kraft valuation final product - texas tech...
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Valuation Analysis
Analysis Group
Oscar Aguilar
Ryan Arrington
Dusty Burkett
Brian Byrne
Mark DeCourcy
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• Executive Summary………………………………………………………………….7
o Industry Analysis ………………………………………………………………………………9
o Accounting Analysis………………………………………………………………………….10
o Financial Analysis, Forecasting, and Cost Estimations………………………….12
o Valuation Executive Summary……………………………………………………………14
• Business Overview…………………………………………………………………15
• Industry Overview………………….………………………………………………16
• Five Forces Model……………..……………………………………………………17
o Competitive Force 1: Rivalry among Existing Firm……………………….…….18
Industry Growth…………………………………………………………………...18
Concentration and Balance of Competitors……………….……………..20
Degree of Differentiation ……………………………………….………………21
Switching Costs…………………….………………………………………..…….23
Scale Economies …………………………………………………………………..23
Excess Capacity………………………………………………………………….….24
Exit Barriers…………………………………………………………………………..25
Conclusion…………………………………………………………………..…….….26
o Competitive Force 2: Threat of new entrants……………………………….…….26
Economies of Scale ……………………………………………………………..27
First Mover Advantage …………………………………………………….…….28
Distribution Channels …………………………………………………………..29
Legal Barriers …………………………………………………………………….30
Conclusion……………………………………………………….……………………31
o Competitive Force 3: Threat of Substitute Products…………………………….32
Specific Competitors………….……………………..……………………………32
Relative Price and Performance…………………………………………..…..32
Customers Willingness to Switch.………………………………………..…..33
Conclusion…………………………………………………………………………….34
o Competitive Force 4: Bargaining Power of Customers…………………..……..35
Switching Costs……………………………………………………………………..35
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Differentiation……………………………………………………………………….36
Important of product for cost and quality…………………………………37
Number of Buyers………………………………………………………………….37
Volume per Buyer………………………………………………………………….38
Conclusion……………………………………………………..…………….……...38
o Competitive Force 5: Bargaining Power of Suppliers………………….…..…..39
Switching Costs………………………………….………………………….….….39
Differentiation……………………………………………………………….….….40
Importance of Product for Costs and Quality……….…………….….…40
Number of suppliers…………………….………………….………….…………41
Volume per supplier……………………………….………………….…….……41
Conclusion….…………………………………………………….…….……………41
o Conclusion to five Forces Analysis…………………………..……….…………..….42
• Key Success Factors……………………………………………………………….42
o Cost Leadership………………………………………….……………………………….….43
Economy of Scale and Scope………………………………….………..…….43
Simpler Product Designs…………………………………….…………………..44
Efficient Production………………………………………………………………..45
o Differentiation……….…………………………………………….………………………….46
Superior Product Quality……………………………………….………………..47
R&D Development……………………………………………………………….…47
Enhanced Brand Image………………..………………………………..………48
Conclusion……………..………………………………………..……………………49
• Competitive Advantage…………………………………………..…………….…49
o Cost Leadership…………………………………………………..….……………………...50
Economies of Scale…………..…..……………………………………….………50
Efficient Production………………………………………………..….…………..51
Simpler Product Designs………………………………………………………...52
Low-Cost Distribution……………………………………………………………..52
Research and Development……………………………………………..……..53
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o Differentiation……………………………………………………………………….………..53
Research and Development…………………………………………………....53
Enhanced Brand Image……………………………………………………..…..54
Superior Product Quality………………………………………………………...55
o Conclusion…………………………….……………………………………………..….……..55
• Accounting Analysis…………………………………………………………….….56
o Key Success Factors…………………………………………………………………………57
Economies of Scale………………………………………………………………..57
Investment in brand Image…………………………………………………….61
o Key Accounting Policies…………………………………………………………………….63
Goodwill……………………………………………………………………………….64
Research and Development…………………………………………………….65
Pension Plan………………………………………………………………………….66
Defined Medical Benefits…………………………………………………………68
Operating vs. Capital Leases……………………………………………………70
Currency Exchange and Commodity Price Risk Management………71
Conclusion…………………………………………………………………………….73
o Accounting Flexibility……………………………………………………………………….73
Goodwill……………………………………………………………………………….74
Research and Development…………………………………………………….75
Pension Plans………………………………………………………………………..76
Operating and Capital Leases………………………………………………….78
Currency Exchange and Commodity Price Risk Management………80
Conclusion…………………………………………………………………………….80
o Accounting Strategy…………………………………………………………………………81
Economies of Scale………………………………………………………………..82
Goodwill……………………………………………………………………………….83
Research and Development…………………………………………………….84
Pension Plans………………………………………………………………………..85
Operating and Capital Leases………………………………………………….87
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Currency Exchange and Commodity Price Risk Management………88
Conclusion…………………………………………………………………………….89
• Quality of Disclosure and Red Flags……………………………………………90
o Qualitative Analysis………………………………………………………………………….91
Goodwill……………………………………………………………………………….91
Research and Development…………………………………………………….92
Pension Plans………………………………………………………………………..92
Operating and Capital Leases………………………………………………….95
Currency Exchange and Commodity Price Risk Management………97
o Quantitative Analysis………………………………………………………………………..98
Sales Manipulation Diagnostic Ratios……………………………………….98
• Net Sales/AR……………………………………………………………….98
• Sales/Inventory………………………………………………………….100
• Net Sales/Cash From Sales………………………………………….102
Expense Diagnostic Ratios…………………………………………………….103
• Asset Turnover…………………………………………………………..104
• Cash Flow from Ops./Op. Income…………………………………106
• Cash Flow from Ops./Net op. Assets…………………………….107
• Total Accrual/Sales……………………………………………………..108
Conclusion…………………………………………………………………………..110
• Undo Accounting Distortions…………………………………………………..111
o Goodwill Impairment………………………………………………………………………111
o Conclusion…………………………………………………………………………………….116
• Financial Analysis Forecasting, and Cost Estimation…………………….117
o Financial Analysis…………………………………………………………………………..118
o Liquidity Ratios………………………………………………………………………………118
Current Ratio……………………………………………………………………….119
Quick Asset Ratio………………………………………………………………...120
AR Turnover………………………………………………………………………..121
Days Sales Outstanding………………………………………………………..123
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Inventory Turnover………………………………………………………………124
Days Supply of Inventory……………………………………………………..125
Working Capital Turnover……………………………………………………..127
Conclusion…………………………………………………………………………..128
o Profitability Ratios………………………………………………………………………….129
Gross Profit Margin……………………………………………………………….129
Operating Profit Margin…………………………………………………………131
Net Profit Margin………………………………………………………………….132
Asset Turnover…………………………………………………………………….134
Return on Assets………………………………………………………………….135
Return on Equity………………………………………………………………….137
Conclusion…………………………………………………………………………..138
o Firm Growth Ratios………………………………………………………………………..139
Internal Growth Rate……………………………………………………………139
Sustainable Growth Rate………………………………………………………141
Conclusion………………………………………………………………………….142
o Capital Structure……………………………………………………………………………143
Debt to Equity Ratio………………………………………………………….…143
Times Interest Earned………………………………………………………….145
Debt Service Margin……………………………………………………………..146
Z-Score……………………………………………………………………………….148
Conclusion…………………………………………………………………………..151
• Cost of Equity………………………………………………………………………152
o Size Adjusted CAPM……………………………………………………………………….154
o Backdoor Cost of Equity………………………………………………………………….154
o Adjusted Backdoor Cost of Equity…………………………………………………….155
• Cost of Debt………………………………………………………………………..156
o Weighted Average Cost of Capital……………………………………………………158
o Conclusion…………………………………………………………………………………….160
• Financial Statement Forecasting……………………………………………..160
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o Unadjusted Income Statement……………………………..…………………………161
o Restated income Statement……………………………….…………………………..165
o Unadjusted Balance Sheet…………………………………….……………..………..168
o Restated Balance Sheet……………………………………………………….…………172
o Unadjusted Statement of Cash Flows………………………………………………175
o Restated Statement of Cash Flows……………………………………….…………178
• Valuation Ratios………………..…………………………………………………181
o Price to Earnings……………………………………………………………………………181
o P/E Trailing……………………………………………………………………………………182
o P/E Forward………………………………………………………………………………….183
o Price/EBITDA…………………………………………………………………………………183
o Price to Book…………………………………………………………………………………184
o Dividends to Price………………………………………………………………………….185
o Price Earnings Growth……………………………………………………………..…….186
o Price to Free Cash Flows…………………………………………………………………187
o Enterprise Value to EBITDA…………………………………………………………….188
o Conclusion…………………………………………………………………………………….189
• Intrinsic Valuation Models .……………………………………………………191
o Dividend Discount Model………………………………………………………………..191
o Discounted FCF Model…………………………………………………………………….194
o RI Model……………………………………………………………………………………….197
o Abnormal Earnings Growth Model……………………………………………………199
o Long Run Residual Income Model..………………………………………………….202
• Analyst Recommendation ……………………………………………………...207
• Appendices………………………………………………………………………….209
• Works Cited………………………………………………………………………...245
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Executive SummaryAnalysis Recommendation: Fairly Valued, Hold
As of April 01, 2009
KFT‐ NYSE (04/01/2009) $22.81 Altman Z‐scores
52 weeks Range: 20.81‐37.97 2004 2005 2006 2007 2008
Revenue: 42.2 Billion Initial Score: 2.19 2.01 2.42 1.60 3.32
Market Capitalization: 32.71 Billion Revised Scores: 2.08 1.96 2.25 1.50 1.53
Shares Outstanding: 121.2 Million Current Market Price Share: (04/01/09) $22.81
As stated Restated Financial Based Evaluations
Book Value Per Share: 15.11 N/A As stated Restated
Return on Equity: 11.2% 9.7% Trailing P/E 11.59 14.56
Return on Asset: 4.9% 1.5% Forward P/E 10.91 32.13
Cost of Capital Dividends Per Price 0.052 0.052
Estimated Adj. R^2 Beta Ke P.E.G. Ratio 1.47 1.47
3 Months 0.2661 0.7284 7.82% Price to EBITDA: 5.39 6.73
1 year 0.2654 0.7261 7.81% EV/EBITDA: 8.56 10.69
2 Year 0.2654 0.7261 7.81% Price to FCF: 11.6 11.6
5 Year 0.2646 0.7218 7.78% Price to Book: 1.47 1.47
10 year 0.2644 0.7994 8.31%
Upper Lower Intrinsic Valuations
Published Beta: 0.59 Price Restated
Estimated Beta: 0.728 Discounted Div: $6.41 N/A
Size Adj. Cost of Cap 6.84% 8.68% 5.01% Free Cash Flows: N/A N/A
Size Adj. Cost of Equity 8.52% 11.88% 5.16% Residual Income: $20.83 $1.28
Backdoor Ke 10.97% Long Run Residual Income: $20.03 $0.84
Adjusted Backdoor Ke 20.24% Abnormal Earnings Growth: $21.42 $0.92
Cost of Debt: 4.82%
WACC (BT): 6.50%
Adjusted WACC (BT): 6.12%
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Executive Summary
Industry Analysis
Kraft Foods is a food production and distribution company that became fully
independent in 2007 after finalizing a split with Altria Group. Kraft is currently the
largest company operating in the food industry in America which is represented in 99%
of households in the country, and the 2nd largest food company in the world. Their
strategy for maintaining value is based on large scale mergers and acquisitions which
includes the recent acquisition of Danone Biscuits.
Competitive Force Degree of Competition Rivalry Among Existing Firms High
Threat of New Entrants Moderate Threat of Substitute Products High Bargaining Power of Customers Moderate Bargaining Power of Suppliers Low
Understanding the industry and level of competition it maintains is the first step
to valuing a company. The food industry is dominated by Nestle which is the world’s
largest food company, and Kraft, however many smaller companies are looking to
expand. We will focus on the largest companies in the food industry which in
competition with Kraft including Nestle, ConAgra, Sara Lee, and Heinz. The food
industry is defined by its competitive nature which is best measured by Michael Porters
Five Forces Model, which categorizes different areas of competition in an industry. The
food industries high level of competition is mostly derived from the existing firms and
the constant threat of substitute products. These large existing firms compete through
the use of both differentiation and cost control, constantly looking to create a
competitive advantage that will set them apart from the rest of the industry. As
mentioned before Nestle and Kraft control the large majority of market share, over 70%
annually. This dominance is related to highly recognized name brands through
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marketing, superior products, and the ability to minimize costs through economies of
scale and scope. Suppliers of the industry have very little bargaining power because
there is a low degree of differentiation between their products. There are a few
primary customers operating in the food industry, most notably Wal-Mart and Costco,
who because of their large size and use of economies of scale maintain a relatively high
level of bargaining power. There is however an enormous number of smaller customers
which lowers the bargaining power of the major wholesale chains, giving the customers
as a whole a moderate level of bargaining power. New entrants have many barriers to
entry which ensures that they cannot quickly become competitive therefore causing
very little threat to the existing companies. Overall the food industry is highly
competitive, focusing primarily on cost control for competitive advantage, however
establishing differentiation of products and brand names has been a key success factor
for several companies.
Accounting Analysis
A very sensitive and vital component of valuing a company is the accounting
analysis. This process will reveal potential fallacies in the financial statements and
establish a benchmark of comparison that will be used to understand the reasoning
behind them. It is important to keep in mind that accounting numbers are man-made
and are used to judge the performance of the company. This creates incentive for
manipulation of the books to enhance the image of the company to investors and
analysts, which is generally the cause behind any accounting fallacies. This accounting
analysis will reveal what flexibility Kraft is given when reporting financials within SEC
boundaries, and the level of transparency they reveal relating to the actual performance
of the company.
The food industry has many regulations when reporting accounting numbers, but
has a substantial level of flexibility for the amount of information required to be
reported and the method in which this is done. Kraft has elected to respect these
regulations and has reported relatively transparent financial statements in its history.
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By taking advantage of a few key success factors, the company has effectively used its
resources to create a competitive advantage in the food industry and control a
substantial portion of the market share. The factors that we focused on include Kraft’s
strategy used in reporting goodwill, R&D, pension plan, benefit plans, operating and
capital leases, and risk management.
In our analysis we found that only goodwill area required further investigation.
Goodwill is one area that the food industry has a high level of flexibility in reporting,
and has been the source of manipulation by several companies in the past. Recently
GAAP requirements were altered in hopes of limiting the ability to manipulate the
goodwill account by implementing an annual impairment policy rather than the previous
amortizing strategy. In the past five years Kraft has recorded miniscule amounts of
impairment of goodwill, while instead expanding the account through mergers and
acquisitions. This strategy has inflated goodwill to its current level representing nearly
half of the company’s total assets. This massive intangible account was much larger
than Kraft’s competition which raised a red flag for the company giving us incentive to
restate the financial statements to include goodwill impairment.
By impairing the goodwill account we are given an idea of the true value of the
company’s assets. We chose to impair the account on a 20% annual basis for 6 years,
which we felt was the most effective approach. This had a devastating impact on many
of Kraft’s numbers noticeable on each of the three financial statements. The
impairment expense was recognized on the income statement which dropped net
income. The net income then flowed to the retained earnings account, which also
significantly dropped. Because of this, we assumed that no dividends were going to be
paid out over those years due to the lack of surplus earnings. The impairment had
such a considerable effect on the financial performance of Kraft because the goodwill
account originally made up nearly 45% of the company’s total assets.
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Financial Analysis, Forecasting Financials, and Cost Estimations
In order to successfully value a company, we must analyze the past performance
using financial ratios, attempt to forecast future financial performance, and estimate the
costs of capital. By using this information, it provides us a means to apply valuation
techniques to reasonably estimate a cost of equity.
The financial ratios provide comparable numbers that analysts can use to identify
trends and relationships within the industry. These ratios compare and contrast
liquidity, profitability, and capital structure of the firm and its competitors. The
calculation of the liquidity ratios measures the ability of a firm to meet its short term
financial obligations. For the most part, the liquidity ratios for Kraft were close to or
above the industry average. Inventory turnover is one ratio that Kraft consistently
leads their competitors in. Being in the food industry, managing inventory with
efficiency is very important because most food products have a very short life.
The profitability ratios are the next category to be done. They measure the
ability of a firm to effectively generate revenues to cover expenses. Looking at these
ratios, Kraft is consistently around the industry average with the exception of asset
turnover. Their low asset turnover can be contributed to large amounts of goodwill
compared to their competitors. After restating goodwill, Kraft’s asset turnover moves
closer to the industry average but it is still below.
The last ratio structure is the capital ratio structure. These ratios help determine
the source of financing to acquire assets to be used in the creation of revenues. Firms
can finance their assets in two ways, debt or equity financing. The ratios are also
important because they provide insight to the firms default risk, and show how the firm
is dealing with interest payments, liabilities, and financial leverage of the company.
Kraft is usually around the industry averages with a few variations in different years,
but for the most part Kraft is improving on the areas that they lagged behind in. Their
Z-Score has improved each year and they are now in a stable, liquidable position. After
computing these three categories of ratios you can determine potential growth rates
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using the sustainable and internal growth rates. Kraft’s growth rates fall below the
industry average but are more stable than their competitors. This can appeal to
investor because the risk of having a negative year is much lower.
The cost of capital explanation is the next step in this analysis. The cost of
equity and cost of debt need to be calculated before we can find the weighted average
cost of capital. Through our regression analysis, we came up with an estimated beta of
.73. Once a stable beta was found, the cost of equity can be computed using the CAPM
equation. The market risk premium of 6.8% and risk free rate of 2.87% are then
added to the equation to come up with a cost of equity of 7.82%. However, when
computing CAPM it fails to account for the market value of the firm known as the “size
effect.” Because of this, the appropriate cost of equity for Kraft based on our market
value is 8.52%. When comparing our size adjusted cost of equity of 8.52% to our
backdoor cost of equity of 10.97%, we feel that the backdoor cost of equity is a more
accurate portrayal because the size adjusted is unrealistically low. The cost of debt is
the next computation to be found by taking the weighted average of liabilities times the
interest rates given to the liability. With our cost of debt as 4.82% and cost of equity
figured using the backdoor method, we found our weighted average cost of capital
before tax and after tax to be 7.61%. Adjusting for goodwill, our restated WACC before
tax was 6.98% and 6.10% after tax.
The third part of the prospective analysis involves forecasting the financial
statement. The first and most important step in doing this is forecast sales growth,
because the rest of the forecasting is linked back to this growth rate. From our
analysis, due to the current recession we assumed a -8% sales rate in 2009 with it
steadily rising to 6.5% in the year 2018. After sales has been forecasted out, the rest
of the income statement was forecasted using some of the profitability ratios such as
gross profit margin for gross profit and operating profit margin for operating income.
We were able to connect the income statement to balance sheet though the asset
turnover ratio. Using this ratio you can obtain total assets and forecast a good portion
of the balance sheet. The statement of cash flows is the hardest to predict and the least
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precise. CFFO was first forecasted using CFFO/Sales. The trends for CFFI and capital
expenditures followed similar patterns which lead us to use CFFI/capital expenditures to
forecast CFFI as accurately as we could. We feel confident with our income statement
and balance sheet forecasts, but because of the difficulty in forecasting the statement
of cash flows we remain hesitant in our assumptions.
Valuation
In order to estimate the true equity value of a firm, we must utilize both the
methods of comparables and intrinsic valuation models. The methods of comparables
are a much simpler valuation while the intrinsic valuation models are much more
complex and accurate. This valuation attempts to estimate the correct market price as
of April 1, 2009.
First, the methods of comparables compare financial ratios of the firm such as
the price to earnings ratio and price to book ratio to the industry’s averages. This
method does have its flaws in that it prices the company solely on the performance of
its competitors. This means any competitive advantage that Kraft may have can be
overlooked if it is not involved in the ratio. Of the eight comparable ratios used, four
indicated Kraft was fairly valued, three indicated they were undervalued, and one
indicated they were overvalued. The vast variation shown in these results is the
reason that these ratios cannot be used when creating a valuation, and therefore will
not be considered in our final valuation.
Our final method of analysis and that which we will largely base our valuation on
is the implementation of intrinsic valuation models. We used the dividend discount,
discounted FCF, residual income, AEG valuation, and long run residual income models.
Although the dividend discount and discounted FCF models suggested that Kraft is
overvalued, we found that the three other models which implied fair valuing are much
more accurate and reliable. The consistency of the results had a strong impact on our
final valuation, along with previously gained knowledge to determine fair valuation.
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Business and Industry Analysis
Company Overview
Kraft Foods Inc is a worldwide manufacturer and marketer of various foods and
beverages. It is the world’s second largest prepared food and beverage company
behind Nestle. The company is currently represented in 99% of US households. Most
people would recognize Kraft’s blue Macaroni & Cheese box if one was presented to
them. Kraft is a large job producer worldwide, consisting of 103,000 men and women
who are employed with multiple benefit plans which will be discussed in a later section.
Kraft was founded in 1903 by J.L. Kraft as a wholesale cheese company in
Illinois. Kraft relies primarily on mergers and acquisitions for means of expansion, most
recently acquiring the global biscuit business of Group Danone. In 2007 Kraft became
a fully independent company after completing a spin off with Altria Group Inc. It
currently has locations in the United States, Canada, Europe, Latin America, the Asian
Pacific, and Africa. Kraft’s segmentation is divided into two operating segments: Kraft
North America and Kraft International. Kraft North America is divided into five sections:
Beverages, Cheese & Foodservice, Convenient meals, Grocery, and Snacks & Cereals
(www.kraft.com).
% Change in Sales from Previous Year 2004 2005 2006 2007 2008Kraft 4.27% 5.48% 6.05% 0.71% 8.40%
(In millions) 2004 2005 2006 2007 2008Total North America revenues $20,937 $22,060 $23,293 $23,118 $23,939 Total Foreign Revenues $9,561 $10,108 $10,820 $11,238 $13,302 TOTAL NET REVENUE $30,498 $32,168 $34,113 $34,356 $37,241
The two tables above display Kraft’s percentage change in revenues from year to
year on a five year history, and the total revenues from the North American sector and
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the foreign sector of operations for Kraft Foods Inc. It can be seen that Kraft is a
relatively steady growing business, and much of the growth of the firm is attributed
from the foreign markets in which it operates.
Percentage of total net revenues reported in Kraft International:
Kraft International: 2003 2004 2005 2006 2007 2008 European Union 17% 14% 15% 12% 13% 10% Developing Markets(1) 7% 5% 8% 9% 11% 13%
Kraft International is managed by geographic location due to the large number of
countries in which it is represented. Currently, Kraft has operations in 70 countries, and
does business in 150 countries. In 2007, 42% of revenue reported by Kraft was from
the constantly growing international division according to the company’s 10K.
Industry Overview
Kraft Foods Inc competes in what we will call the food industry which is often
referred to as the “Foods-Major Diversified Industry”, or the “Processed and Packaged
Foods Industry”. The food industry includes a vast number of markets such as frozen
pizza, microwaveable goods, beverages, and many others. For the sake of this analysis
only those companies whose operations expand over multiple markets will be
considered. The majority of the current market share is dominated by a handful of large
corporations which this analysis will focus on. These consist of Kraft’s largest
competitors: Nestle, Heinz, ConAgra, and Sara Lee.
Although Nestle and Kraft control a large portion of the market share, the other
firms in the food industry force them to maintain competitive prices and provide
alternatives for customers. The target customers of food industry companies are food
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wholesalers and retailers. The dominant food retailer that has emerged for the industry
is Wal-Mart, who has forced most of its competitors to vastly decrease scale of
operations. However, the food industry also makes sales to convenience stores, gas
stations, and any other company that sells food goods.
Five Forces Model
In order to properly value a firm, one must have a grasp of the procedures and
standards of the industry in which that firm operates. Understanding how firms are
competitive and in what areas of business each of those firms focuses helps an investor
or analyst grasp the real success of a specific firm. Currently the best way to create this
understanding is through the use of the five forces model. This model which was
created by Michael Porter narrows business down to five forces: 1. Rivalry amongst
existing firms, 2. Threat of new entrants, 3. Threat of substitute products, 4. Bargaining
power of customers, 5. Bargaining power of suppliers. This model provides a powerful
tool in discovering the level of competition within each of the listed forces within an
industry. By understanding the area of business in which the level of competition is high
or low we will develop a basic knowledge of the reasoning behind allocation of funds.
