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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 212846  
Subject: Re: why kraft? Date: 2/24/2008 8:46 AM
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In short, the company is debt heavy, with low single digit top line
expectations, pressure on margins from commodities, and uncertain plan for
margin improvement. I know I'm missing something - opinions?


I agree that it isn't all that obvious to me, but that doesn't mean much.

One possible thought:
One of the best single predictors of longer run future returns is
historic growth in book value per share, which for Kraft has been
running around 10% since their 2001 listing. I like the way that
Value Line calculates it, being the smoothed average of rolling 5
year periods. For example, the average of the 99-04 and 00-05 book
growth rates was 13.3% per year, but a bit slower lately.
Meanwhile, the price has pretty much gone net nowhere--a couple of
percent per year, barely more than the dividend, despite a lot of
shares having been repurchased. In effect, the book value growth
rate was probably much higher, since the over 10% of shares which
were repurchased at prices above book value decrease reported book value
per share, even though they may increase intrinsic value per share.
If these two trends (high book growth and low price growth) remain true
long enough, the stock is at some point an extremely good deal.
It would appear that Berkshire has spotted some sort of crossover point,
where the margin of safety has become irresistible. There is certainly
a lot of unassailable brand value, and who knows, perhaps some untapped
pricing power, in tune with your comments about a margin trough.

The debt is high, but not unsustainable. A good rule of thumb is
total debt less than 5 years' profits makes for a conservative balance
sheet. As you point out, they owe a lot, but it isn't wildly out of
proportion: they would be running at around 7.8 years, which isn't
exactly running on the ragged edge of overleverage. This is about
as sustainable as a business can get, and I have little doubt that
they will still be around in a century. Leverage is sensible if it
is not anywhere near enough to cause a risk of distress. So long
as interest is tax deductible, prudent returns per share are often
maximized at the highest gearing that is absolutely safe and sustainable.

Historically, the stocks that I buy and understand why they should
do really well in the next few years have substantially underperformed
the stocks that Berkshire buys and for which I do not understand
the reasoning behind the purchase (except for Berkshire itself).
Based on batting average, the odds favour Kraft being worth four times
as much per share in a decade on an NPV total return basis, even if
I don't really know why. I'm OK with that---a new learning opportunity!

Jim
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