Hathaway Class B stock split, Wells Fargo’s results, executive compensation, and Ben Bernanke’s prospects for a second term as Federal Reserve Chairman.  In addition, Mr. Buffett is not planning to increase Berkshire’s stake in Posco at this time and indicated that reports yesterday to the contrary may have been due to a misunderstanding with Posco’s CEO due to language translation.

CNBC Interview: Part One

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CNBC Interview:  Part Two

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The author owns shares of Berkshire Hathaway.