This basic knowledge of the industry will also make alterations in financial documents
more noticeable when evaluating the firm’s level of disclosure.
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Competitive Force Degree of Competition Rivalry Among Existing Firms High
Threat of New Entrants Moderate Threat of Substitute Products Low Bargaining Power of Customers Low Bargaining Power of Suppliers High
Competitive Force 1: Rivalry among Existing Firms
The profitability of an industry is directly influenced by the competition among
existing firms. In some industries firms compete aggressively on price, sometimes to
the point where marginal revenues are at or below marginal costs. Other industries
focus less on price competition, using product and brand name differentiation to gain a
competitive advantage. The following are important factors in order to determine the
level of competition among existing firms within the food industry.
Industry Growth
The industry growth rate is a powerful influence on the level of competition
among existing firms. In a growing industry, price competition generally declines. The
reason behind this is because rather than attempting to take market share from rival
firms, the focus generally becomes product development and advertisement in order to
entice new customers. Prices often increase and industry firms prosper. On the other
hand when an industry is declining existing firms are forced to focus on stealing market
share from competitors. The most effective way to accomplish this is by offering a
similar product for a lower price. Having a tight cost control system is the most efficient
way to achieve a lower priced product, which will be discussed in depth in a later
section.
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Total Net Sales (Millions) 2004 2005 2006 2007 2008Kraft $32,168 $34,113 $33,256 $36,134 $42,201Heinz $8,415 $8,912 $8,643 $9,002 $10,071ConAgra $14,522 $14,567 $11,579 $12,028 $11,606Sara Lee $11,029 $11,115 $11,175 $11,983 $13,212Nestle $69,919 $73,009 $78,766 $89,926 $101,391Industry Avg. $27,211 $28,343 $28,684 $31,815 $35,696
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
Industry Avg.
Industry Sales (In Millions)
‐25.00%
‐20.00%
‐15.00%
‐10.00%
‐5.00%
0.00%
5.00%
10.00%
15.00%
2004 2005 2006 2007 2008
Change in Growth Rate
Industry Avg.
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The above graph indicates that the food industry has experienced massive
growth over the past five years. Because of the massive size of Nestle the industry
average is largely dependent upon their individual operations. However the average
growth rate still gives a relatively accurate picture of each firm’s productivity. 2004
proved to be a down year for the food industry with sales declining by over 20% from
2003. However the companies managed to alter business strategy and stopped that
declining growth trend before any crisis arose. Since 2004 sales have increased more
than 30% showing that the industry is in a time of growth allowing companies to focus
less on cost competition and more on differentiation.
Concentration and Balance of Competitors
Understanding the number of firms operating in an industry and their general
sizes will help paint a picture of the level of competition that an industry is
experiencing. This is called the degree of concentration in an industry. Pricing tends to
directly reflect the concentration of the industry. When market share is relatively
evenly distributed, prices will decrease as firms attempt to gain market share from its
competitors. Also, if the industry has one or two dominant firms, prices set by other
firms tend to follow trends set by those dominant competitors.
22
Industry Market Share of Total Sales
As displayed above, Nestle is clearly the leading firm currently competing in the
food industry with Kraft owning the majority of remaining market share. While this
considers only total sales, Nestle has a clear advantage in nearly every aspect of
business (Kraft is competitive in total assets however after adjusting their statements
for goodwill Nestle becomes dominant). By maintaining the vast majority of market
share Nestle is able to set industry standards and focus on their own business plan
rather than adjusting to compete with other companies. In a following section we will
discuss how this domination of market share creates a substantial barrier to entry.
Degree of Differentiation
Differentiation is the way a company sets itself apart from industry competitors
in order to create a competitive advantage. This is done by enhancing the quality or
the perceived quality of the product sold by a firm, or enhancing the image of the firm.
The degree of differentiation plays a more significant role in some industries than
others. For example, the paper industry is less focused on differentiation because there
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
23
is little room for their product to change. However industries such as music electronics
including Apple or other similar companies spend vast funds on creating differentiation
from its competitors. These industries tend to have less price competition than those
more concentrated on cost leadership.
Being aware of the degree of differentiation within the food industry will be a
good indicator of the techniques used by each firm in its allocation of capital. An
effective method of finding degree of differentiation would be to find the amount of
spending each firm put into research and development and advertisement. Overall
research and development expenditures tend to be low in the food industry because
there is little change to be made to the product. Some firms do however choose to
spend more on research and development such as Nestle which has proven to be
successful in the past. Advertisements tend to be a bit more of a focal point in the food
industry because companies attempt to create brand recognition in hope that
customers, if given two identical choices, will buy the product that they recognize from
television, billboards, or magazines. Below is a chart showing the advertising
expenditures for each of the leading food producing firms for the most recent five
years. These figures show that Nestle and Kraft focus on advertising to differentiate
their products.
Advertising Expenditures 2004 2005 2006 2007 2008
Kraft 1258 1314 1396 1554 1639
ConAgra 368 321 334 452 393 Nestle 2984 3034 3250 3446 3651 Sara Lee 460 425 452 433 342
Heinz 286.1 273.7 296.9 315.2 339.3 Average 1071 1073 1145 1240 1272
24
Switching Costs
The cost of a firm switching sales of a specific product line or switching the
entire industry in which it operates is called the switching cost. Having a low switching
cost enables a company to change its business plan with minimal costs. On the other
hand a high switching cost implies that a firm would need to sink large amounts of
capital in order to alter its business plan, most likely due to using assets that are
industry or product specific.
Firms operating in the food industry maintain high switching costs for several
reasons. Most importantly the machines used in order to produce and distribute
products are customized to create and maintain food products alone. In order for a
firm to create a different product these machines would need to be either replaced or
completely remade to complete the new tasks. Another factor that adds to the
switching cost in the food industry involves employees possessed by each firm. The cost
of either retraining or replacing the vast number of workers would be devastating to a
firm’s success.
Economies of Scale
The size of a company’s total operations, most commonly measured by total
assets possessed, is considered economies of scale. This plays an important role in
most industries because in most cases the larger the size of a company, the more
money that the company will make. For example, if there are only two firms competing
in an industry, one with operations all over the country while the other operates in a
single city, which of those firms would make more money and be more prosperous?
The firm with national operations has a clear advantage and would feel no threat by the
smaller firms to change prices or products. The larger company would also have better
brand name recognition giving consumers a sense of security when buying its products.
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While this example is very broad and omits many key factors, it creates a transparent
view of the effects of economies of scale.
Total Assets (thousands) 2004 2005 2006 2007 2008Kraft $59,928 $57,628 $55,574 $67,993 $63,078Heinz $9,877 $10,578 $9,738 $10,033 $10,565ConAgra $14,230 $12,792 $11,970 $11,836 $13,683Sara Lee $14,883 $14,412 $14,522 $12,190 $10,830Nestle $70,181 $82,306 $81,444 $96,456 $97,984Industry Avg. $33,820 $35,543 $34,650 $39,702 $39,228
As shown above, the asset size of the food industry firms competing firms vary
greatly. Nestle and Kraft clearly operates at much larger scales than their competitors
over the last five years creating a strong competitive advantage. This increased size
allows the larger firms to cut costs in many areas including transportation which will be
discussed in more detail later. The industry as a whole shows signs of steady growth in
total assets indicating stability and due to recent economic activity that the industry is
capable of surviving even in times of recession.
Excess Capacity
Excess capacity occurs when demand falls below the amount of purchased goods
of a firm, leaving leftover inventory which either becomes unusable or requires extra
funding to be maintained. Generally in this situation companies will attempt to cut
prices in order to fill the capacity gap. “The problem of excess capacity is likely to be
exacerbated if there are significant barriers for firms to exit the industry.” (Palepu &
Healy) The food industry does have a high barrier to exit which will be discussed later.
26
The most effective way to measure excess capacity is to divide a firms COGS by
its PP&E. This ratio computes the dollar amount of product throughput sold for every
dollar invested in property plant and equipment. Maintaining a greater COGS/PP&E ratio
indicates more efficient use of capacity, while a decreasing ratio implies changes may
need to be implemented in order to control excess capacity.
As displayed above, the top competing firms in the food industry have between a
2 and 4 COGS/PP&E ratio, with an industry average hovering consistently just under 3
over the past five years. This implies that on average every dollar invested in PP&E
results in about $3 of product throughput sold within the industry.
Exit Barriers
Companies at times have incentives to leave one industry and pursue a more
profitable one. Exit barriers are the invisible barrier that stands in the way of the
company making this transition. There may be certain regulations that firms have to
comply with before leaving such as legal proceedings such as patents owned by the
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
Industry Avg
COGS/PP&E
27
company committing them to a certain business for some years. Most companies also
own large, expensive manufacturing equipment which is specialized to carry out specific
tasks. In order to change industries these machines would need to be either sold and
replaced or altered to perform new tasks. There is also a large amount of stakeholders
involved for these firms that would have conflicts to be resolved if the firms were to exit
the industry. These stakeholders include shareholders and employees. These costs of
exiting would be high for firms operating in the food industry which would make this
transition uneconomical.
Conclusion
The processed and packaged foods industry as a whole has been steadily
growing the past 5 years and is forecasted to continue this growth. However, the
industry is moderately concentrated and there really is no market trend setter.
Differentiation in the industry is established by marketing and brand recognition.
Products are similar, but some brands in the industry have developed a very strong and
loyal following. Because of high investments in capital, switching costs in this industry
are very high. A firm needs to have a high amount of capital in order to compete in this
industry. Excess capacity in this industry is low, except for a handful of firms. There
are significant barriers to exiting this industry. All of these factors have led us to
conclude that the processed and packaged foods industry is highly competitive.
Competitive Force 2: Threat of new entrants
The food industry is made up of several large firms that hold relative control,
with many smaller companies operating in more specific markets. There are several
barriers to entry which these smaller firms must attempt to overcome in order to
emerge as one of the major players in the industry. While it is highly unlikely to
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overcome these barriers while maintaining any capital, it is impossible to rule the
possibility of emerging firms stealing large market shares due to the highly competitive
nature of the industry.
Economies of Scale
The most basic reason that the food industry is controlled mostly by several large
firms is that they have the ability to purchase huge amounts of goods at a time, which
substantially lowers the cost of purchasing and shipping. Because new firms most likely
would not have the capital required to make these types of transactions, they would be
forced to operate at a much smaller scale, or make large sacrifices to obtain the initial
payments. Furthermore, it is not just the suppliers that this large scale economy effects.
In order to begin making a profit on any product, there would also be shipping fees,
packaging fees, and selling fees included. Considering that the existing firms already
have relationships with all of these aspects of business, it would be nearly impossible to
operate on the large scale that a firm would hope for. This is the reason that large
amounts of firms choose to compete with only a portion of the industry, being content
with smaller revenues. These firms focus on quality and customer loyalty to gain a
competitive advantage in their market segments.
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Total Assets
The above graph displays the size of the existing dominant firms currently
operating in the food industry. These companies, specifically Nestle and Kraft, show no
signs of declining operations even in the current economic recession. Because the
existing firms operate at such an ample scale the capita that would be required to
create a competitive company would be unreasonable for the potential entrant.
First Mover Advantage
In the food industry, standards have been set by large corporate firms, who
were early entrants in the food manufacturing and distribution business. The first
movers in the food industry have developed major advantages in all stages of business.
These large firms have had long standing contracts with suppliers and distributors. They
also are able to get large discounts on raw materials and other supplies because they
purchase these goods in bulk. The first movers have this ability to operate in such large
scales because they have been in the food business for such a lengthy time, always
$0
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
$80,000
$90,000
$100,000
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
In Millions
30
looking to expand. Another advantage held by the first movers in the food industry is
the relationships they have developed with their customers. After years of working
together, the early entrants in the food industry have a large presence in most whole
sale stores such as Wal-Mart. The more shelf space set aside for a company will no
doubt increase sales of that product.
Another, and perhaps the most substantial advantage held by first movers in the
food industry is strong brand recognition and brand loyalty. Why would someone
choose a more expensive brand he or she has never heard of over the cheaper brand I
have been eating or drinking for years? In general the public is very loyal to food and
beverage products. In order to convince Even if a new firm obtains the assets and
creates a high quality product, the advertising expense to let the public know about it
would be overwhelming.
Most of the competitive firms in the industry have been doing business with and
against each other for decades. In this time, selling prices have gone from low to lower,
and firms have expanded from a national to global level. In order to fund the start-up
costs required to be competitive with these food industry giants, a firm would require a
loan from just about everyone. These facts all indicate that the thought of a new firm
entering and competing at a high level with the early entrants in the food industry is
nearly out of the question. The early firms are very aware of this, and are able to
operate knowing exactly who they are competing with.
Distribution Channels and Relationships
Distribution Channels play an important role in a firm’s ability to create and
distribute products to customers efficiently. In most industries including the food
industry, distribution channels are dominated by large companies. These large
companies are generally first movers in the industry and have been partaking in
business with and establishing secure relationships with suppliers and customers.
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Firms that hold a larger portion of the market share of an industry have an
advantage that smaller firms find difficult to compete with. Larger preexisting firms with
historical business relationships have the advantage of reserved shelf space for their
products. This creates a significant barrier to entry for potential new entrants into the
industry because buyers have to have enough incentive to switch suppliers. Retailers
have limited capacity in their distribution channels, and the high costs associated with
creating new distribution channels limit potential business partnerships. In order to
become competitive the new company would need to either create new distribution
channels or divert those controlled by existing firms. Doing this would be very costly
and difficult because of the risk that suppliers and customers would obtain by
decreasing business with current partners and investing in a more than likely untested
company.
Legal Barriers
The health food trend has been a growing market segment for food producing
companies that has helped generate new revenues. Of course, firms see the
opportunity for profit in this market segment and will place a label describing any health
benefit regardless of scientific evidence supporting it. According to a Wall Street Journal
article, “The European Union is cracking down on foods that advertise health benefits
without scientific backing, potentially undermining a strategy increasingly important to
the food industry.” This shows that governments will step in with legal barriers to
prevent firms from misleading consumers.
100 years ago customers would buy steak in a package that simply said “steak”
on the front. For all they knew this meat was just chopped up in the back of the store
by the cashier. No health facts, expiration dates, or any other sort of information was
required to sell these items. Sometimes, this resulted in customers becoming ill due to
the steak being under cooked, contaminated, or one of any dozens of other potential
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problems. Of course steak is just an example, while this problem was common in all
foods sold. This lead to the creation of the U.S. Food and Drug Administration (FDA),
and several other companies formed to regulate food production and distribution.
These regulations that have been formed over the years now add to the list of
difficulties a new firm would have to overcome to join the food industry. In order to
begin production and distribution of food, a laundry list of licenses must be acquired.
These licenses ensure safe and healthy production of all food goods. However getting
the licenses in order to begin production is only half the battle. Once operations begin,
the new firm must pass rigorous inspections by the FDA.
The capital required in order purchase FDA approved licenses adds up quickly.
Once the licenses have been purchased, production must be carefully monitored in
order to create a clean, healthy environment for goods. Maintaining this cleanliness
requires sprays, pesticides, secure packaging, and dozens of other small, yet costly
measures.
Conclusion
The food industry is strongly dominated by large firms, making it very difficult for
new firms to become potential threats. First mover firms have set standards for prices
and costs extremely low. Business takes place at such large scales that it seems
impossible to raise the capital required to even attempt to compete. Suppliers and
consumers seem very comfortable in the current niches in which they reside, bringing in
a very stable profit. Regulations in the food industry are increasingly rigid, thanks to the
FDA and other inspection services. When these factors are all considered, the threat of
new firms entering the food industry is low.
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Competitive Force 3: Threat of Substitute Products
The food industry benefits from its products being a necessity, no matter what
the current economic conditions are. Even if the public’s disposable income level is low,
the first thing they will buy will always be food. There is no substitute for food.
However there are substitutes to the kind of food consumers buy, such as different
qualities and brand names.
Specific Competitors
The food industry is made up of several leading competitors followed by many
smaller niche firms. Kraft is one of the major leading firms in the food industry.
According to www.hoovers.com, Kraft Foods competitors are primarily in the
nonalcoholic beverages, appliances, candy & confections, and canned & frozen foods
sectors. The company’s main competitors include ConAgra, Sara Lee, Heinz and Nestle.
Another source of major competition that controls a large section of the market share in
the food industry is the generic store produced brands. Sales of the big firms in the
industry will continue to be hurt by store brands taking market share.
Relative Price and Performance
A substitute is a product that performs a similar function as another competing
product. In most cases the most successful of these competing products is the one with
the lowest price. The food industry is full of substitute product competition, leading
price to be the main sales driver for the industry. In order to accomplish these low
prices a company must be cost efficient and well managed. Generally the largest
companies are capable of maintaining the lowest prices through successful use of
economies of scale, cutting costs in all stages of business. While very few products are
34
exactly the same, the entire industry is practically one big substitute market. If a
consumer plans on purchasing rice but finds a good deal for pasta on the way and
purchases that instead, that is a substitution.
The other performance driver that persuades consumers to purchase a certain
brand name or type of food is offering a premium product or brand for a slightly
increased price. The premium label is created though advertisements and product
placement to ensure that a consumer recognizes a brand and thinks quality when they
see it. This premium quality is created through the use of premium inputs that are
fresh, and the marketing of the firm to establish premium product recognition in order
to differentiate it from its substitutes.
The food industry is one of the most stable markets because its product is a
necessity. However at times of economic distress such as today consumers tend to shy
away from premium products with higher prices and focus on finding the lowest costing
product. This can lead to positive or negative performances by food industry
companies. However as in most other industries performance has declined over the last
year for most competing parties.
Customers Willingness to Switch
Food producing firms’ customers are the retailers and wholesalers that purchase
their products to sell to consumers. The consumers drive the demand for the food
products that are produced. Consumers buy food products at retail establishments that
purchase the products from the food manufacturers. Even though food producing firms
sell to the retailers the demand is ultimately derived from the consumers. If consumers
don’t purchase the products from retailers then retailers will not continue to purchase
the products from the food manufacturers. This means that the retailers will continue to
purchase products from the manufacturers if consumers demand them.
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There are many factors that could lead a retailer to switch suppliers of food
products. The food supplier could increase their prices too high which would eliminate
the retailer’s profit margin. In a tough economy consumers have less disposable income
and might prefer the cheaper substitute product. This could lead to retailers focusing on
less costly generic products because the demand for brand recognized more costly
products will drop. In this case, the food suppliers would encounter financial distress
due to customers switching their suppliers.
Increased costs in such factors as transportation or other costs incurred in
purchasing the products could lead to customers cancelling business relationships.
Other factors that could lead to customers switching suppliers are bad business
relationships. If customers don’t appreciate the supplier’s dealings the business
relationship could be lost.
Conclusion
Threat of substitute products is always a driving force in the food industry
because food products can easily be substituted. In the current economic recession it is
more noticeable than usual. In order to remain competitive competing firms are forced
to alter their business plans to meet the demand of the market, which is currently the
lowest prices possible. If consumers are willing to spend more money on food products
they are expecting the quality of the product to be fresh and superior to alternative
goods. Customers are willing to switch suppliers when demand for their products are
down or when business relationships go sour.
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Competitive Force 4: Bargaining Power of Customers
The ability for customers to control prices is considered the bargaining power of
customers. According to Palepu & Healy, “Two factors determine the power of buyers:
price sensitivity and relative bargaining power. Price sensitivity determines the extent to
which buyers care to bargain on price; relative bargaining power determines the extent
to which they will succeed in forcing the price down.” The ability to bargain prices and
price sensitivity is based on several factors including the relative number of consumers
and suppliers and the volume of purchases. The food industry consists of many
customers however the majority of market share is dominated by Wal-Mart and Costco.
Because such a large portion of the food products sold is through these wholesalers
they have a relatively high bargaining power.
Switching Costs
Switching costs is the relative capita that would be spent in the process of
moving from one supplier to another. This cost plays a large part in a buyer’s
consideration of switching suppliers. If switching costs are relatively low it would be
profitable to change to the supplier who can provide the lowest prices. If switching
costs are high the decision becomes dependant on the level of business done with the
buyer. Switching suppliers may cost more than it would save if a small portion of
business is done with the supplier in question. Also it would be very costly to break a
contract with a current business partner which must be considered. The food industries’
switching costs are relatively low because there are many suppliers selling similar
products and it is a highly competitive industry. This is another contributing factor in
the price competitive nature of the industry.
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Differentiation
In the food industry, differentiation is one of the most important aspects of
business for suppliers in regard to selling their products to customers. Differentiation is
a key success factor that a supplier can have to achieve product and price leadership.
Every supplier tries to make their product unique at a lower or higher price depending
on the market they are targeting. Enhancing brand name, product quality, and
advertising are several of the factors used to achieve that differentiation and increase
customer loyalty. In the food industry creating differentiation is important to draw
consumers to a certain product because there are so many similar options. Companies
who focus on differentiation to gain a competitive advantage face difficulty in times of
economic distress when consumers tend to look for lower prices rather than higher
quality. Below is a chart of the advertising expenditures for each leading food producing
firm for the past five years. This shows that these particular firms invest heavily in order
for them to try to differentiate themselves from other food producers. Since most food
products are relatively homogenous this gives customers more bargaining power and
would allow them to be more price sensitive.
Advertising Expenditures Millions 2004 2005 2006 2007 2008 Kraft 1258 1314 1396 1554 1639
ConAgra 368 321 334 452 393 Nestle 2984 3034 3250 3446 3651 Sara Lee 460 425 452 433 342
Heinz 286.1 273.7 296.9 315.2 339.3 Average 1071 1073 1145 1240 1272
38
Importance of Product Costs and Quality
In the food industry price competition is extremely important. This indicates that
large companies operating with moderate economies of scale and control distribution
channels have a substantial competitive advantage. These large companies are able to
offer low prices on a large scale making business with them very attractive to
consumers. These consumers maintain some power because if a current supplier
increases prices too much there are many other companies willing to do business.
However if the supplier’s product is important to the customers’ own product quality
then that could determine whether price becomes the main determinant in the buying
decision. Wal-Mart is a company that has a lot of bargaining power relative to prices
because the loss of their business would be devastating to suppliers in the industry due
to the volume of sales. For instance if Kraft chose to raise prices, driving Wal-Mart to
cease business with them, the company would instantly lose around 30% of their
annual sales.
Number of Customers
The food industry has a massive volume of customers. While several large
companies purchase a high volume of total products sold, there is a vast market
consisting of customers ranging from large independent grocery stores to small gas
stations. Although there are several large customers in the industry, the large number
of potential customers gives the food industries suppliers bargaining power over their
customers.
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Volume per Customer
The volume of business per customer is the main reason that customers
maintain some bargaining power in the food industry. The majority of food sales are
done through large wholesalers, which is the target consumer of most supplying firms
because the wholesalers have the ability to sell vast ranges of products in the same
place. This reduces selling costs for supplying firms that would be spent on locating
many smaller customers and shipping to each of them individually. Because of the
volume of business these large wholesalers are able to control prices to a certain
extent.
Conclusion
Bargaining power of customers in the food industry is for the most part mostly
low. However the large wholesalers such as Wal-Mart and Costco do maintain relatively
high bargaining power over suppliers. This is due mainly to the relatively low switching
costs and the high volume of purchases from these companies. The smaller customers
in the industry including independent wholesalers, convenience stores, and gas stations
maintain little to no bargaining power because of the vast number of customers in this
market.
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Competitive Force 5: Bargaining Power of Suppliers
The bargaining power of suppliers is the level of influence the supplier has over
its customers, the firm. It is affected by the same factors as the bargaining power of
buyers that include switching costs, differentiation, importance of products for costs
and quality, number of suppliers, and volume per supplier. These factors directly affect
price sensitivity, the extent to which buyers care to bargain on price, and relative
bargaining power, the extent to which they will succeed in forcing the price down. In
industries with few substitute products available to customers, the suppliers would have
more power and are able to charge a premium for these products. In addition, when
the suppliers are scarce they are also in a position of power over the customers. The
food industry contains many supply outlets that provide the inputs such as general
commodities to the firms such as Kraft. These suppliers are available all over the world
with little differentiation which greatly reduces the bargaining power of the suppliers.
