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The Dow Dumped Kraft Foods Inc, Should You?

On September 14th the Dow Jones Industrial Average announced that it was dropping Kraft Foods Inc (NASDAQ:KFT) from its index of 30 companies intended to capture the daily price performance of the entire U.S. stock market and replacing it with health insurer UnitedHealth Group Inc. (NYSE:UNH). Ironically, Kraft was added to the index in 2008 to replace an insurer of a different color: American International Group. Kraft’s portfolio of packaged food products is wide-ranging: Oreo, Nabisco, Oscar Mayer, Trident, Maxwell House, and Cadbury among many others. The company currently stands at a market capitalization of just over $70 billion. It has underperformed the market this year with only a 7% return, but its low sensitivity to the broader market (beta of 0.3) has paid off for investors in the past as well. Kraft is actually 15% above its price from five years ago, while the S&P 500 hasn’t gotten back to breaking even.

Warren Buffett portrait

The Dow’s decision, which may be partly due to Kraft’s plans to spin out its global snacks business, comes following a quarter in which Warren Buffett’s Berkshire Hathaway sold 25% of its stake in Kraft. This was the fifth quarter in a row that Berkshire had sold shares on net, but it still owned 59 million shares at the end of June (representing a position worth $2.3 billion at that time). Find stocks that Warren Buffett has been buying. Berkshire was also by far the largest holder of Kraft stock out of all the investors in our database of 13F filings. Nelson Peltz’s Trian Partners also had a large position in Kraft, owning 10.5 million shares, but it too had reduced that position during the second quarter (see Nelson Peltz’s stock picks). Billionaire Ken Griffin’s Citadel Investment Group, however, thought the stock was a buy as it added shares and closed the quarter with 2.5 million shares in its portfolio (research more moves that Citadel has been making).

Kraft’s revenues took a hit in the second quarter of 2012 but the company’s gross profits ended up almost exactly even compared to the same period in 2011. Other expenses also fell and so Kraft was able to report a small increase in net income (and, therefore, in earnings per share). These gains built upon a first quarter of the year that was about even with the first quarter of last year. Kraft has seen operating income growth in both Europe and in developing markets as well as in the U.S. It now trades at 20 times trailing earnings. Earnings per share are expected by the Street to grow 6% in 2013 over this year, and the forward P/E is 15. Kraft’s attractiveness as a defensive stock is buttressed by its decent 2.9% dividend yield to accompany its fairly weak correlation with the broader market.

Kraft can be compared to fellow food manufacturers ConAgra Foods, Inc. (NYSE:CAG), H.J. Heinz Company (NYSE:HNZ), and The Hershey Company (NYSE:HSY). These companies have a wide range of trailing P/E multiples, from 9 at Hershey to 23 at ConAgra, and their forward multiples are only slightly less diverse: 12 for ConAgra, 15 for Heinz, and 18 for Hershey. All three of these peers showed little change in revenue last quarter compared to a year earlier. They also are all defensive stocks as Kraft is, with their betas in the 0.4-0.5 range and paying dividend yields that are in the same ballpark as well. We do think that Kraft looks a bit overpriced at current multiples, and we can see why Buffett is selling. We aren’t sure how to interpret the fluctuating P/E multiples for ConAgra and Hershey; those might require more research, though if ConAgra is in fact trading at 12 times next year’s earnings it is likely the best value. Heinz is only narrowly lower-valued than Kraft and is a considerably smaller business, so Kraft may well deserve its small premium there.

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