Buffett Bashes Kraft's Cadbury Buy: 'I'd Vote No'

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When it comes to mergers and acquisitions, Warren Buffett is truly a master of the universe. While other M&A machines have faltered or even crashed -- Tyco (TYC), for example -- Buffett's Berkshire Hathaway (BRK.A) continues to grow.Buffett is also not afraid to speak his mind when he dislikes a transaction, especially for one involving a portfolio company. This has certainly been the case with Kraft's (KFT) $19.5 billion deal for Cadbury (CBY). Buffett is Kraft's largest shareholder, with a hefty 9.9% stake.

On Jan. 5, Buffett said he wanted fewer shares issued for the deal; Kraft complied by boosting the cash portion to 60% of the offer. But this week, in an interview on CNBC, Buffett called the transaction a "bad deal" and said he "feels poor" in its aftermath. In fact, he said he would vote "no" on the deal. But he won't get the chance to, because there are not enough shares involved to trigger a shareholder vote.

Why the displeasure? Well, it goes to Buffett's M&A approach. Here's a look at some of his core principles:
  • Think like an investor: When buying a company, you need to look at the potential returns that you can make on other investments. Moreover, you need to go beyond the financial statements and dig deep. What are the intangible assets, like the brands? Can the company create long-term value? Ultimately, you need to find a company's intrinsic value. According to Buffett's 1992 annual letter, this is "the only logical way to evaluate the relative attractiveness of investments and businesses."
  • Make friendly deals: Management and the rank-and-file employees are critical for success. But if an acquirer forces a deal, the seller may be less inclined to engage in teamwork.
  • Avoid deal fever: Investment bankers can be quite convincing, and get CEOs excited about doing deals which may turn out to be duds.
  • Structure matters: What are the tax consequences of the deal? Are your company's shares undervalued and as a result, not a good currency for doing a deal?
Next, let's apply these principles to the Cadbury acquisition and see how it measures up.

On its face, the valuation for Cadbury looks reasonable in light of the company's assets. Its brands include Halls, Trident, Dairy Milk, Créme Eggs, Dentyne and Halls. It also has an attractive footprint in emerging markets, so it's poised for long-term growth.

Based on the latest financials, the Cadbury valuation comes to roughly 13 times earnings before interest, taxes, and depreciation (EBITDA). This is a relatively low comparable valuation over the past decade. Just look at the $23 billion Mars-Wrigley deal in 2008, which was valued at 18.5 times EBITDA. Ironically, Buffett provided a $2.1 billion equity infusion for the transaction.

So why is Buffett concerned about the valuation of Cadbury? As should be no surprise, he has done deeper analysis; his conclusion is that the true valuation is 17 times EBITDA. To get to this number, he has factored in his discount for the undervaluation of Kraft's shares. He also believes that the $3.7 billion sale of Kraft's pizza business -- to raise cash -- was problematic. The division had negligible tax basis, which means the sale will require sending a large check to the IRS. In fact, he pegs the valuation of that deal at a paltry 9 times EBITDA.

But even taking those aspects of Buffett's analysis into account, doesn't the Cadbury deal still seem reasonable? This is where you need to look at the touchy-feely issues. In transformative acquisitions, corporate cultures matter. Cadbury was founded 186 years ago and is a quintessential part of Britain's heritage. Management and the rest of the employees don't want to lose their independence to a global conglomerate. And they no doubt expect that job losses will be concentrated on the Cadbury side.

There is already evidence of the "optics" of the cultural differences. When the conference call to announce the transaction was made on Tuesday, no one from Cadbury was on it. This doesn't bode well, given the huge challenges of integrating two global operations, and cultural issues are often magnified in cross-border deals.

However, the adrenaline rush of deal-making and the desires of investment bankers can push such deals to completion. This is what Buffett suspects may have occurred: In the CNBC interview, he noted that the bankers and advisers will likely scoop up $390 million in fees.

Of course, Buffett is far from perfect, but his judgments are often spot-on. Kraft appears to be taking a leap on this deal; it will have much to prove over the next few years.
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