Switching Costs
For suppliers, switching costs is the amount associated with switching from one
buyer to another. Suppliers in the packaged and processed foods industry provide
general commodities such as dairy, coffee, wheat, and corn products. These
commodities are the same throughout the market which leaves the suppliers with little
to no relative bargaining power. However, the commodity prices are generally set by
the market as well as government programs so the buyers have to be less price
sensitive than what they might like. When switching from one commodity supplier to
another, it will not change anything within the manufacturing process or end products.
Overall, switching suppliers is easy and very low cost.
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Differentiation
If the products available to firms have few substitute products, then the suppliers
are able to charge a premium. When the products are similar, as in the food industry,
it is classified as having low degrees of differentiation. As mentioned earlier, firms buy
general commodities such as dairy and wheat from the suppliers. These commodities
are available from numerous sources with very little differentiation. This puts the
suppliers at a disadvantage because the firms would have more bargaining power. In
order to differentiate, the supplier must have great customer service, large inventories,
and fast delivery to satisfy the needs of large food companies.
Importance of Product for Costs and Quality
Having the ability to maintain lower input costs and create a higher quality
product leads to a more successful company in any industry. When the cost is the
driving force in an industry the leverage power shifts to the firms, whereas in a more
quality based market the suppliers maintain power. The food industry is more cost
based because general commodities are available from numerous sources.
The food industry is highly regulated by the FDA so quality is very important in
this industry. Even the generic brands need their products to meet the general
standards. The commodities bought are the starting point for the firms finished
products. If the firms inputs are low quality, their finished products will not meet
regulations and the firm will incur huge losses. If suppliers offer better quality
commodities for the same prices this could give them some bargaining power.
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Number of Suppliers
There are a great number of raw materials available, and they are available from
numerous sources. The large number of commodity growers puts the suppliers at a
disadvantage because distinguishing one supplier from another would be relatively
difficult unless one offered other services. With low switching costs, this allows
customers to search for commodities at their preferred prices and this gives the
suppliers little relative bargaining power. However, since commodity prices are
generally influenced by the market and various government programs, the firms don’t
have much bargaining power of their own.
Volume per Supplier
Suppliers sell commodities in bulk orders to the firms such as Nestle and
ConAgra. Even though the suppliers sell large amounts at a time to the firms, the
volume purchased doesn’t give suppliers more bargaining power. This is due to the
large number of suppliers to buy from, and the switching costs of moving to a different
supplier are relatively low. ”… there will be an adequate supply of the raw materials we
use and that they are generally available from numerous sources.”(Kraft 10-K) Due to
the lack of switching costs and low differentiation, the volume per supplier does not
affect their bargaining power.
Conclusion
The number of suppliers, the amount of commodities sold, the availability of the
commodities, and switching costs incurred by the customers dictate the bargaining
power of suppliers in the processed and packaged foods industry. With the market
offering the same products, it is very hard to differentiate one supplier from another.
This doesn’t allow suppliers to be price sensitive or have very little relative bargaining
power. For these reasons, the bargaining power for suppliers is low.
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Conclusion to Five Forces Analysis
The preceding pages have analyzed in detail the food industry using Porter’s Five
Forces Model. Rivalry among existing firms proves to be the highest threat in the
industry with substantial advantages accompanying economies of scale and first
movers. Threat of new entrants in the food industry is low which directly relates to the
competitive nature of existing firms. There is a high threat of substitute products which
keeps current firms in check despite a relatively high level of customer loyalty
established by several of these companies. Both customers and suppliers have a
relatively low bargaining power in the industry because of the large number of options
for both purchasing and distribution of the goods being sold. Overall the industry is a
highly competitive one, focusing most resources on cost leadership to achieve
maximum profit margins.
Key Success Factors
In order for a firm to create a competitive advantage in an industry it must focus
on a specific strategy for success. There are two commonly practiced success
strategies used by companies operating in every industry. The first strategy is to create
a company on a cost leadership basis in order to cut costs and increase profit margins,
enabling the company to sell for less yet still achieve revenue goals. The other common
strategy for success is attempting to differentiate your company and the product being
sold to be able to charge a premium. Ideally if the company is able to execute either of
these strategies successfully a competitive advantage will be obtained and profits will
reflect this success. The following section will discuss in detail each strategy including
the steps that must be taken to make them work.
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Cost Leadership
Cost leadership is a very basic strategy which if executed effectively will lead to a
successful company. This is the most commonly practiced strategy in the food industry
mostly because of the high level of rivalry among existing firms, high threat of
substitute products, and relatively low bargaining power of the majority suppliers and
their customers as discussed in the five forces analysis. We have broken down the cost
leadership strategy into several parts that are used to effectively lower costs and
increase profit margins. These parts include the use of economies of scale and scope,
simplifying product designs, and efficient production.
Economies of Scale and Scope
There is an inverse relationship between firm growth and costs incurred for a
firm. When a company transforms into a large firm, the costs for the firm decrease in
multiple ways. When more supplies are ordered, costs go down because the firm is
buying in bulk or because the firm has more price leverage as a buyer. When a new
production plant is built with efficient machinery, the cost of production goes down. It is
mainly only large firms that incur the advantages of economies of scale. Kraft has
established its own private fleet of trucks in North America enabling distribution of
products at a much lower price than its competitors.
The food industry market is only comprised of a few food manufacturers, the
rest being niche food producers. The reason that there are only a handful of firms
producing is because of high barriers to entry. The dollar amount of assets that these
major firms hold is in the billions. No small food producer could compete because they
do not have the resources to incur the same economies of scale that the major food
producers do. “Competition and customer pressures may restrict our ability to increase
prices in response to commodity and other input cost increases.”(Kraft 10-K) The
45
major food producers have the advantage of bulk buying with long-term contracts on
food commodities, and the cost of capital is much cheaper for publicly traded
companies. Larger firms also incur economies of scope. There are many products that
these firms produce and the cost of distribution decreases as the number of items
shipped increases.
Simpler Product Designs
An effective way to minimize production costs is to simplify. This does not mean
just transportation and production, but often the actual product itself, or the container
it is sold in. This includes buying the cheapest material, and using as few resources as
possible on each package. If a soda producing firm finds a way to replace an ingredient
such as sugar for a similar, cheaper product, such as Sweet and Low, millions could be
saved. Similar cost reduction techniques can be used for the carrier of goods. For
example, if a firm currently sells a product in a glass package, costs would be cut
tremendously if it found a way to sell the same product in plastic packaging. Even
limiting the amount of paper used on the package to display brand name, health facts,
and other information would save a company huge amounts of money over several
years. For example, Kraft recently changed its product packaging to use less plastic and
save more money. “This award-winning package design uses 19 percent less plastic.
This means a lighter package, saving more than 3 million pounds of plastic annually,
and increased shipping efficiencies by 18 percent as the package is smaller.”
(prblog.typepad.com)
46
Efficient Production
Efficient production is the execution of operational tasks in a way that minimizes
overall costs and time spent. Because of the short expiration time of many products
sold in the food industry an important part of maintaining this efficiency is reducing
inventory turnover. This measure is most clearly presented by the day’s sales
outstanding ratio which displays the average number of days each company takes to
distribute on hand inventory. This is calculated by dividing total costs of goods sold by
inventory on hand.
The above graph illustrates how efficiently the most competitive companies in
the food industry move inventory. In comparison to most other industries these
numbers are relatively low, averaging about 70 days.
Another measure of efficient production is how effectively assets impact net
income. If this number is low it indicates that assets are not being used at their full
potential which wastes time and money. This number can be found by taking net
income over the preceding year’s total assets. The following graph will show that the
40.00
50.00
60.00
70.00
80.00
90.00
100.00
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Days Supply of Inventory
47
companies in the food industry vary in how efficiently they use assets. Nestle annually
has the highest return on assets which correlates with their high profit margins.
Differentiation
Differentiation is the ability to sell a product that performs a similar function as
its competition at with some element of the product or service perceived as superior by
its user. Although this strategy is less common in the food industry it still plays an
important role contributing to the success of many companies. The high threat of
substitute products creates an incentive to draw customers to the product in different
ways than low prices. Because there is a low threat of new entrants in the industry the
top companies often invest excess revenues into creating product and brand name
differentiation. There are several ways to differentiate a company or product which we
will focus on including producing superior product quality, investment in research and
development, and enhancing brand image through use of advertisement.
‐5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
2004 2005 2006 2007 2008
Kraft
Kraft Adjusted
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Return on Asset
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Superior Product Quality
Consumers who purchase brand name products as opposed to less expensive
private label products do so based on superior product quality. Customers may
recognize from billboards or commercials these brand name products, but if they
purchase them and that product does not meet their expectations they will likely switch
to a cheaper brand next time. If a company is looking to charge a premium, they must
sell a product that is better than the competition or customers will be lost. “It is
important that our products provide higher value and / or quality to our customers than
less expensive alternatives. If the difference in value or quality between our products
and those of store brands narrows, or if such difference in quality is perceived to have
narrowed, then consumers may not buy our products.” (Kraft 10-K) Kraft clearly
recognizes superior product quality is what they are known for and it is what draws
consumers to their brand. Continually providing superior product quality helps increase
customer loyalty which is very important during times of economic uncertainty.
Research and Development
Research and development is not one of the larger departments of most food
companies because there is little change available to be made to most products they
sell. However it is worth mentioning because if used effectively it has the potential to
drastically increase success. This is illustrated most clearly when looking at Nestle, the
industry’s largest company. Their business strategy is largely based around investment
in research and development. “Research and development is vital for the long term
growth of Nestlé. It is the engine that drives innovation. It maintains and strengthens
the competitiveness of the Company and its brands. (www.nestle.com)”
Nestlé’s strongest competitor Kraft has also incorporated research and
development into their business strategy which has proven to be successful. “Kraft's
Research & Development Center is a crucial component of the company's drive to reign
49
supreme in the food industry. (www.allbusiness.com)” The remaining companies in the
industry invest much less into the research and development department however
perhaps the success Nestle and Kraft have had will alter that trend in the future.
Enhanced Brand Image
In many cases the only difference in two products is the brand name or label
under which it is sold. This is often the case in the food industry because the products
are relatively straight-forward allowing little change without completely altering the
food. This makes the brand image increasingly important because customers, if given
two options, will almost always choose the one that they are familiar with. To give
customers this familiarity with their products companies invest in advertisement on
television, billboards, or any number of different communication methods. Advertising is
not cheap which is why only the larger companies can afford to use this sales technique
in the food industry.
Firms will try to enhance their brand image by convincing the public that their
existence is positive for society. “Kraft Foods and Save the Children Team Up to Fight
Malnutrition in Indonesia and the Philippines. (www.savethechildren.org)” After reading
this headline while browsing the internet, any customer’s likelihood of purchasing Kraft
if given an option will increase. This is another strategy used to enhance the brand
image of a company. Donating to charities or becoming involved in other non-profit
organizations can be a relatively inexpensive way of drawing new customers and
creating strong customer loyalty. Several of the well established companies operating in
the food industry partake in this strategy because of this.
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Conclusion to Key Success Factors
There are many possible success strategies available to use in the food industry
to create a competitive advantage within a company. Cost leadership is the strategy
most used due to the competitive nature of the industry among existing firms and the
low bargaining power that both customers and suppliers have. Differentiation although
less used, has shown to be very profitable and is likely to gain popularity among small
companies that are looking to expand and compete at a large scale.
Competitive Advantage
Because of the number of companies operating and constantly looking to expand
in the food industry it is extremely important for each to attempt to establish a
competitive advantage. Selling goods for low prices is a proven strategy to create this
advantage, however not all companies are capable of competing in this category with
those operating at a much larger scale. Producing a product that is better than its
competitors or selling similar products under a more respected label is an alternative
means of competing in the food industry. Using both of these strategies increases the
likelihood of a company experiencing success. Kraft engages in both price competition
and differentiation to create a competitive advantage. Kraft’s strategy for achieving a
competitive advantage is to “offer products that appeal to consumers, at the right price
(Kraft 10-K).” The following section will discuss in detail the areas utilized by Kraft, and
how effectively they operate in each of those areas in order to obtain a competitive
advantage.
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Cost Leadership
The food industry is oriented largely on price competition. The best way to
obtain a competitive advantage in this area is by increasing overall operation size,
maximizing efficiency, simplifying designs, cutting distribution costs, and several other
budgeting tricks. Large firms like Kraft and Nestle who are known for quality need to
focus on cost leadership in order to compete with the prices of less expensive generic
brands. “We are using our large scale as a competitive advantage as we better leverage
our portfolio. Our “Wall-to-Wall” initiative for Kraft North America combines the
exceptional benefits of our direct store delivery with the economics of our warehouse
delivery to drive faster growth. Wall-to-Wall will increase the frequency of our retail
visits and build stronger, ongoing relationships with store management allowing us to:
reduce out-of-stocks; get new items to the shelves more quickly; and increase the
number and quality of displays (Kraft 10-K).” Kraft’s Wall-to-Wall program is a cost
leadership strategy designed to cut costs and increase revenues. This program will
allow them to earn above-average profits while still focusing on superior quality.
Economies of Scale and Scope
Leaders in the food industry excel in utilizing their economies of scale and scope.
This is one of the key tools separating Kraft and Nestle from the smaller firms. These
smaller companies are generally incapable of obtaining similar input and transportation
costs and have difficulty expanding because of the current level of the market share
controlled by the two leading companies. Other than Nestlé who currently operates with
$100 billion and Kraft with over $60 billion of total assets, it is rare to find a company
with assets exceeding $10 billion. The large size of these large companies enables them
to make contracts for low prices because their business partners are transacting for not
only food goods, but the luxury of guaranteed business on a large scale.
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Kraft (in
millions) 2003 2004 2005 2006 2007 2008 PP&E 10155 9985 9817 9693 10778 9917
With over 9 billion in property and equipment, Kraft’s PP&E is larger than a few of their
main competitor’s total assets. This large amount of PP&E allows them to consistently
take advantage of economies of scale and drive overhead costs down.
Also, Kraft was able to invest in a private transportation truck fleet which in the long
run vastly reduced, and will continue to keep distribution expenses lower than most of
its competitors. This displays an effective use of resources in order to lower costs,
creating a competitive advantage from its rivals.
Efficient Production
Maximizing efficiency is the most general way to compete on a cost leadership level.
Just about every topic mentioned in this section is a different, more specific way of
accomplishing this. In general in the food industry, being efficient is the process of
cutting out any area of business that is not absolutely necessary. This includes
obtaining cheap transportation, eliminating unnecessary parts of containers such as
excess paper, lowering energy costs, and the list goes on. Kraft will complete a five
year restructuring program in 2009 that will allow them to be more efficient and help
drive up profits. “The objectives of this program are to leverage our global scale, realign
and lower our cost structure, and optimize capacity. As part of the Restructuring
Program, we incurred $3.1 billion in pre-tax charges reflecting asset disposals,
announced the closure of 36 facilities, and will use cash to pay for $2.0 billion of the
$3.1 billion in charges.” (Kraft 10-K)
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Often R&D costs are put toward efficiency to maintain competitive advantage
over competing firms. Kraft recently “commissioned an innovative food wastewater
treatment facility at a US cheese plant, which it claims will reduce waste by more than
90 per cent (http://www.foodproductiondaily.com/Processing/Kraft‐Foods‐aims‐for‐energy‐
and‐environmental‐efficiency)).” If this venture is successful the company will most likely
implement the system in more of their production plants. It would reduce costs, and
help the environment, which will enhance their company name, boosting sales.
However one can be sure that if this happens, competing firms will follow suit,
implementing similar systems with hopes of eliminating Kraft’s competitive advantage.
Simpler Product Designs
Simplifying product designs is always an effective way to lower production cost.
It also helps maintain market share or capture increased market share. Kraft is a leader
in this field, spending a substantial portion of R&D on product design each year.
Recently Kraft was awarded the Spirit of Innovation Award for their continuous efforts
to develop innovative goods and designs. These innovative designs include packages
that use less plastic which increases shipping efficiency since the packages are smaller.
The organizations goal is to be the worldwide leader in food production and distribution,
and efforts such as this are the reason they are the cusp of reaching that goal.
Low-Cost Distribution
A large expense that must be incurred by any company in the food industry is
distribution cost. There are several ways to distribute goods, including using suppliers
or customer distribution systems. However some large firms now have the ability to
distribute their goods using no outside help, leading to lower overall costs. Kraft has
established their own private fleet named Full Fleet to handle transportation, including
54
distribution to consumers. This greatly reduces costs in multiple phases of business.
The private fleet also has become “the "Go-To” carrier for customer service purposes
(fullfleet.com),” leading to a helpful revenue builder for Kraft.
Research and Development
Kraft Foods recently announced their new robotic system of production.
Currently outsourcing is the most efficient means of production, but this new robotic
system should diminish those costs exponentially if successful. However, unsuccessful
research and development can cost a firm huge amounts of capita if unsuccessful, or
the cost of implementation is greater than the resulting savings. This is why R&D
expenditures must be carefully examined so not to be overabundant.
Differentiation
Investment in Research and Development
“More than a decade ago, developers at Kraft Foods virtually reinvented the
frozen pizza category with the introduction of rising crust technology and the DiGiorno
line. The company's developers have not rested on those laurels, however, and have
continued to augment the segment with new interpretations and varieties. Their latest
endeavor would take frozen pizza crust into an entirely new
area.”(http://findarticles.com/p/articles/mi_m3289/is_10_177/ai_n30917284). It is
comments like this that illustrate the effectiveness of research and development in Kraft
Foods. Even if the company is the leader of a certain market segment, Kraft remains
focused on finding further means of development through R&D. This state of mind
55
along with previous success show why Kraft feels that investing in R&D is a profitable
endeavor. Currently Nestles research and development department is much larger than
that of Kraft, and produces a larger turnover. However it appears that Kraft is
attempting to broaden the department with the hopes of competing with Nestles
success.
in millions 2004 2005 2006 2007 2008 Kraft 388 385 414 442 449
Enhanced Brand Image
Kraft is one of the largest food producers in the industry which gives them the
ability to invest large amounts of capital into marketing and advertising expenses
annually. As a result, Kraft has established significant brand recognition and consumer
awareness. The company has spent large sums of money to establish this
differentiation from the rest of the competition within the industry in order to ensure
that they maintain the competitive advantage in brand image.
Another strategy Kraft has used to enhance their brand image is engaging in
charities and other non-profit organizations. “Kraft Foods Builds on Tradition of Giving
by Feeding Gulf Coast Families Affected by Hurricane Ike. (www.csrwire.com)” Having
headlines such as this in public forums draws a consumer group that might not be
attracted to other forms of marketing. This also gives current customers a sense of
security when dealing with Kraft, leading to the belief that the company has enough
income to spare to help those in need.
Because there is a high level of competition in the food industry, other firms will
look to ride the coattail of innovations set by Kraft and Nestle. When the market for a
new product that Kraft introduces gets diluted and simplified by cost leadership based
56
producers, Kraft still keeps its fair share of the market pie because Kraft maintains a
premium label name. This is why Kraft can continually sinks more funds in the
advertising of their products to promote brand image, and to maintain and grow their
market share.
Superior Product Quality
Kraft is known as a leader in product quality. This is the reason that Kraft
charges a premium for their products. Cheese is one of Kraft’s most publicly recognized
products. Everyone knows that Kraft uses 100% real cheese, while there are instances
where generic brands will use imitation cheese product. This automatically differentiates
Kraft from inferior competitors because Kraft actually uses a more quality product to
produce its goods. Although consumers prefer product quality, the extra price premium
is not always a factor that consumers are willing to incur. That is why it is important for
a company like Kraft to keep the cost margin gap as minimal as possible so they don’t
lose market share and therefore revenues.
Competitive Strategy Conclusion
Kraft has developed a strong competitive advantage over the majority of its
competition in multiple areas of business since its establishment in 1903. This has lead
to the company being a worldwide leader in food production and distribution. Kraft
effectively implemented a cost leadership strategy by taking advantage of economies of
scale, using first mover advantages, minimizing costs of distribution, and simplifying
product designs. The company also has differentiated its products from others in the
industry by pouring funds into R&D, advertisements, and assuring that they maintain a
quality brand name and produce better products than its competition. Overall when
57
compared to food industry competitors, Kraft has a strong competitive advantage and
intends on increasing that advantage in the future.
Accounting Analysis
Firms must be held accountable to stakeholders and the government for the
financial operations of their business. Firms are required to report the operations of
their business to the government and public with documentation such as a 10-K. It is
the firms that draft these documents and display the figures that are based on the
firms’ financial evidence as well as their assumptions and estimates. This can be
problematic because there may be incentive for firms to skew information in favor of
the company’s financial outlook. This is why it is imperative for accounting analysis to
manifest the real value of the company. There are 6 steps used in accounting analysis.
Firms have core key success factors that drive value and growth for their
company. The financial statements of the firm attempt to show the value of the key
success factors but they sometimes fall short. The firms reporting the information have
a varying degree of flexibility based on the industry in which they operate in choosing
the accounting policies and estimates that effect the financial statements. Even when a
firm is compliant with GAAP standards, financial statements can still be misleading.
Managers reporting statistical figures of the operations sometimes do not accurately
reflect the true underlying values of the firm.
The transparency of the financial statements can sometimes be low which can
lead to a lack of information for investors which could lead to uninformed investment
decisions. Firms also have the discretion to disclose as much additional information as
they want above and beyond minimum GAAP standards. The degree of disclosure is
determined by the firms accounting strategy. Companies can use their accounting
58
strategy to give an optimistic picture of the firm’s financial standing or they can
conservatively understate the value of the firm; which can be just as misleading as the
aggressive approach.
The quality of disclosure exposed to the public is also an option that firms
possess in reporting annual financial statements. Firms can make the
comprehensiveness of the financial statements more or less resourceful for users. When
analyzing financial statements discrepancies can occur. These can be identified as red
flags. A red flag indicates questionable accounting methods that need further
investigation, but it does not necessarily suggest fraud. The last step in the accounting
analysis process is to undue accounting distortions that can mislead users of financial
statements. This step is a consolidation of the previous steps and is the ultimate goal
of accounting analysis.
Key Success Factors
Economies of Scale
Expansion of business activities of a firm usually associated with increases of
property, plant, and equipment, tends to drive down the average cost per unit of
production. This is referred to as economies of scale. In the food industry, it is highly
beneficial to incur this advantage because of the mass amounts of inventory produced
and sold. To illustrate a comparison of the five major food producing companies, Kraft,
ConAgra, H.J. Heinz, Sara Lee, and Nestle, we will apply several ratios to determine the
length to which the competing firm’s take advantage of their economies of scale in
order to create competitive advantage.
59
First we can utilize the gross profit margin ratio by taking the gross profit and
dividing it by the total revenue of each firm. This percentage will give us an idea of the
operating efficiency of the companies’ production and distribution processes. The higher
the percentage is the more efficient the firm tends to be.
Gross Profit Margin 2003 2004 2005 2006 2007 2008
Kraft 39.20% 37.00% 36.00% 36.10% 33.80% 33.21%ConAgra 25.50% 24.60% 24.30% 25.60% 23.40% 23.40%Nestle 60.70% 65.70% 65.70% 66.00% 65.50% 56.92%Heinz 35.10% 39.80% 38.20% 35.80% 37.70% 36.54%
Sara Lee 41.60% 39.20% 40.10% 38.70% 37.00% 38.28%Average 40.73% 42.33% 42.08% 41.53% 40.90% 38.79%
The statistics show that the firms displaying the highest level of economies of
scale to the lowest level according to the gross profit margin ratio are Nestle, Sara Lee,
Heinz, Kraft, and ConAgra respectively. These numbers represent the net revenue of
continuing operations less the cost of goods sold for each firm. The cost of goods sold
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Gross Profit Margin
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is affected by the price premium of products and the efficiency of the production
process. The price premium could be higher for firms with differentiated products and
lower for firms whose business strategy is based on cost leadership. The food industry
has limited room for a price premium because food products are relatively elastic and
many substitutes exist. The price premium could be too high for Kraft keeping sales
down resulting in the smaller gross profit margin.
Production efficiency is the other factor that drives the cost of goods sold. How
efficient is the production process for each firm? These ratios tell part of the story.
Keeping the cost of goods sold as low as possible will result in a much higher gross
profit. First the firms can acquire the raw materials at a lower cost by buying in bulk.
Larger firms tend to do this because they have a larger capacity and sales volume. The
next factor for production efficiency is the work in progress. How long does it take to
turn the raw materials into a finished good? The longer this process takes the higher
the cost will be for the firms. It also costs money to hold the finished goods as
inventory. The faster the food gets produced and shipped out with this process
repeated, the more money comes in and the cheaper the cost of production.
Another way that we can measure the level of economies of scale is by using the
fixed asset turnover ratio. This ratio takes the net sales of a firm and divides it by the
net property, plant, and equipment. This ratio tells us the efficiency and utilization of
every dollar spent on PP&E and the return that it receives on sales. The higher the
ratio is the more efficient the investments in PP&E are.
Fixed Asset Turnover Ratio 2003 2004 2005 2006 2007 2008
Kraft 3.0032 3.1677 3.4164 3.3875 3.7278 3.9154ConAgra 3.7939 5.0423 6.1594 5.0885 5.4511 4.6614Nestle 4.5554 4.0897 4.2815 4.1821 4.4451 4.5951Heinz 3.7341 4.1207 4.1184 4.5479 4.7627 5.371
Sara Lee 3.33 3.33 3.4348 3.9404 5.1673 5.4015Average 3.85335 4.145675 4.498525 4.43973 4.95655 5.00725
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It is important to show the historical rates for the fixed asset turnover because
there is a lag in the revenues gained from the investments in property, plant, and
equipment. The majority of the firm’s ratios range from around 4.25 to 4.63. Kraft falls
well behind its competitors in the outcome of the ratios. This indicates that Kraft has
too much capital invested in property, plant, and equipment. Efficient firms can invest
less and produce more with the assets that they have. The numbers displaying Kraft’s
investments in PP&E report that the firm is not performing efficiently in this area. This
could be attributed to overinvestment in PP&E because they are encountering
decreasing marginal returns. If Kraft wants to compete with the other leading firms in
the industry they need to divest in PP&E to cut costs.
The final step that we can take to show how efficient the company is run is by
taking the selling, general, and administrative expenses and dividing it by the total
sales. This ratio will show us the trend in the amount of overhead expenditures related
to the amount of sales. The lower the ratio is the more SG&A expenses are spread out
over the firm. If the amount of sales increases while the amount of SG&A expenses
stays stagnant then the company is incurring economies of scale.
2.25
2.75
3.25
3.75
4.25
4.75
5.25
5.75
6.25
6.75
2003 2004 2005 2006 2007 2008
Kraft
ConAgra
Nestle
Heinz
Sara Lee
Average
Fixed Asset Turnover
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SG&A to Sales Ratio 2003 2004 2005 2006 2007 2008
Kraft 20.30% 20.70% 20.90% 21.10% 21.00% 21.46% ConAgra 16.60% 16.00% 16.70% 18.10% 15.20% 15.21% Sara Lee 53.50% 49.70% 43.30% 33.60% 30.60% 30.57%
Heinz 22.40% 22.90% 22.90% 21.60% 21.00% 20.96% Nestle 36.80% 41.00% 32.60% 31.40% 31.90% 32.60%
Average 32.33% 32.40% 28.88% 26.18% 24.68% 24.84%
Looking at the different firms’ ratios shown, you can see there is a relatively
large standard deviation in the industry. Sara Lee has the highest and ConAgra has the
lowest amount of SG&A expenses per unit of sale. Kraft’s ratio is quite low; meaning
that the firm has utilized their economies of scale with the cost of SG&A spread out
among business operations.
From the perspective of the gross profit margin ratio, the fixed asset turnover
ratio, and the SG&A to sales ratio, Kraft is not the leader in achieving economies of
scale, but is not falling far behind in the industry norm. Kraft’s gross profit margin is far
behind the other firms in the industry, but is a leader in advertising and keeping the
SG&A expenses low. It was indicated that economies of scale was one of Kraft’s main
key success factors, but according to the ratios calculated Kraft falls behind the industry
standards.
Investment in Brand Image
Companies that differentiate themselves tend to invest heavily in the image of
the products that they sell. This is accomplished through advertising and promotions to
the public. One of the main differences in firms that strategize for differentiated
products and low cost products is the amount of expenditures for advertising and
promotions. How much revenue does the money spent on advertising and promotions
63
bring in for the firms? We can analyze this by taking the advertising expenditures and
dividing it by the net revenues for each of the firms in the food industry. This
calculation is known as the advertising sales ratio and tells us how effective the
advertising and promotional campaigns have been in generating revenues. Generally
the lower this ratio is the more effective the campaigns tend to be.
Advertising Sales Ratio 2003 2004 2005 2006 2007 2008
Kraft 3.70% 3.90% 3.90% 4.10% 4.20% 3.88% ConAgra 3.40% 2.80% 2.90% 4.30% 3.40% 3.38% Nestle 3.90% 4.00% 4.00% 3.90% 3.80% 3.80% Heinz 3.80% 3.40% 3.40% 3.50% 3.40% 3.36%
Sara Lee 4.20% 3.80% 4.00% 3.60% 2.60% 2.58% Average 3.83% 3.50% 3.58% 3.83% 3.30% 3.28%
The outcomes of the ratios are normally distributed with no outliers meaning that
conclusions can be drawn. ConAgra’s advertising and promotions seem to be the most
effective while Kraft seems to be the least effective at generating revenues. The other
firms advertising sales ratios fall between these two companies. One of Kraft’s main
2.50%2.70%2.90%3.10%3.30%3.50%3.70%3.90%4.10%4.30%4.50%
2003 2004 2005 2006 2007 2008
Kraft
ConAgra
Nestle
Heinz
Sara Lee
Average
Advertising Sales Ratio (Percentage)
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key success factors was identified to be their investment in brand image. Kraft invests
large amounts in advertising every year, but appears slightly lower than the industry in
generating revenue from the dollars spent. Nestle spends nearly double in advertising
on an annual basis, but only generates a very small percentage more compared to
Kraft. As with economies of scale mentioned earlier, Kraft falls just below the industry
standard.
Key Accounting Policies
The first step in the accounting analysis is identifying the key accounting policies
for the firm. The most important key accounting policies directly relate to the key
success factors that help a company maximize profits and create a competitive
advantage. Firms usually choose accounting policies that produce the most favorable
financial image and a review of these is necessary to gain a fair value of the company.
Kraft’s main key success factors include economies of scale and investment in brand
image. In order to better understand the key success factors, an in depth analysis of
the firms accounting policies is required. Kraft takes advantage of hedging,
diversification of leasing, investment in research and development, goodwill, and
defined benefit plan pension liabilities. Kraft prepares their financial statements “in
conformity with accounting principles generally accepted in the United States of
America (“U.S. GAAP”), which require us to make certain elections as to our accounting
policy, estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent liabilities at the dates of the financial statements
and the reported amounts of net revenues and expenses during the reporting
periods.”(Kraft 10-K)
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Goodwill
Goodwill is an estimation made by a firm’s management of the value of the
company in excess of physical assets. In the food industry, goodwill is generally a large
portion of a firms overall value. The management has the ability to report goodwill as
they feel is accurate, and to impair it at their discretion as long as it falls within the
confines of GAAP. However, goodwill is an asset that is possible for management to
manipulate in order to alter the perception given by the company’s financial statements.
Kraft
(in millions) 2003 2004 2005 2006 2007 2008 Goodwill 25402 25177 24648 25553 31193 27501
PP&E 10155 9985 9817 9693 10778 9917Total Assets 59285 59928 57628 55574 67993 63078
From 2002 to 2007 goodwill consistently made up about 45% of Kraft’s total
assets. This staggering number annually is largely due to mergers and acquisition
including the recent acquisition of Danone Biscuit, increasing goodwill by more than $5
billion. While these numbers seem unrealistic, Kraft’s management feels otherwise,
issuing no impairment after the firm’s annual review in 2007 and very little if at all in
the recent years before that.
In order to understand the strength and value of the company, we will need to
amortize Kraft’s current goodwill 20% over five year. This would result in a
substantially lower operating income in 2007, as well as a decrease in total assets.
Similar results would be seen in the past five years of operation. The size of the
company would be cut in half, along with revenues decreasing, and expenses
increasing. Stockholders would be deprived of dividends, undoubtedly leading to a drop
in stock price and rating.
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Research & Development
Research and Development is a great way to gain a competitive advantage.
Money spent on R&D can lead to future profits. However, even though R&D can lead to
future profits, it is hard to distinguish what has future value and what does not. For
those reasons, GAAP requires companies to expense R&D costs as they incur them.
Because of this, it can lead to a distortion of reported accounting numbers on the
income statement. Expenses are overstated and net income is understated. Industries
with heavy R&D expenses will appear to have lower profitability than industries with low
R&D. If this is the case, the income statement and balance sheet will need to be
restated to make them appear more transparent.
The above graph shows R&D as a percentage of net revenues and operating
income for 2008. As you can see, food companies spend large amounts on R&D, but as
a percentage of operating income this number is fairly small and even smaller as
compared to net revenues. Kraft spends close to $0.5 billion on research and
development every year. This amount is about 1.2% of net revenues and 10% of their
operating income. It is important that Kraft continues to invest in R&D and keep up
with new products introduced by their competitors. Firms in the food industry strive for
product safety and quality, growth through new products, superior customer
satisfaction, and reduced costs. The firm reports R&D conservatively so they expense
the costs as they are incurred as GAAP regulations require.
Company R&D (in millions)
Net Revenues (in millions) % of Net Revenues
% of Operating Income
Kraft $499 $42,201 1.20% 10.60% ConAgra $68.30 $11,605.70 0.58% 14.16% Sara Lee N/A N/A N/A N/A Nestle $1,665 $104,079.00 1.60% 12.47% Heinz N/A $11 N/A N/A
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Even though food advancement is not a serious need, better product development can
lead to higher earnings. Through R&D, Kraft was able to develop the DiGiorno pizza
brand about a decade ago. This frozen pizza with its new rising crust basically
reinvented the how frozen pizzas are made. This gave Kraft a competitive advantage in
the frozen pizza market and shows why R&D should be a continual investment.
Pension Plan
Employees of firms do not have the ability to work all of their life. People realize
that when they reach a certain age in their elderly years they need to retire. This is the
reason that pension plans are organized. A pension plan is a type of retirement plan
where employers set aside funds for employees and pool them into some investment
for the employee’s future benefits. There are two main types of pension plans: (1) A
defined benefit pension plan and (2) a defined contribution benefit plan. A defined
benefit plan is where employers guarantee a specified amount of benefits regardless of
the performance of the investment pool. The benefits are dependent upon several
factors including but not limited to the length of employment, and the salary history of
the employee. What makes the defined benefit pension plan so different from other
retirement plans is the fact that the benefits are specified and guaranteed. This means
that if the investment pool looses value and benefits must be paid, the firm must dip
into their earnings in order to make payments. The defined contribution plan is a
retirement plan where the employer has a fixed amount of funds or fixed percentage of
funds that will be invested for the employees future benefit. This means that the future
benefit is not a definite amount, but is dependent upon the performance of the
investment of funds.
Kraft uses a defined benefit pension plan for their employees. This creates a
larger liability for the firm as opposed to having a defined contribution plan. ConAgra, a
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competitor of Kraft, also uses a defined benefit pension plan as well as the Sara Lee
Corporation. This means that the corporations of food industry generally use a defined
benefit pension plan making the liabilities of these firms proportional. According to the
Kraft 10K, “at the end of 2007, the projected benefit obligation of our defined benefit
pension plans was $10.2 billion and assets were $11.0 billion.” Kraft states that, “they
model their discount rates using a portfolio of high quality, fixed-income debt
instruments with durations that match the expected future cash flows of the benefit
obligations.” Below is a chart displaying the percentages Kraft used for the discount
rate, the expected inflation, and expected return on plan assets.
U.S. Plans 2003 2004 2005 2006 2007 2008
Discount Rate 6.50% 6.25% 5.75% 5.60% 5.90% 6.30%
Expected Rate of Return on Plan Assets 9.00% 9.00% 8.00% 8.00% 8.00% 8.00%
Rate of Compensation Increase 4.00% 4.00% 4.00% 4.00% 4.00% 4.00%
Non-U.S. Plans 2003 2004 2005 2006 2007 2008
Discount Rate 5.56% 5.41% 5.18% 4.44% 4.67% 5.44%
Expected Rate of Return on Plan Assets 8.41% 8.31% 7.82% 7.57% 7.53% 7.43%
Rate of Compensation Increase 3.12% 3.11% 3.11% 3.11% 3.00% 3.13%
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The percentages that Kraft uses to estimate the future liabilities of pension plans seem
to be fairly estimated, but could be more conservative. A four percent rate of increase
in compensation for U.S. plans seems to be a reasonable assumption. A constant 8%
return on plan assets was a reasonable assumption at the time.
ConAgra2003 2004 2005 2006 2007 2008
Pension plan asset growth rate 7.75 7.75 7.75 7.75 7.75 7.75
Pension plan discount rate 5.75 5.75 5.75 5.75 5.75 5.75
Compensation increase 4.25 4.25 4.25 4.25 4.25 4.25
ConAgra, a competitor of Kraft, uses more conservative figures. They used a
4.25% growth rate for the compensation increase, 25 basis points higher than Kraft.
ConAgra also uses a more conservative 7.75% expected return on plan assets, 25 basis
points less than Kraft’s assumptions. The discount rate used for fiscal years 2006-2008
was 5.75%, which is fairly comparable with Kraft. If Kraft’s discount rates are averaged
for those three years the discount rate would be 5.75%.
Defined Medical Benefit Plan for Retirees
Firms also have the liability to provide their retired workers with a medical
benefit plan. This liability for the firm is much like that of the pension plans. The firms’
method for valuation is identical to that of the pension plans. Kraft uses a 6.1%
discount rate for the U.S. postretirement plans. Their health care cost trend rate
assumptions are at 7.5% for U.S. postretirement plans and 9% for Canadian
postretirement plans. These were based on the assumption that the healthcare costs
will be increasing over the years. From 2013 and outwards, the assumption was at a
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5% for U.S. plans and 6% for Canadian plans. This estimate is not reasonable by any
means. If healthcare costs have been increasing every year for many years, why would
they assume a lower percentage cost of healthcare run as a perpetuity? According to H.
J. Heinz Company’s 10K, they “use an average initial health care trend rate of 9.3%
which gradually decreases to an average ultimate rate of 5% in 5 years. The foreign
postretirement health care benefit obligation at April 30, 2008 was determined using an
average initial health care trend rate of 6.7% which gradually decreases to an average
ultimate rate of 4% in 7 years.” The assumption is made that the cost of healthcare is
going to decrease as time goes on. Once again biased assumptions are made to
understate the liabilities of the
firms.
(In millions) 2004 2005 2006 2007 2008 U.S. pension
plan cost $ 46.00
$ 256.00
289
$ 212.00
$ 168.00
Non - U.S. pension plan cost
$ 93.00
$ 140.00
$ 155.00
$ 123.00
$ 82.00
Postretirement health care cost
$ 237.00
$ 253.00
$ 271.00
$ 260.00
$ 254.00
Postemployment benefit plan cost
$ 167.00
$ 139.00
$ 237.00
$ 140.00
$ 571.00
Employee savings plan cost
$ 92.00
$ 94.00
$ 84.00
$ 83.00
$ 93.00
Net expense
for employee benefit plans
$ 635.00
$ 882.00 1,036
$ 818.00
$ 1,211.00
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Operating vs. Capital Leases
Firms have the option to choose an operating lease over a capital lease for long-
term assets. The benefit of using an operating lease is to keep some major operations
off of the balance sheet, enhancing perception of the firm’s success given by financial
statements. The interest payments and lease expenditures are deducted from the
operating income which lowers the taxes payable. Operating leases can be misleading
to financial statement users because it understates the actual lease liabilities of the
firm. This is why it is necessary for a firm to disclose the type of lease they use in their
financial statements. When firms choose a capital lease they acquire an asset as well
as a liability that are reported on the balance sheet. When a firm uses a capital lease it
has to incur depreciation expense in addition to the lease’s interest expense. Because
depreciation is expensed, capital leases are considered both an asset and a liability.
When firms use operating leases no depreciation is recorded so the only reduction to
the firms operating income is the deduction for the lease payments. Firms have the
incentive to use operating leases for all their long-term assets to defer expenses to later
periods and to keep the lease liability off the books. Generally speaking, capital leases
recognize expenses sooner than equivalent operating leases.
Under GAAP a lease must be recognized as a capital lease if it meets any of the
following four criteria:
(a) if the lease life exceeds 75% of the life of the asset
(b) if there is a transfer of ownership to the lessee at the end of the lease term
(c) if there is an option to purchase the asset at a "bargain price" at the end of the
lease term.
(d) if the present value of the lease payments, discounted at an appropriate discount
rate, exceeds 90% of the fair market value of the asset.
If a firm’s present value of future operating lease payments exceeds 10% of the
present value of long-term debt it is a material amount that must be converted to a
capital lease to accurately portray the appropriate amount of lease liabilities. For Kraft,
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the present value of the future operating lease payments is estimated at 4.1% of the
present value of long-term debt. The operating lease liabilities represent the future
payments of the minimum rental commitments under non-cancellable operating leases.
Payments Due
Total 2009 2010-11
2012-13
2014 andThereafter
(in millions)
Long-term debt (1) $19,393 $757 $2,702 $5,845 $ 10,089 Operating leases (3) 796 250 335 140 71
Currency Exchange and Commodity Price Risk Management
The ability to avoid risk in commodity trading and foreign exchange rates is a
crucial asset in maintaining stability within a company. Often it is impossible to predict
the fluctuations of the market and currency exchange rates. Some firms choose to take
risks and hope to recognize financial gains in these areas. However, while this presents
the potential to increase profits, it also may be detrimental to the firm should they
predict fluctuations inaccurately. Most firms choose to limit risk as much as possible. A
widely used and reliable way to limit the risk in dealing with these aspects of business is
hedging. This ensures that if capital is lost in one market, excess profit will be realized
in an opposing one.
“Our risk management program focuses on the unpredictability of financial
markets and seeks to reduce the potentially adverse effects that the volatility of these
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markets may have on our operating results.” (Kraft 10K) Kraft hedges by using multiple
types of contracts in the purchasing of commodity goods. The firm uses forward
contracts, meaning payment will take place before the actual transaction of goods in
order to fund items such as “coffee, milk, sugar, cocoa and wheat.” (Kraft 10K) To
ensure that this prior payment form does not cost the firm capital due to inflation and
value changes of goods, Kraft also engages in futures contracts. A futures contract form
of payment consists of payment at a later date, at a price specified today. The firm uses
this form of payment for goods including “dairy, coffee, cocoa, wheat, corn products,
soybean and vegetable oils, nuts, meat products, sugar and other sweeteners, and
natural gas” (Kraft 10k) By using both forward and futures contracts, value and price
fluctuation’s effects on either contract will ideally be cancelled out by the other. In
order to avoid risk in the foreign exchange market, Kraft uses several different financial
instruments. “These instruments include forward foreign exchange contracts, foreign
currency swaps and foreign currency options.” (Kraft 10K) Foreign currency swap
includes operating in multiple currencies at a fixed rate. Foreign currency options
consist of a predetermined exchange rate, regardless of the actual current rate.
In order to measure the risk of loss on a certain day, Kraft uses a value at risk
computation. This measure forecasts: “1) the potential one-day loss in the fair value of
our interest rate-sensitive financial instruments; and 2) the potential one-day loss in
pre-tax earnings of our foreign currency and commodity price-sensitive derivative
financial instruments” (Kraft 10K)
Conclusion
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The food producing industry doesn’t require huge advances in technology. The
process of producing the products is fairly straightforward. Because of this the food
producing companies do not require heavy expenditures in research and development.
Therefore, R&D doesn’t have a dramatic affect on the accounting methods used. Firms
have the choice whether to use operating or capital leases for their assets. If the
present value of the operating leases is greater than 10% of the present value of long-
term debt then the operating leases must be converted into capital leases to portray the
appropriate amount of lease liabilities. Companies with pension plans and medical
benefits have to estimate the future liability of benefits that have to be paid. The
estimations of the firms’ to determine the liability have considerable flexibility. Firms
that operate globally or internationally have to manage foreign currency risk. If dealing
with commodities the firm might want to hedge prices to limit risks. Goodwill is an asset
that misrepresents the companies’ assets. If the goodwill represents more than 20% of
total assets then it must be impaired to more accurately value the company’s financial
standing.
Accounting Flexibility According to the book Business Analysis & Valuations, the accounting policies
and estimates that a firm has the ability to use in their financial statements is known as
accounting flexibility. As the book Business Analysis & Valuations mentions, “Some
firms’ accounting choice is severely constrained by accounting standards and
conventions” (Palepu & Healy). These constraints put in place by the SEC and GAAP
represent the minimum disclosure required by all firms; however there is still room for
policy mobility in several accounts. “If managers have little flexibility in choosing
accounting policies related to key success factors, accounting data is likely to be less
informative for understanding the firm’s economics. In contrast, if managers have
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considerable flexibility in choosing policies, accounting numbers have the potential to be
informative, depending on how managers exercise this flexibility” ( Palepu and Healy).
Accounting flexibility has an impact on the performance of the firm, since these
policies are a key factor used to analyze and report financial numbers. The flexibility of
a firm reflects the severity of the industry standards and regulations. Furthermore, the
GAAP can only set general rules which leave the overall transparency a firm chooses to
use at the firms discretion. However, any distortion in a company’s financial documents
used to alter the firms perception is considered fraudulent and illegal, with big
consequences.
In a competitive market like the food industry where low prices and quality are
important factors, Kraft managers have added pressure to take advantage to any
accounting flexibility. According to Kraft 10-k, “To counter some of these costs, the
Company tries to induce supply chain efficiency, including efforts to align product
shipments more closely with consumption by shifting some of its customer marketing
programs to a consumption based approach, financial condition of customers and
general economic conditions” (Kraft 10K-2005). Kraft’s flexibility plan is to maintain
competitive products in an industry where competition is high.
Goodwill
Goodwill has always been a controversial area in finance and accounting.
Goodwill is basically the price premium that companies pay to acquire other firms above
the fair value of the acquired firm’s assets. If the company suffered an unsuccessful
financial year, management has the ability to manipulate goodwill in order to hide these
losses. It has been very difficult to catch these alterations because it is physically
impossible to narrow the goodwill of a firm down to an exact dollar amount.
Accounting for goodwill is approached somewhat cautiously by GAAP standards.
This cautious approach is taken because it is difficult to decipher the accuracy of
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goodwill, purely because it is an estimate made by the firm. Since (“SFAS No. 142”) was
released by the FASB, effective March 15 2001, goodwill is no longer amortized, but
impaired at least once per year. This and several other changes such as acquisition
policies were made in hopes of keeping firms modest, while giving financial statement
viewers a more transparent view of the firm. So while there is still some flexibility in the
accounting of goodwill, firms must be careful and follow the guidelines given by GAAP.
Research & Development
Research and Development is one of the key tools used by firms to develop growth
through new product innovation. In the food industry, Kraft and their competitors use research
and development as a means to create a competitive advantage and improve profits. GAAP
requires firms to list their research and development as an expense on the income statement
which deducts from their net income. The future revenues from the research and development
have not been earned yet, but the expenses are incurred at the present time which causes an
incorrect valuation of the company. The accounting flexibility of research & development in
the food industry is not as important as it would be in other industries since there is
little need for advancement of food products. Kraft has stated that their objective for
R&D is to increase product safety and quality, obtain growth through new products,
maintain superior consumer satisfaction, and reduce costs.
In contrast to other industries, research and development costs are relatively low
in the food industry. However, while R&D expenses consisted of less 2% of total sales
revenue, it is important to maintain a constant capital flow to the department in order
to assure that a firm does not fall behind its competitors.
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The table from above displays Kraft’s research and development as a percentage
of net revenues for the last five years. The cumulative research & development
expense for the past five years as a percentage of net revenues is 1.26%, which is a
relatively small percentage devoted to R&D. These expenses are also consistent
throughout the years which are a good sign when looking at flexibility. That shows that
they are not making any drastic or undisclosed changes in what they label as research
and development expenses. Also, because they devote such a small percentage to
R&D, capitalization of these expenses is not required. Due to the small percentages
spent on R&D and the fact that two of Kraft’s competitors don’t disclose their R&D
expenditures, it can be concluded that the food industry has low disclosure of research
and development expenses.
Pensions
Pension plans are agreements between the employer and the employee to make
monthly payments into the employees’ accounts through future payments to the
0.0%
1.0%
2.0%
3.0%
2004 2005 2006 2007 2008
R & D as a Percentage of Net Revenues
78
retirement account. The amount of effort the employer is going to put on the employee
depends on the years the employee has been working for the firm.
The amount the employer contributes depends on the years that the person has
been working for the company. The amount that is designated to the employee is
based on the discount rate the company chooses to match up. The company tries to
make an educated estimation for how long the prospective or current workers are going
to be employed for the company, and when employees plan to retire. Moreover, the
discount rate is estimated by the future payments to the present value. Kraft’s discount
rate is measured on “a portfolio of high quality, fixed-income debt instruments with
durations that match the expected future cash flows of the benefit obligation,”
according to Kraft 10-k. The changes in the discount rate are a factor of the changes in
bond yields.
The table from below represents the discount rates Kraft used for the last five years.
U.S. Plans 2003 2004 2005 2006 2007
Discount Rate 6.50% 6.25% 5.75% 5.60% 5.90%
Expected Rate of Return on Plan Assets 9.00% 9.00% 8.00% 8.00% 8.00%
Rate of Compensation Increase 4.00% 4.00% 4.00% 4.00% 4.00%
Non-U.S. Plans 2003 2004 2005 2006 2007
Discount Rate 5.56% 5.41% 5.18% 4.44% 4.67%
Expected Rate of Return on Plan Assets 8.41% 8.31% 7.82% 7.57% 7.53%
Rate of Compensation Increase 3.12% 3.11% 3.11% 3.11% 3.00%
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The flexibility that firms have with pension plans is highly ductile. The firms have
the ability to determine the discount rates that they desire to show the future liabilities
as they see fit. If the discount rate is too small, the liabilities will be overstated. If it’s
too large they will be understated. The growth rate assumption for plan assets is also
another factor that has considerable flexibility. No one can know the outcome of
investments and everyone must make the most reasonable guess with the information
that is available. If firms decide to use too high of a growth rate for assessing future
pension liabilities then the liabilities will be understated. If the assumption is too low
then the liabilities will be overstated. The last factor that attributes to the estimation of
future pension liabilities is the rate of compensation increase. This is basically an
estimation of the inflation rate. This number should be around the same for all
industries because they all have the same available information; assuming that all firms
base the cost of living increases on inflation rates.
The major concept is that firms have the ability to use any figures that they want
to calculate the amount of future pension liabilities. The main reason that they don’t
use drastically unreasonable assumptions is because of the transparency of the firms.
Their assumptions must be disclosed in the financial reports, and they must also be
relatively similar with other firms in the same industry.
Operating & Capital Leases
Operating and Capital Leases are reported differently in the financial reports
which give them some accounting flexibility. The difference between the two is how
the leases are used and how they are reported in the financials. Capital leases are
treated as an asset and a liability on the balance sheet because the lessee assumes
ownership. Therefore, capital leases are amortized over the life of the lease. Operating
leases are different in that they are not depreciated and therefore not recorded as an
asset. Since no amortization is required, the only costs you see are the lease and
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interest payments as a reduction in the income statement. The reason for this is that
the lessee does not retain ownership and assume the lease as rent. Operating leases
must be disclosed in the 10-Ks since they are not reported on the balance sheet. It is
important that investors be aware of the amount of operating leases a firm carries
compared to the industry.
Since operating and capital leases are reported differently, GAAP has tried to
reduce the flexibility management has in choosing between the two. Leases must be
classified as capital if it meets anyone of the following conditions—
(a) If the lease life exceeds 75% of the life of the asset
(b) If there is a transfer of ownership to the lessee at the end of the lease term
(c) If there is an option to purchase the asset at a "bargain price" at the end of the
lease term.
(d) If the present value of the lease payments, discounted at an appropriate discount
rate, exceeds 90% of the fair market value of the asset.
These rules appear to reduce the accounting flexibility, but managers can still
manipulate terms to appear as operating leases to reduce liabilities. That is why it is
important to know that types of leases as compared to the industry. Kraft carries 90%
of lease obligations as operational. This amount is not unusual compared to their
competitors but the large percentage of operating leases could warrant hesitation on
the part of the prospective investor.
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Currency Exchange and Commodity Price Risk
Management of risk concerning currency exchange and commodity prices is an
important asset to a firm’s success. The Securities and Exchange Commission maintains
a relatively moderate degree of regulation in this sector. However, there is still
considerable room for flexibility when reporting these items on financial statements.
GAAP strongly suggests use of footnotes to discuss the manner in which industry firms
report risk management. These footnotes discuss the types of contracts used for both
currency exchange and commodity purchases. While the majority of competing food
firms uses a fairly consistent hedging strategy, it is not one that is required by the SEC.
The exchange rates and commodity policies used by firms in the food industry
are required to be made public by the SEC. This is to make the information given in
financial statements more comprehensible for foreign companies and auditors
attempting to value potential clients.
Conclusion
To conclude, there are many regulations placed on the food industry relating to
accounting policies, but there is still a substantial flexibility margin available for firms to
operate in. It is still possible to use conservative or aggressive accounting when
preparing financial statements, however it is up to the individual firms to decide the
amount of disclosure to use. Although GAAP has established clear guidelines to be
followed, the reputation of the financial sector of the market still suffers. Cases such as
Enron and more recently Bernie Madoff don’t add to the reputation by choosing to
determine their own meanings of the word “flexibility”.
It appears that Kraft has chosen to respect industry guidelines and regulations,
creating a relatively transparent view of the company in their annual financial reports.
The firm has incorporated effective accounting policies with successful risk and overall
management, maintaining a strong profit margin in recent years.
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Accounting Strategy
The accounting strategies that firms use directly affect to the financial reports
that they file. When firms have flexibility, they can use it either to communicate their
economic situation or to hide true performance. For this reason, it is important to
evaluate the strategies used and determine if they are reported correctly as compared
to the industry. Through new regulations, the SEC and GAAP have tried to limit the
possibility of manipulation of financial statements. However, there are still a number of
ways managers could get creative through the general accepted accounting principles
to present a better picture of their books.
When evaluating the strategies, an assessment on the quality of disclosure
within their financial statements is needed. High disclosure presents information above
and beyond what is required by the SEC. A company with high disclosure presents
thorough information regarding accounting number, policies, and company strategies
implemented. It also allows analysts to gauge a true picture of a company through
their transparent statements. Low disclosure does not present information above and
beyond the requirements and gives an impression that a company could be hiding
something. After determining the disclosure, analysts should be able to tell if the firm
uses conservative or aggressive accounting policies and successfully evaluate the
accounting strategy.
Kraft reports financial statements with a fairly high disclosure policy. Their
reports are open as to what they are doing, and provide the same if not more
information than their competitors. If any numbers seem out of place it is usually
explained in detail shortly after in the footnotes of the 10-K. Within the rules of GAAP,
Kraft tends to use somewhat aggressive accounting policies. The management feels
that this is the most accurate way of depicting the firm’s value to investors.
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Economies of Scale
Having the ability to operate on a large scale is one of the defining contributors
to the success of Kraft. Due to the massive amounts of goods and capital being used,
the firm has obtained more efficient means of business at all levels. Kraft is able to
purchase goods at discounted prices from long time business partners due to loyalty
and more importantly the scale of purchases. Costs of distributions have plummeted
because they have obtained rights to a private fleet of transportation trucks in America,
and are taking similar steps to lower distribution costs abroad. The large scale of Kraft
has also created brand name recognition all over the globe which gives consumers a
subliminal trust in the company’s products.
It is simple to say that Kraft’s large size is a key success factor, and a large
advantage over most of its competition. A more in depth question now becomes how
did the firm grow to its current size? And has the company hit its peak or still growing?
The answer resides in the management of Kraft’s aggressive expansion strategy though
mergers and acquisitions. In 2007, Kraft acquired Danone Biscuit which increased
goodwill in excess of $5 billion. This most recent acquisition is just an example of the
growth trend that is seen throughout Kraft’s history which has been so successful.
Information discussing the levels of operation concerning economies of scale and
mergers and acquisitions is highly disclosed on the financial report. It is not difficult to
discover the source of value creation in the footnotes, which go into great detail of
recent transactions. While economies of scale cannot really be classified as aggressive
or conservative, mergers and acquisitions are quite the opposite, which is the main
reason that the firm is a leader in economies of scale. Kraft aggressively records
goodwill when making acquisitions; however that will be discussed in greater depth in a
following section.
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Goodwill
In the food industry goodwill generally accounts for somewhere between 20 and
30% of total assets of a firm in recent years. As stated before, goodwill represents
nearly half of Kraft’s total assets (45.8% in 2007). Of course the first question asked by
a reader of Kraft’s financial statements would be why is goodwill so much larger for this
firm than the industry par?
The staggering goodwill account in Kraft has accumulated through substantial
mergers and acquisitions over the firm’s history. The most recent notable change in the
goodwill account came with the acquisition of Danone Biscuit, increasing goodwill by
$5,239 million late in 2007. Transactions such as this help explain the staggering
$31,193 million goodwill account (from $25,553 in 2006). Since the adoption of (“SFAS
No. 142”) Kraft has found little need for impairment of goodwill reported in the annual
reviews. There is belief within the firm’s management that these numbers accurately
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
2002 2003 2004 2005 2006 2007 2008
Kraft
Sara Lee
ConAgra
Nestle
Heinz
85
portray market value of the firm, and are necessary in order to provide a clear view of
financial statements.
Kraft appears to have a relatively high amount of disclosure relating to
accounting for goodwill. Gains and impairments are clearly labeled in the footnotes, and
translated onto the financial statements. Kraft tends to take an aggressive approach in
accounting for goodwill. In the acquisition of Danone Biscuit, Kraft spent a total of
nearly $7.5 billion, and as discussed earlier it seems that the majority of that cash
outflow went directly into the firm’s goodwill account.
Research and Development
Research and Development is required by GAAP to be expensed as it occurs.
Because of this, there is very little accounting flexibility and often has little disclosure as
well. With accounting flexibility, firms have options with certain policies that could hide
their true performance. If managers have incentives to reach certain profits, strict R&D
policies could force them to be creative with reporting other expenses to adjust for the
overstated expenses.
As stated earlier, firms in the food industry appear spend large amounts on R&D.
If R&D were to exceed 20% of operating income then it would need to be capitalized
for the last few years. Kraft spends close to half a billion every year on R&D, but as a
percentage of operating income this number is about 10%. Compared to net revenues
this percentage drops to a little over 1%. Only a small sub-section is devoted to R&D in
Kraft’s 10-K which means they don’t spend a lot of time elaborating on it. Two of their
competitors, Sara Lee and Heinz, don’t disclosure R&D in their reports. For Kraft, the
only amount of disclosure spent toward R&D is the amount spent on R&D for the year
and their goals. Kraft has similar goals as their competitors that include product safety
and quality, growth through new products, superior customer satisfaction, and reduced
costs. As you can see, R&D is important in this industry, but there is not a need for a
serious advancement of food products so only a small percentage is devoted to R&D.
86
Due to the previous reasons, it can be concluded that R&D in the food industry exhibits
low disclosure.
Pensions and Employee Benefits
Pension plans are a benefit given to employees provided by the firm. Kraft
provides a range of benefits to their employees and retired employees. The benefits for
working for Kraft are “health care benefits and postemployment benefits, consisting
primarily of severance” according to Kraft 10-k.
Kraft’s disclosure for their pension liabilities is relatively high and comparable
with the other leading firms in the food producing industry. All of their assumptions are
explained in detail with figures and statistics. The pension liabilities are broken down to
the U.S. segment as well as the international pension liabilities. The benefit obligations
are also broken down into the particular costs such as service, interest, benefits paid,
and settlements.
The three factors that affect the estimated pension liability are the assumptions
of the discount rate, the growth rate for pension plan assets, and the rate of
compensation increase. The way to determine whether Kraft uses these assumptions on
a conservative or an aggressive approach is to compare it with the assumptions used by
the competitors in the industry.
The next page contains a graph of the pension plan asset growth rate for five
firms in the industry during the last six years. Kraft starts their asset growth rate too
high in 2003, but their estimate declines until 2005 where it stays constant at 8%. The
8% percent assumption is right in the middle of the other firms’ assumptions. This
means their estimate is neither conservative nor aggressive.
87
The other factor that determines the pension plan liability is the discount
rate used. Compared to the other firms in the industry Kraft’s discount rate is again the
median for the other firms in the industry. Once again Kraft’s assumption is neither
aggressive nor conservative.
6
6.5
7
7.5
8
8.5
9
9.5
2003 2004 2005 2006 2007 2008
Kraft
ConAgra
Sara Lee
Nestle
Heinz
Penision Plan Asset Growth Rate
4
4.5
5
5.5
6
6.5
7
7.5
2003 2004 2005 2006 2007 2008
Kraft
ConAgra
Sara Lee
Nestle
Heinz
Pension Plan Discount Rate
88
The last factor that affects the pension plan liability is the rate of
compensation increase. Kraft uses a constant four percent assumption on the rate of
compensation increase. Being consistent with appropriate assumptions, Kraft’s cost of
living increase rate is right in the middle of the industry assumptions. This means that
this assumption is also neither aggressive nor conservative.
To conclude, on the strategy of estimating the pension plan liability Kraft is fairly
valuing the liability. Their assumptions are appropriate except for the high return on
plan assets.
Operating vs. Capital Leases
The level of disclosure provided about the type of lease used could potentially
have an adverse effect their valuation. Firms have the choice of either operating or
capital leases which are reported differently in the firm’s financials. Operating leases
are treated as rent and are left off the balance sheet even though there is a cash
outflow. Firms dealing with capital leases assume ownership and therefore the lease is
capitalized and appears on the balance sheet. It is more beneficial to firms to report
2
2.5
3
3.5
4
4.5
5
5.5
2003 2004 2005 2006 2007 2008
Kraft
ConAgra
Sara Lee
Nestle
Heinz
Rate of Compensation Increase for Pension Plan
89
leases as operating because it reduces the liabilities. With these two types of leases,
there is plenty of room for accounting flexibility. The flexibility that companies have
when reporting their leases makes it very easy for management to manipulate or distort
numbers to make the firm seem more valuable. It is important to determine a firm’s
level of disclosure and determine if a further assessment is needed. Kraft’s level of
disclosure provided on leases is classified as relatively low.
A large portion of Kraft’s lease obligations are reported as operating. Kraft
reports for 2008 shows that about 90% of lease obligations are operating. There is
little reasoning provided as to why this strategy is used. The only mention of operating
leases provided is, “Operating leases represent the minimum rental commitments under
non-cancelable operating leases.”(Kraft 10-K) As compared with their competitors, a
majority of firms carry a significant portion of operating leases on their financial
statements. The low level of disclosure provided requires a further analysis of their
statements and could potentially be a red flag.
Currency Exchange and Commodity Price Risk
As discussed earlier, the ability for a firm to minimize risk greatly increases
overall profitability. While a newer firm may have the inclination to take some risks in
hopes of getting a jump start, more established companies generally choose to
minimize any possible unforeseen expenses such as currency exchange and commodity
price inflation. In the food industry, firms that operate at large economies of scale have
the potential to suffer a greater loss if risk is improperly managed.
A common theme in the food, and many other industries, is the use of hedging
to minimize risk. As stated previously, Kraft hedges both in currency exchange and
commodity prices. This theoretically shields them from taking large losses if a market in
which they are operating takes an economical downturn. The firm avoids currency
90
exchange risk by making transactions in many forms of currency, and with several types
of exchange contracts. In order to maintain some stability in the fluctuating commodity
market, Kraft uses both forward and futures contracts. As mentioned before, this
strategy decreases inflation and commodity price risk by purchasing goods both at time
of purchase and at time of transaction.
While the management at Kraft attempts to minimize risk, it is impossible to
eliminate it. However, we often forget that risk goes hand in hand with possible returns
and losses. In 2007 Kraft found itself on the more favorable side of this risk return,
owing a $1,070 million revenue bonus to currency inflation alone. This is slightly
blemished because increasing commodity prices cost Kraft nearly $200 million of
operating income, which due to the current state of the economy may have been
unavoidable.
Conclusion
Kraft has reported annual financial statements with relatively high disclosure in
recent years, helping to establish the company as a trustworthy investment option.
While competitors sometimes tend to make information concerning goodwill or research
and development difficult to pinpoint, Kraft clearly states in the 10-K the reasoning
behind their financial decisions. The firm also reports financial documents somewhat
aggressively. Once again when numbers seem inflated it is not difficult to find the
reasons for any seemingly curious numbers. A large portion of Kraft’s total assets is
found in goodwill. This might be considered a red flag for most companies, but the
numbers appear to be solid on Kraft’s annual reports. The firm’s aggressive strategy for
mergers and acquisition has pushed the goodwill account through the roof. However,
while this account is somewhat aggressively reported, it seems to be considerably
accurate.
91
Quality of Disclosure and Red Flags
Basic information regarding accounting policies and strategies is required by
GAAP from all firms to be made available to the public. However, in order to create the
most accurate valuation of a company an auditor generally requires extensive
information transparency and disclosure to identify the actual state of the firm. The
depth into which a firm discloses information regarding business operations and
accounting strategy beyond requirements set forth by GAAP is left to the discretion of
the firm’s management. Should a company establish a reputation for high disclosure
quality, credit rating and stock prices reflect the reputation, thus increasing the firm’s
overall value.
Investors and auditors must be aware of what is considered “red flags” in
accounting. This is any oddity found in the firm’s annual financial statements compared
to industry standards. While these red flags are seemingly out of place, it is not possible
to label them as distortions in the firms accounting until a more in depth analysis of the
red flag item.
Kraft reports a relatively high quality of disclosure on their financial statements,
giving a transparent picture of all current business operations. Most information is
clearly denoted in footnotes where accounting strategies are discussed. All information
appeared to fit within industry standards with a few exceptions which will be further
examined.
92
Qualitative Analysis
Goodwill
Goodwill is a very sensitive account for competitors in any industry. This is
because goodwill is simply an estimation of the firm’s value beyond physical assets.
Because goodwill is a man made number, goodwill is impossible for auditors and
investors to narrow down to a specific dollar amount. This of course leads to temptation
for management to distort the account in order to enhance the view of the company
given by financial documents.
Kraft’s goodwill account, as mentioned before, makes up nearly half of the
company’s total assets, and qualifying the account to be considered a red flag item.
This leads to immediate questions concerning the origins of the enormity of this
account. It is clear that Kraft reports goodwill aggressively. However nearly doubling
the size of the industries standard goodwill account is cause for a more in depth
analysis. Kraft does discuss goodwill in detail on the annual 10-K’s describing how
mergers and acquisitions are the accounts main contributor. The firm clearly attempted
to reveal high transparency relating to goodwill in order to explain the large account. It
is difficult to locate information prior to 2002 discussing the accounts origins because of
recent mergers and divestitures such as with the split with Altria Group in 2007.
The results of this year’s annual impairment test of goodwill and other intangible
assets were very similar to those of the years before it. Little or no impairment has
been made to the account since 2002, implying that the firm’s management feels the
amounts reported are accurate. If goodwill were to be amortized over five years, Kraft’s
economic standings would drastically change. The results of this test are given in a later
section of this report (in undo accounting distortions section).
While goodwill is discussed in moderate depth in Kraft’s financial statements, the
information given does not appear to be sufficient to deem the account reasonable. The
93
quality of disclosure leaves investors searching for answers, raising concerns of possible
distortions in the account.
Research and Development
Research and development investments vary greatly in the food industry,
generally absorbing somewhere between 8 to 15% of operating income. While Nestle
spends well over $1.5 billion annually on R&D, Kraft generally invests less than one
third of that amount. In both cases, less than 3% of total sales dollars are invested in
R&D. This may be the reason for the relative lack of disclosure given on financial
documents. It is difficult to pinpoint where the dollars invested are being spent and
what return they are generating. Very little information is given discussing the exact use
of research and development and how it is accounted for beyond GAAPs standards.
Overall quality of disclosure of research and development is relatively low in
Kraft’s annual financial statements. There is little transparency, and discussion
concerning this expense is difficult to locate. R&D will not be considered a red flag item
for Kraft due to the relatively small amounts invested in comparison to overall business
operations.
Pension Plans
There is an extreme amount of flexibility in the estimation process of determining
pension plan liabilities. There are three major assumptions that must be made in order
to calculate the estimated pension fund liabilities. The first is the return on the pension
plan assets. There is absolutely no certainty in determining what rate of return a
portfolio will receive. Below is a graph of the rates of return for the five major food
producers in the industry for the past five years.
94
The firms’ estimations range from a maximum of a 9% to just below a 6.5%
return on plan assets. Kraft’s 9% return for a couple of years was way above the
industry norm. This would be identified as a red flag, but in the following years the rate
was dropped to a constant 8% return. Kraft’s 8% return lies just between ConAgra and
Heinz’s assumptions where the estimation is reasonable. Sara Lee has a downward
sloping rate that is on the conservative side of assumptions. The assumptions of the
firms can differ in many ways such as the amount invested in risky securities as
opposed to funds that are invested in lower yield debt instruments. With the overall
estimations of the firms compare to one another as an industry, Kraft does not seem to
be out of line. Therefore no red flag needs to be raised on Kraft’s assumption of the
return on pension plan assets.
Another estimation that firms must make for determining the present value of
the pension plan liabilities is the discount rate that is used. It would not make sense for
a firm to grow plan assets at 20% and only discount the present value back at a rate of
3%. The higher the discount rate the lower the present value of pension liabilities. This
means that firms have the ability to greatly overstate or understate their pension
5
5.5
6
6.5
7
7.5
8
8.5
9
9.5
2003 2004 2005 2006 2007 2008
Kraft
ConAgra
Sara Lee
Nestle
Heinz
Penision Plan Asset Growth Rate
95
liabilities. The graph below shows the discount rates used for the five major food
producers on a five year basis.
The graph seems to be relatively evenly distributed with the exception of Nestle’s
discount rates used until 2005. Kraft’s discount rate is right in the middle of the industry
norm. For all of the firms, the discount rate assumptions were “modeled on a portfolio
of high quality fixed income debt instruments with duration that match the future
expected cash flows of the benefit obligations.(Kraft 10-K)” With all of this in mind the
conclusion can be drawn that Kraft’s discount rate assumptions are appropriate and do
not raise any concerns for red flags.
The last factor for firms to estimate to calculate the amount of pension liabilities
is the rate of compensation increase. This rate should be perfectly correlated with the
inflation rate. Therefore the rates that firms use should all be around the same since
they all have the same information to base the estimation on. The graph below shows
the rates used for the past five years.
4
4.5
5
5.5
6
6.5
7
7.5
2003 2004 2005 2006 2007 2008
Kraft
ConAgra
Sara Lee
Nestle
Heinz
Pension Plan Discount Rate
96
The graph shows that the firms’ expectations vary from 3% to just over 5% from
the past five years. Kraft uses a constant 4% expectation in the amount in increase
wages for employees. This estimate is right in the middle of the industry making it the
average. Therefore there is no reason to identify this estimate as a red flag.
With all three of these assumptions analyzed, conclusions can be drawn. Kraft’s
growth rate for plan assets is a little high making it a more aggressive estimate, but a
fair one. The discount rates and the rates of compensation increases that Kraft uses fall
right in the middle of industry standards. Therefore, the pension liabilities that Kraft
states are fairly estimated and do not raise any concerns for red flags.
Operating vs. Capital Leases
As previously stated, firms in the food industry have the option to lease as
operating or capital. A quick review of the two leases is that capital leases are
capitalized and are treated as an asset and liability. Operating leases are treated as
rent and just show up as an operating expense and left off the balance sheet. If firms
deal with more operating leases, it is imperative that the amount be disclosed in the 10-
2
2.5
3
3.5
4
4.5
5
5.5
2003 2004 2005 2006 2007 2008
Kraft
ConAgra
Sara Lee
Nestle
Heinz
Rate of Compensation Increase for Pension Plan
97
Ks along with the purpose of choosing this type of lease. It was determined earlier that
Kraft’s level of disclosure was relatively low and required a further analysis.
As one would expect, the amount committed to both types of leases is disclosed
and the time payments are due. Kraft’s present value of operating leases is $796
million which amounts to 90.5% percent of lease obligations. Even with that
percentage being so high, Kraft discloses little as to why a large percentage of their
lease obligations are operating. The only managerial statement provided is, “Operating
leases represent the minimum rental commitments under non-cancelable operating
leases.”(Kraft 10-K) Due to the large percentage of operating leases and lack of
reasoning provided, this would almost certainly raise a “red flag.”
Further analysis of Kraft’s lease obligations reveals that this is not the case. All
lease obligations only account for 4.5% of long-term debt. That means that even
though operating leases account for most of the lease obligations, the percentage of
operating leases to long-term debt is only 4.1%. Since Kraft is dealing with 19 billion in
long-term debt, capitalizing the percentage of operating leases for the past 6 six years
would hardly affect the numbers reported in the financials. Reporting a majority of
operating leases is common strategy used throughout the industry, with only ConAgra
reporting a larger percentage of capital leases.
A comparison of the industry does not show that Kraft is intentionally keeping
capital activities off the balance sheet, but it certainly doesn’t point in that direction.
Based on these figures, this analysis provides sufficient information to determine that a
restatement of Kraft’s financials was not needed.
98
Currency Exchange and Commodity Price Risk
Risk management of currency exchange and commodity prices can be either an
asset or liability to a firm. The general strategy used in the food industry is to minimize
risk as much as possible to decrease possible profit loses. This is done through the use
of several types of contracts such as futures, forwards, and currency swaps. More depth
of the strategy of the food industry and Kraft was discussed previously.
Kraft reveals a very transparent view of their policies for minimizing risk, as well
as gains and losses that result from them. In 2007, approximately 42% of Kraft’s sales
took place in foreign countries, which presents a clear need for successful currency
exchange management. The strategies used are well stated in the financial documents,
explaining the types of contracts and how they are used. The firm also systematically
tracks results of hedging using various models, specifically value at risk.
“We made the VAR estimates assuming normal market conditions, using a 95%
confidence interval. We used a “variance/co-variance” model to determine the observed
interrelationships between movements in interest rates and various currencies. These
interrelationships were determined by observing interest rate and forward currency rate
movements over the prior quarter for the calculation of VAR amounts at December 31,
2007 and 2006, and over each of the four prior quarters for the calculation of average
VAR amounts during each year” (Kraft 10-K).
Kraft reports very high disclosure concerning risk management on annual
financial statements. Information is transparent and gives readers an accurate idea of
policies used and the results, whether the outcome is favorable or not. It appears that
the firm has used hedging efficiently, and have seen an increase in profits because if it.
99
Quantitative Analysis
Sales Manipulation Diagnostics
The sales manipulation ratios are useful in analyzing the financial statements of
Kraft and its competitors. These financial ratios examine the relationship between
sales, accounts receivable, and inventory. Comparing Kraft’s ratios to its competitors in
the industry as well as standard business benchmarks will help to raise any red flags in
Kraft’s financial statements. Another goal of this section is to make sure these ratios
don’t have isolated fluctuations and remain relatively consistent. This is shown in the
percentage change graphs that accompany each ratio. The sales manipulation
diagnostic ratios we used are net sales/accounts receivable, sales/inventory, and
sales/cash flow from sales.
Net Sales/AR
Net sales over accounts receivable is a ratio used to measure accounts receivable
turnover. It is found by dividing net sales over accounts receivable. This ratio will help
to show if Kraft and its competitors are distorting their net sales or accounts receivables
numbers. Sales and A/R have a positive correlation. If sales increase the account
receivables should increase proportionally. In most industries a high ratio is expected
and desirable. A high receivables turnover means the company is efficient at collecting
its AR. Firms are able to manipulate their reported financial figures and computing this
ratio reveals whether the figures reported are fictitious or accurate. The following
graphs show the receivables turnover, raw and change, for Kraft and its four
competitors.
100
As the above graphs show, the industry tends to move together in terms of
receivables turnover. All the firms in the industry remain fairly consistent, with few
drastic changes. Kraft’s revenues and A/R move together in a proportional manner that
seems to be realistically accurate. ConAgra’s sales in 2004 fell dramatically from the
previous year in yet their A/R stayed stagnant. This fact raises some concern about
their reporting. In 2007 ConAgra’s sales went up slightly from the previous year, but
4567891011121314
2003 2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
Receivables Turnover (Raw)
‐30%
‐20%
‐10%
0%
10%
20%
30%
40%
50%
60%
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
Receivables Turnover (Change)
101
their A/R went down more than one should expect. This is another issue that raises
concerns for that particular firm. The only other ratio computation that needed
attention was the increase in sales in 2007 for Sara Lee from the previous year where
the A/R fell dramatically sharp. This could be a misrepresentation from the company or
the A/R was just collected promptly. Other than these unusual occurrences, the industry
tends to move in a positive correlation. Because Kraft’s RT ratio has remained constant
and is in line with the industry norm, one can conclude its RT ratio does not raise any
red flags.
Sales/Inventory
Net sales/ inventory measures how fast a firm is turning its inventory into sales.
This is measured by taking the firms net sales for the period and dividing it by the
inventory for the period. Keeping high inventory levels are harmful to a firm because a
firm must not only pay to store it, but the inventory represents a zero or possibly even
a negative return investment. When a product stays in inventory too long its value is
eaten away by inflation. These reasons explain why a firm would want to distort its
accounting numbers to keep a high sales/inventory ratio. Sales and inventory should
have a positive correlation if the industry sells inventory and is not a service sector. Our
goal is to analyze whether the sales and inventory are rising and falling proportionally in
a realistic fashion. The following graphs show the Sales/inventory, raw numbers and
percentage changes, for the processed and packaged foods industry.
102
As seen in the above graphs, Kraft has kept a steady sales/inventory ratio.
Because of the steady nature of Kraft’s S/I ratio, there are no red flags raised. The
only potential red flag would be for Sara Lee from 2005 to 2007. Sara Lee’s
sales/inventory ratio jumped 120% in one year, and then its growth steadied. The
sharp jump in the ratio is due to Sara Lee reporting a nearly 100% decrease in
inventory from 2006 to 2007. This could either be the result of more efficient inventory
management, or it could be Sara Lee keeping its inventory off its books.
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
Sales/Inventory (Raw)
‐80%
‐60%
‐40%
‐20%
0%
20%
40%
60%
80%
100%
120%
140%
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
Sales/Inventory (Change)
103
Net Sales/Cash from Sales
Cash from sales is calculated by the current year’s net sales less the change in
account receivables. Sales/ cash from sales is an indicator of how much cash a firm
generates compared to the sales for a period. There is a positive correlation between
the sales from a firm and the cash received by the firm. The more sales there are the
more cash the firm should collect and vice versa. The net sales over cash from sales
ratio should be around 1:1. If this ratio goes above 1 then the firm is not getting fully
compensated for its sales. If this ratio is not near 1 it could mean the firm is
misrepresenting either its sales or its AR. A significant jump above or below 1 needs to
be further investigated.
0.92
0.94
0.96
0.98
1.00
1.02
1.04
1.06
2003 2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
Sales/Cash From Sales (Raw)
104
As the previous graphs show, most firms stay within the 0.98 to 1.02 range.
Fluctuations in this ratio are too be expected and do not necessarily imply accounting
distortions. Kraft has been steady with this ratio but has seen a recent increase. Still,
the changes for Kraft are less than +/- 2% each year. This is not a significant change
and causes no need for concern.
Expense Diagnostic Ratios
Expense diagnostic ratios are another way to verify and check a firm’s financial
statements. These ratios take various items from the financial statements such as
assets, sales, CFFO, and operating income and record the correlation between the two.
These expense ratios will help to point out any irregularities and possible red flags in
the financial statements of Kraft and its competitors. Just like in the revenue diagnostic
ratios the year to year percentage change is also analyzed to help point out any
potential accounting distortions. The expense diagnostic ratios that we used are asset
turnover, CFFO/OI, CFFO/NOA, and total accruals/sales.
‐6.0%
‐4.0%
‐2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
Sales/Cash From Sales (change)
105
Asset Turnover
Asset turnover is found by dividing net sales by total assets. This ratio represents
the amount of sales each dollar amount of assets produces. It is often used by analysts
to see whether or not a firm is appropriately writing off or depreciating its assets. A
firm’s asset turnover ratio is normally around 1. A 1:1 ratio implies every dollar of sales
matches every dollar of assets. When a firm’s asset turnover is low it could imply they
are not appropriately writing off or depreciating their assets.
0.50
0.60
0.70
0.80
0.90
1.00
1.10
1.20
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
Asset Turnover (Raw)
106
This diagnostic ratio is the first ratio that raises a red flag for Kraft. Although
Kraft has only slight percentage changes in asset turnover, the fact that the firm’s raw
asset turnover is significantly below the industry norm is cause for concern. An
explanation for this could be Kraft’s proportionately large amount of goodwill compared
to its competitors. Almost 45% of Kraft’s total assets are goodwill, significantly higher
than others in the industry. This could imply that Kraft is not correctly impairing
goodwill every year in order to inflate its total assets. According to Kraft’s 10-k, the
firm did not impair goodwill at all in 2005 and 2007 and only impaired it $424 million in
2006. With goodwill being such a significant amount of their total assets, and with very
little impairment being done, the issue of goodwill overstatement will need to be
addressed in the next section, undoing accounting distortions.
‐30.0%
‐20.0%
‐10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
Asset Turnover (Change)
107
Cash Flow from Operations/ Operating Income
This ratio is found by dividing the cash flow from operations on the statement of
cash flows by the operating income on the income statement. Again, for this ratio a 1:1
correlation is optimal. As the ratio nears one it implies that the firm must be getting
more of its operating cash flow from operating income. Any number over one might be
the sign of manipulation of financial statements.
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
2003 2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
CFFO/OI (Raw)
‐150.0%
‐100.0%
‐50.0%
0.0%
50.0%
100.0%
150.0%
200.0%
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
CFFO/OI (Change)
108
As the above graphs show, Sara Lee had greatly fluctuating peaks and troughs
throughout the past five years. This could be a sign of manipulation. Kraft’s ratio is
consistently under 1, but its number rarely fluctuates into a worrisome amount. This
implies that Kraft is getting some of its operating income from a source other than cash
flow from operations. This ratio raised no red flags for Kraft.
Cash Flow from Operations/Net Operating Assets
CFFO over NOA shows how well the operating assets generate cash revenues.
The net operating assets could also be considered the property, plant, and equipment
for any firm. A higher ratio means that the firm generates more revenue with the
operating assets than a firm with a lower ratio.
‐
0.10
0.20
0.30
0.40
0.50
0.60
0.70
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
CFFO/ NOA (Raw)
109
Above is a graph that shows the CFFO/NOA for the five major food producers.
Kraft shows consistency in the outcome of the ratio for the past five years. A key
indicator of accounting distortions is a large percentage increase in cffo/noa. A large
percentage increase may imply the firm is attempting to make its operations look more
efficient than they really are. Since Kraft is below the average and fairly consistent in
the computation of this ratio, no red flags are identified.
Total Accruals/Sales
Total accruals/sales is found by taking the difference between CFFO and net
income and dividing that number by total sales. This ratio measures a firm’s credit
tolerance. Again, ideally this ratio should be 1:1 because it implies that every dollar of
accruals is supported by a dollar of sales. If a firms ratio is higher than 1 we can
conclude that most of the firms’ sales are on credit. If a number is lower than 1 it
implies that at least some amount of sales were in some other form than credit
‐150.0%
‐100.0%
‐50.0%
0.0%
50.0%
100.0%
150.0%
2004 2005 2006 2007 2008
Kraft
Heinz
ConAgra
Sara Lee
Nestle
CFFO/NOA (Change)
110
accounts. The following graphs show the total accruals/sales numbers for Kraft and Its
competitors.
‐
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
2004 2005 2006 2007 2008
Kraft
Heinz
Sara Lee
Nestle
Total Accruals/Sales (Raw)
‐80.0%
‐60.0%
‐40.0%
‐20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
120.0%
2004 2005 2006 2007 2008
Kraft
Heinz
Sara Lee
Nestle
Total Accruals/Sales (Change)
111
As the above graphs show, this industry relies heavily on cash sales and other
forms of non-credit transactions. ConAgra has been omitted from the above graphs
because they were a clear outlier in almost every year. Kraft has remained relatively
steady, with the only significant change occurring from 2004-2005, with a 140%
decrease. However, this change is not as significant when you put it in the context of
the industry. All the firms in the industry experience relatively large percentage
changes in accruals/sales from year to year. Also, Kraft’s raw numbers are in line with
rest of the industry. These two conclusions lead us to believe accruals/sales do not
raise any red flags for Kraft.
Conclusion
After uncovering the level of disclosure presented in Kraft’s financial statements,
several conclusions can be reached. Only one item is considered a red flag area. This is
of course the accounting of goodwill. While it appears that the firm is not hiding
anything from readers of financials, the inconsistency with the industry is too great to
be overlooked. For this reason we will impair the goodwill account in the following
section in order to get a better grasp of the business.
Aside from goodwill most accounting strategies used by Kraft are reported with a
high level of transparency, revealing reasoning behind estimates and policies. Quality of
disclosure appears to be relatively high, leading investors to conclude that the firm
reports financial statements honestly and accurately. Our investigation of the industry
norms with the use of several ratios indicates that Kraft’s financials are a reliable source
for investors to use in valuing the firm.
112
Undo Accounting Distortions
Goodwill Impairment
When a red flag is raised it is an important for an analyst to undo the accounting
distortions to give a more accurate view of the firm’s fair value. All the previous five
steps in accounting analysis led up to this sixth step which is undoing accounting
distortions. The only red flag raised in the quantitative analysis for Kraft was the lack of
goodwill impairment. We felt that Kraft has overstated its assets through goodwill with
almost half of total assets attributed to goodwill.
As the previous chart shows, Kraft’s goodwill is over 2.5 times larger than their
PP&E. This is well above the threshold that states if goodwill is more than 20% of
PP&E it must be impaired. This means their balance sheet and income statement must
be restated. The first step in restating Kraft’s financials is to impair the goodwill for the
past 6 years.
Goodwill As a Percentage of PP&E 2002 2003 2004 2005 2006 2007 2008Goodwill 24911 25402 25177 24648 25553 31193 27581PP&E 9559 10155 9985 9817 9693 10778 9917Goodwill/PP&E 261% 250% 252% 251% 264% 289% 278%
113
Goodwill Restatement 2003 2004 2005 2006 2007 2008 Goodwill Before Impairment 25402 25177 24648 25553 31193 27581Goodwill - Book Value 20322 20097 15548 13344 16315 9440Goodwill After Adjustment 20322 16077 12439 10675 13052 7552Amount Impaired Annually @ 20% 5080 4019 3110 2669 3263 1888Cumulative Amount Impaired 5080 9100 12209 14878 18141 20029Total % Change in Goodwill After Impairment 27.4%
The first row entitled “Goodwill Before Impairment”, is the goodwill reported on
Kraft’s balance sheet. This chart shows the amount of impairment for the past 6 years.
We impaired goodwill by 20% for each year. After these calculations the restated
goodwill is 27.4% less than Kraft’s stated goodwill in 2008. We feel this is an
appropriate amount of impairment to show a more realistic view of Kraft’s assets.
Kraft's Adjusted Total Asset Value 2003 2004 2005 2006 2007 2008 Total Assets 59285 59928 57628 55574 67993 63078Cumulative Impairment Expense 5080 9100 12209 14878 18141 20029Total Assets After Impairment 54205 50828 45419 40696 49852 43049Percentage Decrease in Assets -8.6% -15.2% -21.2% -26.8% -26.7% -31.8%
The above chart is a snapshot of what the adjusted bottom line balance sheet
should look like. The total assets after impairment is calculated by taking Kraft’s balance
sheet total assets and subtracting the cumulative impairment expense that we have
found to be appropriate (20% impairment per year for five years). The cumulative
impairment expense is subtracted from the unimpaired total assets because this
number takes into account the previous year’s impairment expenses. After impairment
114
from the past years total assets for the firm come out to be $43.049 billion. The last
line item shows the percentage decrease in assets due to impairment of goodwill. In
2008 total assets decreased 31.8% from impairment. The last line item also shows the
impairments compounding effect; the per year percentage decrease gets greater as we
further impair goodwill.
Goodwill Impairment's Impact on Net Income Income before taxes 720 1213 1912 2376 1503 3160Effective Tax Rate 34.9% 32.3% 29.4% 23.7% 30.5% 28.2%Income Tax Expense 251 392 562 563 458 893Net Income 468 821 1350 1813 1045 2267
When goodwill is impaired it is impaired as an expense. Expenses are deducted
from earnings leading to earnings before taxes. Since the goodwill was impaired as an
expense the taxable income should be lowered. The above chart shows the adjusted
income before taxes less the goodwill impairment expense. The effective tax rates,
taken from Kraft’s 10-K, are multiplied by the adjusted IBT. This gives the adjusted tax
expense for each year, which leads to adjusted net income.
Decrease in Retained Earnings 2003 2004 2005 2006 2007 2008Unadjusted Retained Earnings 7020 8304 9453 11128 12209 13345Decrease in Retained Earnings 5080 9100 12209 14878 18141 20029Adjusted Retained Earnings 1940 -796 -2756 -3750 -5932 -6684
115
The above chart shows how the goodwill impairment effects retained earnings.
We started with the unadjusted retained earnings and subtracted out the cumulative
impairment expense to show the impairments affect on retained earnings. Since
goodwill was almost half of Kraft’s total assets, a 20% impairment per year caused a
significant impact on net income. This led to negative net earnings, which led to
negative retained earnings. This situation is not likely to occur in the real world. But,
in this hypothetical model it shows goodwill’s distortion of Kraft’s total assets. It is
acceptable for a firm to have negative retained earnings as long as the total owner’s
equity has a positive balance.
The following adjusted balance sheet and income statement from 2003-2008
represents the effects of a 20% impairment of goodwill for each year.
116
Kraft’s Balance Sheet 2003-2008 (In millions) 2003 2004 2005 2006 2007 2008 Total Current Assets
8,124
9,722
8,153
8,254
10,737
11,366
Long-term Assets: Property, Plant, and Equipment
10,155
9,985
9,817
9,693
10,778
9,917
Goodwill 20,322
16,077
12,439
10,675
13,052
7,552
Prepaid pension assets
3,243
3,569
3,617
1,168
1,648
56
Other intangible assets
11,477
10,634
10,516
10,177
12,200
12,926
other assets 884
841
877
729
1,437
1,232
Total Assets 54,205
50,828
45,419
40,696
49,852
43,049
Liabilities Total Current liabilities:
7,861
9,078
8,724
10,473
17,086 11044
Long-term liabilities 11,591
9,723
8,475
7,081
12,902 18589
total liabilities 30,755
30,017
28,035
27,019
40,698 40,878
Stockholder’s Equity
Paid-in Capital 23,704
23,762
23,835
23,626
23,445
23,563
Earning reinvested in the business
1,940
(796)
(2,756)
(3,750)
(5,932)
(6,684)
Accumulated other comprehensive losses
(1,792)
(1,205)
(1,663)
(3,069)
(1,835)
(5,994)
23,852
21,761
19,416
16,807
15,678
10,885
Less cost of repurchased stock
(402)
(950)
(2,032)
(3,130)
(6,524)
(8,714)
Total Stockholders’ Equity
23,450
20,811
17,384
13,677
9,154
2,171
Total Stockholders’ Equity and Liabilities
54,205
50,828
45,419
40,696
49,852
43,049
117
Conclusion
As the above graph shows Kraft’s assets are highly overstated because of the
amount of goodwill as a percentage of total assets compared with the competitors of
the industry. We tried to show a more accurate picture of Kraft’s assets so impairment
of goodwill was necessary. The goodwill was impaired at a 20% rate for six years. The
effects were dramatic when the income statement and balance sheet were adjusted for
the impairment. Net income dropped significantly as did the total assets of the firm.
Realistically if the goodwill was to be impaired it would be done in a period longer than
six years and at a lower rate than 20% because of the significant amount.
Below is a graph of the adjustment of goodwill as a percentage of total assets
compared with Kraft’s competitors. Although this picture looks more accurate, the firms
are not completely comparable because the other firm’s goodwill has not been
impaired. It seems as if the firms in the food producing industry have high levels of
goodwill that all need to be impaired.
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
2002 2003 2004 2005 2006 2007 2008
Kraft
Sara Lee
ConAgra
Nestle
Heinz
118
Financial Analysis, Forecast Financials, and Cost of Capital Estimation
In order to make an accurate valuation of a company an investor must have an
idea of how current trends will be exaggerated over time and how profitable the firm
will be. The valuation is accomplished through the financial analysis, forecasting of the
financials, and determining the cost of capital for the firm. The ratio calculations
compare the firm’s performance to their competitors and industry averages that allow
analysts to determine the firm’s financial performance. The ratios are also key
determinants in the forecasting of the income statement, balance sheet, and statement
of cash flows. Forecasting financial statements for the next ten years will be based on
the previous five years. The final step in the financial analysis is to calculate the
0.15
0.20
0.25
0.30
0.35
0.40
0.45
2003 2004 2005 2006 2007 2008
Kraft
Sara Lee
ConAgra
Nestle
Heinz
Goodwill As A Percentage of Total Assets (Impaired)
119
estimated cost of capital using the CAPM model and regression analysis. These
estimations assist in the valuation and provide the means to further examine the value
of the firm. The following analysis will include information regarding Kraft’s financial
statements after adjustment of goodwill only if that adjustment results in an alteration
of the company’s numbers for the ratio being examined.
Financial Analysis
The financial analysis is performed through a set of ratios using numbers from
companies’ financial statements. The financial ratios help analysts, investors and
creditors evaluate the firm, its competitors and the industry. These ratios help provide
a benchmark to compare the performance of a firm with the industry average to see
how well the firm is doing. The ratios were developed to measure liquidity, profitability
and capital structure of the firms. Once calculated the ratios can provide financial
analysts and potential investors with a valuable tool that can be used to properly value
the company.
Liquidity Ratio Analysis
The liquidity ratios are calculated using accounts from the balance sheet to
assess the cash availability of a firm. They allow analysts to measure the ability of a
firm to meet its short-term financial obligations. Managing cash inflows and outflows is
important because liabilities need to be met on time, and an excess in cash can show a
lack of economic efficiency. High liquidity ratios are desired because that means the
firm has sufficient liquid assets to meet liabilities ensuring short term survival. The
120
ratios include current ratio, quick asset ratio, accounts receivable turnover, day’s sales
outstanding, inventory turnover; days’ supply inventory, and working capital turnover.
Current Ratio
The Current Ratio is a measure of the firm’s ability to meet short term
obligations using their current assets. This ratio is found by dividing current assets by
current liabilities. A firm with a higher current ratio has the ability to meet current these
short term obligations more quickly and easily than others. The food industry
competitors operate with a vast range of current ratios. Overall over the past several
years the industry standard has been dropping slightly due to a reduction in consumer
spending and firms maintaining a tighter budget plan. Kraft’s current ratio has been
steadily declining for the past few years putting the firm well below the industry
standard. However in 2008 the firm increased cash and cash equivalents significantly,
boosting their current ratio nearly 40%. While Kraft is still operating at the lower end of
the industry in this category it appears that they are aware of the problem and are
attempting to make changes in order to have a more competitive current ratio.
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.00
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Current Ratio
121
Current Ratio 2004 2005 2006 2007 2008 Kraft 1.08 0.93 0.79 0.63 1.03 Nestle 1.21 1.16 1.09 0.83 0.99 Heinz 1.46 1.41 1.34 1.21 1.25 Sara Lee 1.06 1.17 1.08 1.31 1.16 ConAgra 1.71 1.89 1.62 1.87 1.67 Industry Average 1.36 1.41 1.28 1.30 1.27
Quick Asset Ratio
The quick asset ratio is exactly the same as the current ratio except it does not
include the inventory account because this can be more difficult to liquidate than other
current assets. This gives a clearer picture of the firm’s actual liquidity. The competing
firm’s within the food industry have very volatile quick asset ratio because inventory is
generally the most stable account included in current assets. Kraft has had a
consistently low quick asset ratio until 2008 which is directly related to their current
ratio because of the recent increase in cash and cash equivalents on hand. Again it
appears that Kraft has located their problem and is attempting to fix it by increasing
current assets in the form of cash on hand. The food industry although appears to be
down now, has had a consistent quick asset ratio standard over the past five years. The
recent drop is most likely related to a reduction in consumer spending.
122
Quick Asset Ratio 2004 2005 2006 2007 2008 Kraft 0.42 0.42 0.39 0.34 0.54 Nestle 0.57 0.88 0.80 0.56 0.62 Heinz 0.92 0.84 0.72 0.66 0.67 Sara Lee 0.47 0.52 0.63 0.89 0.72 ConAgra 0.66 0.63 0.51 0.58 0.28 Industry Average 0.61 0.66 0.61 0.61 0.57
Accounts Receivable Turnover
Account receivables turnover is calculated by dividing sales by total accounts
receivables. This shows how long it takes for a firm to collect outstanding sales, or
accounts receivables. Firms with high A/R turnovers have the ability to efficiently collect
its outstanding sales which implies an effective management strategy. Kraft has
maintained a somewhat steady A/R turnover which is similar to most of their
competitors within the industry. The exception is ConAgra whose turnover is
significantly higher than the rest of the industry and much more volatile. Overall the
food industry has increased their receivables turnover over the past five years. This
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Quick Asset Ratio
123
trend is related to an increasingly efficient management system used in all competing
firms. Having a high A/R turnover looks good to investors because it suggests that the
firm is capable of quickly liquidating their A/R if necessary in order to make quick
payments.
Receivables Turnover 2004 2005 2006 2007 2008 Kraft 9.08 10.08 8.60 6.95 8.97 Nestle 7.35 6.38 6.75 7.22 8.18 Heinz 7.70 8.16 8.63 9.03 8.67 Sara Lee 5.72 5.45 6.39 9.17 8.86 ConAgra 10.49 11.27 9.81 14.69 13.03 Industry Average 8.07 8.27 8.03 9.41 9.54
0.6
2.6
4.6
6.6
8.6
10.6
12.6
14.6
16.6
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Receivables Turnover
124
Days Sales Outstanding
Days sales outstanding is similar to accounts receivables turnover in that it
shows how long it takes for a firm to collect outstanding sales. The difference between
to two is that days sales outstanding gives an actual number of days which is easier to
understand for investors, allowing them to have an actual estimate of the amount of
time it takes for a firm to collect its outstanding sales. Unlike A/R turnover, it is
preferable to have a small day’s outstanding ratio because the less time it takes to
collect outstanding sales leads to a firm that has higher liquidity. Once again ConAgra is
the most successful of the competing firms in the food industry in this category, having
a consistently low DSO of about 30 days. The rest of the competitors including Kraft
have progressed to all having a DSO of between 40 and 45 in 2008, after being largely
inconsistent in previous years.
20.00
25.00
30.00
35.00
40.00
45.00
50.00
55.00
60.00
65.00
70.00
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Days Sales Outstanding
125
Days Sales Outstanding 2004 2005 2006 2007 2008 Kraft 40.18 36.22 42.46 52.50 40.69 Nestle 49.68 57.25 54.04 50.53 44.64 Heinz 63.84 66.99 57.16 39.81 41.19 Sara Lee 63.84 66.99 57.16 39.81 41.19 ConAgra 34.80 32.37 37.22 24.85 28.01 Industry Average 53.04 55.90 51.40 38.75 38.76
Inventory Turnover
Inventory turnover calculates how often inventory is purchased and sold within a
single year. It can be found by dividing cost of goods sold by inventory on hand.
Inventory on hand is considered an asset, but if it sits on the shelves or in warehouses
no benefit is obtained. Inventory is only considered a revenue generating asset if it is
sold to customers. The more the inventory is sold and replaced, the higher the turnover
ratio will be, and the more revenue will come in for the firm.
Inventory Turnover 2004 2005 2006 2007 2008 Kraft 5.88 6.53 6.09 5.87 7.56 Nestle 5.15 4.65 5.07 4.86 5.07 Heinz 4.6 4.54 5.17 4.68 4.64 Sara Lee 4.32 4.56 4.66 7.19 6.68 ConAgra 4.31 4.39 4.11 3.79 4.6 Industry 4.852 4.934 5.02 5.278 5.71
126
As the table shows, Kraft maintains a higher inventory turnover ratio than any
other firm with one exception in 2007. Sara Lee’s 7.19 inventory turnover ratio
outperformed Kraft’s 5.87 in 2007. The reason that Sara Lee’s ratio increased so much
for 2007 was because of inventory liquidation. It can be said that Kraft is the leader in
selling inventory more efficiently than its competitors in the food industry. By looking at
the inventory turnover ratios for all the firms and the industry average, you can see that
the selling of products has increased with time for the industry. This could be due to
efficiency of the firms as well as better control of inventory management. The inventory
turnover ratio will be forecasted by taking the average of the past five years. This
number ends up to be 6.39 turns per year. This number seems reasonable in the
expectation of future years as shown by its past history.
Days Supply of Inventory
The day’s supply of inventory ratio computation takes the inventory turnover a
step further, showing the average amount of days it takes for a firm to sell its inventory
on hand. This number is much simpler to understand than inventory turnover and gives
investors a better tool to evaluate efficiency and liquidity of a firm. It is calculated by
0.6
1.6
2.6
3.6
4.6
5.6
6.6
7.6
8.6
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Inventory Turnover
127
taking the previously computed inventory turnover ratio and dividing it into 365. The
fewer days it takes a firm to sell their inventories the more revenues they are bringing
in. Just like with the inventory turnover ratio, Kraft leads the industry in selling their
products at an accelerated rate. The average amount of days has been decreasing over
the past few years for the industry as a whole. Once again this is probable due to better
management of inventory control.
Days’ Supply of Inventory 2004 2005 2006 2007 2008 Kraft 62.04 55.86 59.96 62.15 48.29 Nestle 70.94 78.57 71.98 75.15 72.03 Heinz 79.28 80.40 70.61 77.96 78.72 Sara Lee 84.41 80.05 78.40 50.75 54.61 ConAgra 84.61 83.24 88.76 96.43 79.30 Industry Average 76.26 75.62 73.94 72.49 66.59
40.00
50.00
60.00
70.00
80.00
90.00
100.00
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Days Supply of Inventory
128
Working Capital Turnover
A company’s working capital is calculated by dividing sales by its current assets
less its current liabilities. The working capital is used to fund the firm’s daily normal
operations and to purchase inventories so that the firm can generate revenues. The
working capital turnover ratio shows the relationship between sales and the working
capital that generates those sales. The higher the working capital turnover the better
the firm is at generating sales with the working capital they have. The working capital
will be forecasted based on the forecast assumptions of sales, current assets, and
current liabilities.
Working Capital Turnover 2004 2005 2006 2007 2008 Kraft 46.35 -59.74 -14.99 -5.69 131.06 Nestle 13.97 15.41 34.84 -14.23 -625.87 Heinz 7.37 8.42 12.61 17.52 15.36
Sara Lee 34.15 13.19 22.48 8.93 21.11 ConAgra 6.78 6.82 6.34 5.17 4.77 Industry Average 21.72 -3.18 12.26 2.34 -90.71
‐100
‐50
0
50
100
150
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Working capital Turnover
129
As the table and graph show, Kraft started leading the working capital turnover
in 2004 but then significantly dropped in the years following. The reason for this is
because Kraft’s current liabilities exceeds it current assets by substantial amounts. This
shows that the firm had liquidity problems in the previous years. Although in 2008 the
firm fixed its liquidity problem by substantially decreasing its current liabilities while
increasing its current assets. The revenues in 2008 also made a substantial jump which
is why these figures collectively raised the working capital turnover ratio to 131.06.
The industry’s figures for the working capital turnover ratio do not appear to
have to distinct pattern. Heinz, Sara Lee, and ConAgra all show consistencies with the
turnover ratio. These three companies’ figures are the ones that could represent the
industry as a whole. Kraft and Nestle are too inconsistent because of their lack of
liquidity which distorts the working capital turnover ratio.
Conclusion
Liquidity plays an important role in a firm’s overall performance and success. The
ability to maintain a substantial amount of cash on hand, and be able to convert assets
to cash quickly to pay off unexpected obligations can help avoid unnecessary debts.
Competitors in the food industry tend to not have the liquidity of firms in other
industries, however are generally well capable of meeting any unexpected obligations.
Over the past few years liquidity has decreased substantially throughout the industry,
especially in 2008 where drastic losses were realized in cash and current assets.
However there is no reason to believe that this trend will continue after the current
recession subsides. Kraft operates with a reasonable liquidity in comparison to its
competition. As the above ratios display the firm is at or near the top of the industry in
most categories with a few exceptions. This implies that Kraft has a good management
system and has the stability and flexibility to continue operations securely.
130
Profitability Ratio Analysis
The objective of the profitability ratio analysis is to evaluate a firms efficiency,
productivity concerning assets, and rate of return on assets and equity. Several ratios
can be utilized to determine profitability that include gross profit margin, operating
profit margin, net profit margin, asset turnover, return on assets, and return of equity.
When these ratios are considered investors and analysts will have a much clearer
picture of how well each firm manages its assets and the efficiency in which they sell
goods.
Gross Profit Margin
The difference between a firm’s sales and cost of goods sold is gross profit.
Gross profit margin simply calculates the percentage of sales that gross profit makes
up. The ratio indicates the extent to which revenues exceed direct costs associated
with sales. Two factors that directly relate to the gross margin are, “the price premium
that a firm’s products command in the marketplace, and the efficiency of the firm’s
production process.”(Palepu & Healy) A high gross profit margin generally shows that a
firm is generating high sales compared to the amount spent on cost of goods sold. A
low ratio indicates that the firm has high cost of goods sold and needs a more cost
effective approach, or the selling price may need to be increased. The gross margin
compared across the industry can show how well a firm competes in their industry
against their competitors.
131
Gross Profit Margin 2004 2005 2006 2007 2008 Kraft 37.0% 36.0% 35.8% 33.4% 33.2% Nestle 58.3% 58.4% 58.6% 69.5% 56.9% Heinz 36.7% 36.0% 35.8% 37.7% 36.5% Sara Lee 68.4% 62.7% 53.0% 39.4% 38.3% ConAgra 22.0% 21.3% 24.3% 26.1% 23.4% Industry Average 44.5% 42.9% 41.5% 41.2% 37.7%
From the graph and table above, Kraft’s gross margin has declined slightly over
the past five years to 33%, down from .37% in 2004. This number is the second
lowest in their industry and falls below the industry average. Kraft’s decline in gross
profit margin can be attributed to cost of sales increasing at a faster rates than sales.
The ratio also shows Kraft is less efficient than their competitors and should explore
better ways to control costs. Nestle consistently operates with the highest gross profit
margin, exceeding 55% each of the past five years. Considering the size of the
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Gross Profit Margin
132
company this proves how efficiently costs are controlled, displaying the success of
Nestlé’s management system.
Operating Profit Margin
Operating Profit Margin is calculated as operating income divided by net sales.
This ratio is designed to display at what percent the firm is converting sales to profits
before interest and taxes. The higher the ratio is, the more efficient the firm is.
Operating Profit Margin 2004 2005 2006 2007 2008Kraft 14.3% 13.9% 13.6% 12.0% 9.0%Kraft Adjusted 14.3% 13.9% 13.6% 12.0% 9.0%Nestle 12.6% 13.0% 13.5% 14.0% 14.3%Heinz 16.4% 15.2% 12.9% 16.1% 15.6%Sara Lee 9.2% 8.5% 3.7% 4.7% 2.0%
ConAgra 9.5% 8.7% 7.5% 10.2% 6.0%Industry Average 12.7% 12.2% 10.8% 11.5% 9.3%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Operating Profit Margin
133
The food industry has maintained a relatively stable operating profit margin with
the industry average remaining between 10% and 12% in recent years. In 2008 this
number declined because of lack of spending due to the struggling economy. There is
no reason to believe that once the recession passes the industry will revert to a higher
average operating profit margin. Kraft’s margin has declined over the past five years,
specifically in 2008 along with the industry trend, and now falls directly on the industry
average. A more in-depth look shows that operating income has declined from 2006-
2008. This can be further traced back to cost of sales increasing at a faster rate than
net sales. As with the gross profit margin, Kraft may not be controlling fixed and
variable costs as well as they could be.
Net Profit Margin
Net profit margin is important in that it shows how efficient a firm is in
converting sales into net income which is generally the goal of any corporation. It is
calculated as net income divided by net sales, taking operating profit margin a step
further by including taxes and interest. As with the previous two profit margins, the
higher the ratio the better. A high net profit ratio is a good indicator that a firm is able
to manage their costs and maintain high net sales. A low ratio may highlight poor cost
management.
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Net profit margin 2004 2005 2006 2007 2008 Kraft 8.3% 7.7% 9.2% 7.2% 7.3% Kraft Adjusted 1.5% 3.4% 4.3% 1.7% 1.7% Nestle 6.4% 9.4% 10.0% 10.6% 17.3% Heinz 9.6% 8.4% 7.5% 8.7% 8.4% Sara Lee 11.5% 6.5% 5.0% 4.2% -0.6% ConAgra 6.1% 4.4% 4.6% 6.4% 8.0% Industry Average 7.2% 6.6% 6.8% 6.5% 7.0%
As indicated in the graph and table, the industry average stays fairly constant
through the years at around 6.5% and 7.2%. Kraft stays consistently around the
industry average along with Heinz and ConAgra, while Nestle has steady inclination with
a sharp jump in 2008. While one might conclude Nestlé’s large jump in 2008 could
raise the industry average, Sara Lee which has been consistently declining realized a
drastic drop in 2008 leading to a loss for the year.
After adjusting Kraft’s financial statements to include an impairment of goodwill
we find that the company would obtain a significant drop in net profit margin due to the
large reduction in net income. This places Kraft at a much lower yet fairly stable net
profit margin of between 1.5% and 4.3%. The large drop in net income indicates that
‐2.0%0.0%2.0%4.0%6.0%8.0%10.0%12.0%14.0%16.0%18.0%20.0%
2004 2005 2006 2007 2008
Kraft
Kraft Adjusted
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Net Profit Margin
135
goodwill represents a staggering amount of the company’s total net income and should
be an area of concern.
Asset Turnover
Asset turnover is found by dividing net sales by total assets. This ratio represents
the amount of sales each dollar amount of assets produces, and overall asset
productivity. It is often used by analysts to determine whether or not a firm is
appropriately writing off or depreciating its assets. A firm’s asset turnover ratio is
normally around 1. A 1:1 ratio implies every dollar of sales matches every dollar of
assets. When a firm’s asset turnover is low it could imply they are not appropriately
writing off or depreciating their assets. Investors and analysis’s often choose to use
asset turnover of a firm as opposed to the number given on the balance sheet in order
to determine how effective and efficient each dollar value of assets is.
0.40
0.50
0.60
0.70
0.80
0.90
1.00
1.10
1.20
2004 2005 2006 2007 2008
Kraft
Kraft Adjusted
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Asset Turnover
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Asset turnover 2004 2005 2006 2007 2008 Kraft 0.54 0.59 0.60 0.53 0.67 Kraft Adjusted 0.64 0.72 0.78 0.93 0.88 Nestle 1.05 0.89 0.97 0.93 1.03 Heinz 0.91 0.82 0.82 0.92 1.00 Sara Lee 0.73 0.75 0.78 0.83 1.08 ConAgra 0.96 1.14 0.97 1.02 0.85 Industry Average 0.81 0.82 0.82 0.86 0.92
Almost all the firms in this industry operate at or above 1 asset turnover, except
Kraft. Kraft consistently falls well below the industry average of 0.93 with 0.67 asset
turnover. Although Kraft has only slight percentage changes in asset turnover, the fact
that the firm’s raw asset turnover is significantly below the industry norm is cause for
concern. An explanation for this is Kraft’s disproportionately large amount of goodwill
compared to its competitors. Almost 45% of Kraft’s total assets are goodwill,
significantly higher than others in the industry. This could imply that Kraft is not
correctly impairing goodwill every year in order to inflate its total assets. After
adjusting goodwill on Kraft’s financial documents the firms asset turnover was
drastically altered. While still below 1 each year, Kraft’s asset turnover would increase
by about .2 per year which would put them much closer to the industry average and
create a much more desirable ratio for investors and analysts to consider.
Return on Assets
Return on Assets is a comprehensive measure of profitability that considers both
profits and resources employed to earn profits. Rate of return on assets is computed as
net income divided by total assets of the prior year. Because assets are lagged one
year, one can see how the previous year’s assets directly affected the current year’s net
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income. A high ratio is desirable because it reflects management’s success in
maintaining costs and utilizing assets to create income for the firm.
Return on Asset 2004 2005 2006 2007 2008 Kraft 4.5% 4.6% 5.5% 3.8% 4.9% Kraft Adjusted 1.0% 2.4% 3.3% 1.6% 1.5% Nestle 6.7% 8.4% 9.7% 9.9% 17.9% Heinz 8.7% 7.6% 6.1% 8.1% 8.4% Sara Lee 8.4% 4.8% 3.9% 3.5% -0.6% ConAgra 5.8% 5.0% 4.5% 6.5% 6.8% Industry Average 5.9% 5.5% 5.5% 5.5% 6.5%
The food industry has maintained a steady average ROA for the past few years
ranging from 5.5% to 6.5% each year. Nestles has maintained the highest ROA of the
listed competitors. After rising steadily for several years the firm jumped to nearly 18%
up from 10% in 2007. Sara Lee was receiving a notable 8.4% ROA in 2004 but has
‐5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
2004 2005 2006 2007 2008
Kraft
Kraft Adjusted
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Return on Asset
138
dropped to -.6% since then leading to the assumption that the company’s management
system may be crumbling.
Kraft has also been operating with a relatively low ROA, however similarly to
asset turnover it has been consistent. Due to the fact that the company has a struggling
ROA it appears that Kraft might be overstated when considering this ratio. After
adjusting the company’s financials Kraft’s ROA drops down to between 1% and 2.4%
with one exception in 2006. Although the asset account realizes the most drastic hit
from amortizing goodwill, the net income takes a similar but less drastic loss.
Return on Equity
Return on equity is a measure to demonstrate how much revenue is generated
through equity financing. In order to calculate the ROE the net income of a firm is
divided by the shareholders equity. Having a high ROE indicates that a firm is
performing very well, and successfully using its resources and capital in order to
generate returns.
‐10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
2004 2005 2006 2007 2008
Kraft
Kraft Adjusted
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Return on Equity
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Return on Equity 2004 2005 2006 2007 2008 Kraft 9.3% 8.8% 10.4% 9.1% 11.2% Kraft Adjusted 2.5% 6.6% 9.5% 5.2% 9.7% Nestle 16.3% 21.8% 20.0% 22.5% 38.4% Heinz 67.1% 39.7% 24.8% 38.4% 45.9% Sara Lee 56.0% 24.4% 18.9% 20.6% -3.0% ConAgra 19.0% 13.3% 11.0% 16.4% 20.3% Industry Average 28.4% 19.1% 15.8% 18.7% 20.4%
The food industry average ROE ranges from over 28% in 2004 to 15.8% in the
last five years. This industry average is strongly affected by the large changes seen by
Heinz and Sara Lee every year, while the other firms tend to remain relatively
consistent. Kraft has a ROE of about 10% over the last few years. Although this
number is not very high, Kraft has been consistent unlike its competitors. This
consistency is a good sign showing that the company has an unchanging management
plan which they stand by each year, lowering the risk of the company. Although the
firm has a low ROE, the size of the company is larger than that of most competitors,
creating larger returns on a yearly basis.
Conclusion
Profitability is the one area of the food industries operations that appears to have
suffered the least from recent economic downfall. The ratios used to evaluate
profitability lead to the assumption that on average the food industry is capable of
maintaining high profit margins. Nestle and Heinz appear to have profit driven success
compared to their competitors, both increasing profitability over the last few years,
especially in 2008. Sara Lee and Kraft operate on the opposite end of the spectrum with
much smaller margins across the board. This is likely related to the firms being more
focused on cost efficiency. After restating Kraft’s financial statements to impair goodwill
the firms inflated numbers become very visible. This will have a negative effect on
possible investors when considering Kraft.
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Firm Growth Rate Ratios
An important part of analyzing a firm in any industry is calculating growth trends
in the last few years. These trends are likely to continue into the future which helps
understand the overall value of the company. If growth rates are increasing one should
expect the company to continue to grow and remain profitable, and of course
downward sloping rates will be expected to have the opposite results. An important
point to consider when evaluating growth ratios is stability. When a firms growth rates
increase steadily over time risk of inflated financials or an unexpected downward turn is
much smaller. On the other hand when a company’s growth rate shows multiple drastic
shifts up or down, questions will arise to the cause of those sporadic changes.
Internal Growth Rate
The internal growth rate measures the extent to which a firm has the potential to
grow internally, or without outside financing such as loans. Having a higher IGR gives
the firm more mobility in dealing with mergers and acquisition and shows that there are
more funds available to be spread throughout the company. The IGR can be measured
by using the equations:
IGR = ROA (Plowback Ratio):
IGR = (Net Income / Assets) x (1 – Dividends / Net Income)
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IGR 2004 2005 2006 2007 2008 Kraft 0.023 0.021 0.027 0.014 0.022 Kraft Restated -0.005 -0.039 -0.008 -0.002 -0.026 Nestle 0.037 0.041 0.061 0.064 0.179 Heinz 0.046 0.036 0.022 0.033 0.036 Sara Lee 0.050 0.021 0.014 -0.003 -0.002 ConAgra 0.023 0.007 -0.003 0.034 0.042 Industry Average 0.039 0.026 0.024 0.032 0.064
The food industry has somewhat of a volatile IGR each year, increasing by 100%
from 2007 to 2008, and having similar vast changes over the last few years. Nestle
jumped from .064 to .179 in 2008 because of the substantial increase of net income to
over $17 billion. Kraft’s IGR is consistently below the industry average; however
appears to be more stable than its competitors, which creates appeal to investors
because the risk of having a negative year is much lower. After restating goodwill Kraft
went from having a low IGR to a consistently negative one. This is directly related to
the drop in ROA and net income in the adjusted financial documents.
‐0.100
‐0.050
0.000
0.050
0.100
0.150
0.200
2004 2005 2006 2007 2008
Kraft
Kraft Restated
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Internal Growth Rate
142
Sustainable Growth Rate
Sustainable growth rate is the maximum possible growth rate of revenues a
company can realize without increasing financial leverage, and is a valuable tool in
evaluating future growth plans. The formula below is used to calculate SGR.
SGR = IGR * (1 + DE)
SGR = (IGR (See above)) * (1 + Debt / Equity)
SGR 2004 2005 2006 2007 2008 Kraft 4.7% 4.0% 5.2% 3.5% 6.3% Kraft Restated -1.3% -11.4% -2.6% -1.1% -124.2% Nestle 8.1% 8.7% 11.8% 13.5% 34.7% Heinz 24.0% 14.6% 10.7% 18.2% 20.1% Sara Lee 25.2% 10.4% 8.1% -1.5% -0.6% ConAgra 6.7% 1.9% -0.7% 8.7% 10.6% Industry Average 16.0% 8.9% 7.5% 9.7% 16.2%
‐140.0%
‐120.0%
‐100.0%
‐80.0%
‐60.0%
‐40.0%
‐20.0%
0.0%
20.0%
40.0%
60.0%
2004 2005 2006 2007 2008
Kraft
Kraft Restated
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
143
The food industry average over the last five years has varied from a 7.5% SGR
up to more than 16% in 2008. This is attributed to the constantly changing debts and
equities within the industries competing firms relating to mergers and acquisitions. Kraft
has maintained a relatively stable SGR of between 4% and 6% with 2008 being the
best year. The firms growing SGR is similar to the trend of the industry average. For
example Nestles SGR topped 30% and Heinz jumped to 20.1% SGR. Only Sara Lee’s
SGR has fallen, dropping into negative growth after being having the most promising
numbers in 2004 at over 25%.
After restating Kraft’s financial statements for goodwill impairment the firms SGR
had a significant change. Each year Kraft would have had negative sustainable growth
rates. 2008 dropped all the way to -124% SGR mainly because owner’s equity
diminished drastically along with goodwill and net income, which implies that the
company would shrink.
Conclusion
Most of the potentially competitive companies within the food industry have
managed to maintain steady growth rates over the past five years. Although they tend
to decline over time, the overall stability is a positive indicator. Nestle is the exception
to this downward trend, experiencing a drastic increase in both IGR and SGR in 2008.
This is cause for further inspection for potentials investors and analysts. Sara Lee has
the most unimpressive growth rates of the measured firms, dropping into the negative
category in 2008. While Kraft appears to have a respectable growth pattern over the
past five years, the restatement of financial statements indicates that this growth
pattern may potentially be overstated. The SGR of Kraft in 2008 dropped so far that if
goodwill were actually impaired in this way over such a short period of time then the
company would be required to take drastic steps to stabilize its growth rates.
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Capital Structure Analysis
The final step we will take in order to analyze companies within the food industry
is to compute several ratios in order to understand the capital structure of each firm.
This will help determine the source of financing to acquire assets to be used in the
creation of revenues. These ratios will be focused on the liabilities and equity portions
of the balance sheet of each firm. The ratios we will use to analyze capital structure
include debt to equity ratio, times interest earned, and debt service margin. We also will
consider Altman’s Z-Score in order to have an idea of which companies are performing
well, and which are failing or nearing bankruptcy.
Debt to Equity Ratio
Firms have the option of financing their companies through debt instruments or
by issuing equity securities. The cost of debt is usually cheaper because it is less risky
for investors, but interest can accumulate that can make earnings volatile. The debt to
equity ratio shows how much financial leverage the firm uses to finance its assets. It is
important to have the right balance of debt and equity used to finance the company.
Too much equity will increase the cost of capital while too little debt will not benefit the
firm because of the tax shield. Too much debt put the firm in a risky position for default
and will lower the credit rating.
Debt to Equity Ratio 2004 2005 2006 2007 2008
Kraft 1.00 0.95 0.95 1.49 1.84Kraft Adjusted 1.70 1.89 2.32 5.41 47.26Nestle 1.19 1.09 0.93 1.11 0.93Heinz 4.21 3.06 3.75 4.45 4.60Sara Lee 4.05 3.91 4.93 3.66 2.85ConAgra 1.94 1.63 1.57 1.58 1.56Industry Average 2.35 2.09 2.41 2.95 9.84
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As the graph and table shows, Kraft hovered around a completely balanced debt-
to-equity ratio in the years 2004-2006. In 2007 and 2008, the debt starting
substantially increasing, leading to the rising D/E ratio of 1.49 and 1.84, respectively.
This means that over the most recent two years Kraft incurred large amounts of debt to
finance its operations. This might be risky for the firm, but the D/E ratio is still around
the industry average. The forecast of the debt-to-equity ratio will be focused on the
equity side. The liabilities will be distorted because our goal is to focus on the equity
valuation.
The industry as whole is more heavily financed by debt. Heinz and Sara Lee are
debt financed around 4 to 1. These two firms distort the industry average. The other
firms such as Nestle, ConAgra, and Kraft are around the 1.5 to 1 debt to equity. These
figures are the ones that we are going to be referring to when forecasting the debt to
equity ratios.
In order to understand the effect of amortizing goodwill on Kraft’s adjusted
balance statements further we included it in this ratios analysis. As the graph clearly
0.005.00
10.0015.0020.0025.0030.0035.0040.0045.0050.00
2004 2005 2006 2007 2008
Kraft
Kraft Adjusted
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Debt Equity
146
indicates, the debt equity ratio is noticeably higher over the past five years, most
apparent in 2008 when the ratio would jump to almost 50. This is caused by the
owner’s equity account diminishing to less than .5% from where it started. These
numbers are a serious cause for concern and require action to be taken in order to
lessen the impact of goodwill on the company.
Times Interest Earned
In order to understand the ability of each company operating in the food industry
to payoff interest expenses and similar charges for each year we found times interest
earned for each firm. This is found by dividing net income before interest and taxes
(NIBIT) by total interest expense for the year. Unfortunately it was difficult to find each
firm’s interest expense from past years so there are a few missing points on the table.
0.00
5.00
10.00
15.00
20.00
25.00
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
147
Times Interest Earned 2004 2005 2006 2007 2008Kraft 0.00 0.00 0.11 0.14 0.32Kraft Adjusted 0.00 0.00 0.11 0.14 0.32Nestle 0.06 0.05 0.05 0.06 0.07Heinz 0.15 0.17 0.28 0.23 0.23Sara Lee 0.00 0.00 0.00 0.00 0.00ConAgra 0.20 0.23 0.29 0.18 0.36Industry Average 0.07 0.08 0.14 0.13 0.22
As the data given shows, the food industry is for the most part able to payoff
interest charges without problems. Nestle operates above its competitors due to its
large NIBIT created. However it is clear that each firm, including Nestle, has a steadily
declining times interest earned. Reasons for this would seem to be simply a declining
NIBIT due to the struggling economy; however that is not the case for each firm. Nestle
and Heinz have both grown their income over the last five years, however their interest
expenses have increased vastly to counter the growing profit. Kraft is one of the firms
with a declining NIBIT which is causing the drop of times interest earned, while
experiencing growing interest expenses at the same time. This problem will need to be
addressed before the firm is able to be considered successful again.
Because there was no difference in Kraft’s times interest earned after adjusting
the financial statements for goodwill impairment, we found that it was not necessary to
include that entry in the above graph.
Debt Service Margin
The firm’s debt service margin finds the availability of cash provided by
operations to pay off the current portions of long term debt. Maintaining a higher debt
service margins displays that a firm has a large amount of cash available to pay off
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debts. The food industry in general has a low debt service margin due mainly to high
amounts of debt required to be paid off each year. This indicates that the industry is
less liquid than most, however due to the nature of business it is to be expected and
does not raise any concern. The debt service margin is calculated using the following
equation:
(Cash provided by operations)
(Installments due on long term debt)
Debt service Margin 2004 2005 2006 2007 2008Kraft 3.02 1.35 1.79 1.14 0.51Kraft Adjusted 3.02 1.35 1.79 1.14 0.51Nestle 0.49 0.57 1.00 1.34 0.46Heinz 8.07 2.66 1.88 19.31 2.54Sara Lee 1.89 1.20 1.93 0.23 0.41ConAgra 1.40 2.68 7.32 2.19 2.58Industry Average 2.97 1.69 2.78 4.84 1.30
0
5
10
15
20
25
2004 2005 2006 2007 2008
Kraft
Nestle
Heinz
Sara Lee
ConAgra
Industry Average
Debt Service Margin
149
As the information above shows, competing firms in the food industry have gone
from an average debt service margin of about 3 down to half of that in just five years.
This sharp drop raises concerns about availability of cash to pay current debts. It also is
due to large amounts of debts that must be paid off each year. While the food industry
has, and will never had high debt service margins, the downward sloping trend that we
have seen in the past few years needs to be addressed. Kraft is worse off than the
industry average, down more than 80% since 2004 to having a .51 debt service margin.
Cash flows from operations have remained relatively steady; however debt seems to be
piling up for Kraft. This could be directly related to the large expansion efforts seen by
the firm recently, acquiring several new companies in the last few years alone.
Adjusting Kraft’s financial statements for the impairment of goodwill had no
effect on the company’s debt service margin giving us no reason to include adjusted
numbers on the above graph.
Z-Score
Kraft’s Z-score is calculated by the five weighted variables listed below to
compute a bankruptcy score. Many firms and investors would make use of this method
to ensure that the company is not in risk of bankruptcy. Prospective shareholders
would use the Z-score method to calculate the risk when the investor wants to buy
stock in the firm.
The Z-score is used by creditors to calculate the credit score and credit risk
among firms. If the firm has a score below 1.81 in regard to the Z-score, the model
predicts bankruptcy. On the other hand, if the Z-score is found to be above 2.67, the
firm is considered to have good performance for the year. The higher the Z-score, the
better the firm is rated. Having a Z-score above 3.00 implies a lower interest rate used
by the firm. To calculate Kraft’s Z-score and the other leading firms in the food industry
we used the formula below:
150
1.2(Net Working Capital/Total Assets)
+1.4(Retained Earnings/Total Assets)
+ 3.3(Earnings before Interest and Taxes/Total Assets)
+ 0.6(Market Value of Equity/Book Value of Liabilities)
+ 1.0(Sales/Total Assets) = Kraft’s Z-Score
0.6
1.6
2.6
3.6
4.6
5.6
6.6
7.6
8.6
9.6
2004 2005 2006 2007 2008
Kraft
Kraft Adjusted
ConAgra
Heinz
Sara Lee
Nestle
Industry Avg
Z‐Scores
151
Z-Scores 2004 2005 2006 2007 2008Kraft 2.196 2.0085 2.4162 1.6011 3.3194 Kraft Adjusted 2.0849 1.9559 2.2516 1.5017 1.5294 ConAgra 2.7682 3.0692 2.7319 3.1345 2.5218 Heinz 6.8578 6.9910 8.7918 8.7372 8.4327 Sara Lee 2.3205 2.3029 1.8865 2.4754 2.3806 Nestle 2.2709 2.1300 2.2666 3.8271 4.4112 Industry Avg 3.2827 3.3003 3.6186 3.9551 4.2131
The Z-scores for Kraft came are relatively low compared to the industry average.
The Z-score for 2007 showed that the company was in a hazardous financial position.
The firm started raising its financial position as shown in 2008 with a 3.3194 Z-score.
This means Kraft is currently liquid and solvent, and that the credit risk is low.
Investors should not be deterred from Kraft based on the Z-score calculated. Another
benefit that Kraft could have based on the current Z-score is lower interest rates
meaning that Kraft could borrow more money to finance business operations at a lower
cost of capital.
The adjusted Kraft Z-score was much lower than the unadjusted ones because
the retained earnings on the adjusted balance sheet were negative, and the assets
were much lower. If the firm did impair its goodwill at the rate we applied the firm
would definitely be in financial distress. Each year of impairment would lead to the
companies Z-score being very near or below 2, well below the industry average and the
unadjusted score. In the early years the drop in Z-score is relatively small, increasing
with each passing year of impairment ending with nearly a 2 point difference in 2008.
The industry average is higher than most of the firms’ Z-scores because Heinz
tends to be an outlier compared to the industry norm. The reason Heinz has such a
high Z-score is because they obtain revenues with much lower total assets. The firm is
152
more efficient at generating revenues than the others in the industry. Heinz Z-score is
above a 6.00 for the last five year period which led them to higher performance and a
low probability of bankruptcy.
Nestle shows a growing trend of increasing financial position. One factor for this
growth is the fact that Nestle issued large amount of securities during the 2007-2008
period. The equity financing decreased the risk of bankruptcy, and moved their Z-score
from a “grey area” to a stable, liquidable position.
Conclusion
Kraft profitability ratios are considered to be average in comparison to the whole
industry. Kraft is not one the best companies when we analyzed the Z-score, but is not
one of the inferior firms. Kraft is being outperformed by their competitors in some
aspects such as keeping the lowest ratios among their competitors which represent
more equity to the firm rather than debt.
The capital structure analysis is computed by: the debt service margin, debt to
equity ratio, and the times interest earned. These three ratios will give you a better
picture of the analysis on the Z-score. First, Kraft’s debt to equity is one of the lowest
ratios in comparison to their competitors which consist of more equity than debt.
Second, the times interest earned ratio is considered to be above the average since
Kraft’s times interest has been increasing for the last three years. Third, the debt
service margin for Kraft has a low variation since the firm has maintained constant with
the industry.
Kraft has continually been a top performer in the food industry and it will most
likely continue this trend since the company doesn’t currently have a low Z-score. Kraft
appears to be a healthy company to invest in for their regular Z-score, but not one of
the top performers in the industry. In other words, rating institutions like Moody’s and
153
S&P rating firm will rate Kraft as an average firm that will most likely survive the
current recession and the competition among competitors.
By including Kraft’s adjusted financial numbers in the ratio analysis we have a
general idea of the company’s actual performance levels over the past five years. The
lack of goodwill drastically decreases Kraft’s business outlook and makes the company a
much less attractive investment from an outside view. All ratios involving total assets
or goodwill in any way realized unhealthy changes, often altering the ratio enough to
cause a panic if the numbers were true.
Cost of Equity
One way for firms to acquire capital is to issue stock. The cost of equity is the
minimum return that shareholders are expecting from their investments. We used the
capital asset pricing model to determine the cost of equity for Kraft. It is calculated by
taking the estimated beta, multiplying it by the market risk premium, and adding the
risk free rate.
CAPM = Risk Free Rate + Beta (Return on the market – Risk Free Rate)
Regression analysis was implemented in order to find the most appropriate
estimate of beta for Kraft. The beta explains how the firm reacts to systematic risks in
the market. The return on the market was found by calculating the average return of
the S&P 500 for the past eighty months, and then adjusted appropriately for outliers.
The risk free rate was acquired from the St. Louis Fed on 10-month Treasury bills.
In order to calculate the most accurate beta, five points on the yield curve were
considered. Returns that are used in the regression include the 3 month, 1 year, 2 year,
5 year, and 10 year treasury notes, and the average return on the market. It was then
implemented into, 24, 36, 48, 60, and 72 month time horizons to determine the most
effective and appropriate beta estimation found on the St. Louis Federal Reserve
economic database. In order to find the most accurate beta the regression model
154
containing the highest adjusted R^2 is used that shows how high the explanatory
power of the regression is. The regression model with the highest adjusted R^2 was at
.266 for the 24 month slice of the three month Treasury bill with an estimated beta at
.728. The adjusted R^2 isn’t very high, however it is the best that was available. After
all of this information was calculated and made available we were able to implement
the capital asset pricing model. We determined Kraft’s cost of equity to be at 7.82%.
We also calculated the upper and lower bounds of the cost of equity with a 95%
confidence level. These percentages turned out to be 4.46% on the lower bound, and
11.18% on the upper bound. With this range in mind, the estimated cost of equity at
7.82% seems very reasonable. Below is the 24 month regression model which was used
in order to best estimate Kraft’s beta.
Regression Statistics
Multiple R 0.5459
R Square 0.2981 Adjusted R Square 0.2662
Standard Error 0.0621
Observations 24
ANOVA
df SS MS F Significance
F
Regression 1 0.03600 0.0360
0 9.3415
7 0.00578
Residual 22 0.08477 0.0038
5
Total 23 0.12077
Coefficient
s Standard
Error t Stat P-value Lower 95% Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0113 0.0142 0.7955 0.4348 -0.0182 0.0409 -0.0182 0.0409
X Variable 1 0.7284 0.2383 3.0564 0.0058 0.2342 1.2227 0.2342 1.2227
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Cost of Equity Using CAPM:
2.87% + .73 (9.67% - 2.87%) = 7.82%
Cost of Equity with upper 95% CI
Upper Ke: 2.87% + 1.22267 (9.67% - 2.87%) = 11.18%
Lower Ke: 2.87% + .23416 (9.67% - 2.87%) = 4.46%
Size Adjusted CAPM
There is an additional theory in the capital asset pricing model that there is a size
premium for the firm that’s cost of equity is being determined. It is thought that smaller
companies tend to hold more risk than much larger firms. Smaller firms tend to be more
risky so the expected return should subsequently be higher. Conversely, larger firms are
less risky for investors so the expected returns should be lower. On a scale of one to
ten, with one being the smallest sized firm, Kraft comes out to be a nine. Using the
table from Business Analysis Valuation by Palepu and Healy, the size premium is a .7%
increase on the cost of equity. This makes the size adjusted CAPM for Kraft at 8.52%.
Size Adjusted Cost of Equity: 2.87% + .728415 (9.67% - 2.87%) + .7% = 8.52%
Backdoor Cost of Equity
The backdoor method is an alternative method used to estimate the cost of
equity. This valuation method uses a formula based on the price to book ratio, the
return on equity, and the growth rate of equity. The formula is listed below.
(Price / Book) – 1 = ((ROE – Ke) / (Ke – g))
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The price to book ratio which is found on Yahoo! Finance is currently listed at
1.51. The return on equity was found by calculating the average of the lagged ROE
ratio from the forecasted years 2009–2018. This resulted in an average ROE of 13.53%.
The growth rate used in the backdoor method is found by averaging the growth rate of
forecasted owner’s equity. Kraft’s forecasted growth rate resulting from that average is
5.94%. By plugging those numbers into the formula listed above we were able to
calculate Kraft’s estimated cost of equity through the backdoor method, which we found
to be 10.97%.
Backdoor ROE P/B g Ke 13.53% 1.51 5.94% 10.97%
Although the CAPM method of finding Ke is more commonly practiced, after
comparing it to the backdoor method, we came to the conclusion that the cost of equity
resulting from the backdoor method is a more reliable estimation. We came to this
conclusion because the 7.82% Ke calculated by the CAPM method is unreasonably low.
The capital asset pricing models is based on how the firm reacts to market wide risks or
systematic risks. The backdoor method is based on firm specific risks, and gives a more
accurate estimation on the cost of equity. This firm specific risk found by the backdoor
method has a higher cost of equity and is therefore more realistic and reliable.
Adjusted Backdoor Cost Equity
The inputs to calculate the backdoor cost of equity change when the impairment
of goodwill takes place. The ROE changes because the net income is affected by the
goodwill impairment expense. The shareholders equity also changes because of the
change in net income which moves to the retained earnings account. The retained
earnings lowered drastically which lowered the shareholder’s equity. When this ratio is
computed it gives an unusually high average forecasted ROE of 32.43%. This number is
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clearly too high if the company isn’t paying dividends to the stockholders, and is a
distortion due to the unrealism of impairing that large of an amount of goodwill. The
growth rate is calculated as an average -3.65%. The price to book ratio is also
the same one used from Yahoo Finance which would drastically change if this
impairment actually did take place.
The adjusted cost of equity using this method surprising gives a rational 20.24%.
This makes sense because investors would require a higher return since they are not
receiving dividends and the financial stability of the firm is more risky.
Cost of Debt
Firms incur debt in order to finance the operations of the company, as well as
other liabilities such as pension plans and healthcare costs for employees. The cost of
debt for a firm can be calculated by taking the weighted average of all liabilities for the
firm with their corresponding interest rates. The cost of debt is typically lower than the
cost of equity because it is less risky. Lenders are paid their investments back first if a
company goes bankrupt, therefore being less risky.
Current Liab. Amount Int Rt. Weight Weighted Int.
A/P 3373 0.0048 0.082514 0.000396 Short Term Debt 897 0.0048 0.021943 0.000105 Current Portion of Long Term Debt 765 0.062 0.018714 0.00116 Accrued Marketing 1803 0.062 0.044107 0.002735 Accrued Employment Costs 951 0.062 0.023264 0.001442 Other Current Liabilties 3255 0.0048 0.079627 0.000382 Total Current Liabilities 11044
Backdoor ROE P/B G Ke 32.40% 1.51 -3.65% 20.24%
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Long Term Liabilities Long Term Debt 18589 0.062 0.454743 0.028194 Deferred Income Taxes 4064 0.0287 0.099418 0.002853 Accrued Pension Costs 2367 0.062 0.057904 0.00359 Accrued Post Retirement Healthcare Costs 2678 0.062 0.065512 0.004062 Other Liabilities 2136 0.062 0.052253 0.00324 Total LT Liabilities 29834
Total Liabilities 40878 Cost of debt 0.04816
The interest rate used for accounts payable, short term debt, and other current
liabilities was derived from the three month AA rated commercial paper from the St.
Louis Fed website. The interest rate used for long term debt and its current portion was
calculated by taking the weighted average of all long term debt outstanding. The
information regarding this calculation is provided below.
Long Term Liabilities
Amount Interest Rate Weight Weighted Interest Rate
U.S. Notes 15130 0.061700 0.78467 0.048414 Euro Notes 3970 0.059800 0.205892 0.012312 Debenture 182 0.113200 0.009439 0.001068 Total 19282 0.061795
Accrued marketing and employment costs were given an interest rate that was
provided on Kraft’s 10-K for the discount rate on pension plan liabilities. These discount
rates on pension liabilities were then calculated as a weighted average. The calculation
for this is provided below. Coincidentally, when the interest rates are rounded the cost
of long term debt and the discount rate for pension liabilities both end up being 6.2%.
The line item “other liabilities” was also given a 6.2% interest rate. The deferred
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income taxes line item was given the 2.87% risk free rate. With all of these statistics
calculated the cost of debt figures into a 4.82%.
Amount Interest Rate Weight
Weighted Interest Rate
Pension Plan U.S. 160 0.061000 0.661157 0.040331 Pension Plan non U.S. 82 0.064100 0.338843 0.02172 Total 242 0.06205
Weighted Average Cost of Capital
Firms are financed through debt and equity and both of these instruments have
different costs to them as shown. It is beneficial to take these two costs and implement
a weight on them on a before and after tax basis to create a single cost of capital
known as the WACC. We decided that the backdoor cost of equity was a more
appropriate figure than the cost of equity valuation methods because it raised the cost
to a more realistic number. The before tax WACC was calculated at 7.61%, and the
after tax WACC at 7.61%. The after tax WACC incorporates a tax shield that is one less
the effective tax rate at 28.2%. Since Kraft had an extreme amount of goodwill on their
balance sheet we had to impair it to show a more realistic financial standing. The
impairment affected the total amount of assets which changes the weight of debt and
equity. The adjusted before tax WACC was calculated at 6.98%, and the after tax
adjusted WACC at 6.10%. The calculations for these figures are provided below. The
line item titled “interest rate” represents the cost of debt and equity for Kraft. The
“weight” box is a ratio of debt to total assets and equity to total assets on an adjusted
and unadjusted basis. The weighted interest rate is the product of the interest rate,
weight, and tax shield if applicable.
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Interest Rate Weight Weighted Interest Rate
Debt 4.82% 0.5467 2.63% Equity 10.97% 0.4533 4.97% Before Tax WACC 7.61%
Interest Rate Weight Tax Shield Weighted Interest Rate
Debt 4.82% 0.5467 0.718 1.89% Equity 10.97% 0.4533 4.97% After tax WACC 6.87%
Interest Rate Weight Weighted Interest
Rate Debt 4.82% 0.6481 3.12% Equity 20.24% 0.3519 7.12% Adjusted Before Tax WACC 10.24%
Rate Weight Tax Shield Weighted Interest Rate
Debt 4.82% 0.6481 0.718 2.24%Equity 20.24% 0.3519 7.12% Adjusted After Tax WACC 9.36%
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Conclusion
It was decided that the backdoor method was the most appropriate to
determine the cost of equity. The capital asset pricing models appeared to be
unrealistically low, and therefore were disregarded. The cost of debt calculated by the
weighted average of multiple variables turned out to be 4.82%. This figure seemed to
be reasonable, and was accepted. The adjustment for impairment of goodwill affected
the weighted average cost of capital by lowering it. The denominator for the calculation
of the weight for debt and equity is total assets. Total assets decreased when we
impaired goodwill which made the denominator smaller which changed the weights.
The adjusted weight for debt rose while the equity weight dropped. Because of these
circumstances and the fact that debt is cheaper than equity the WACC dropped. This
also was an acceptable assumption.
Financial Statement Forecasting
Financial statement forecasting is used to make logical estimations of future
business performance based on future market conditions. Forecasting estimations
consists of reviewing historical and current data in order to make educated assessments
of the company’s future performance. When looking at past information, it is crucial to
determine which trends, averages, and ratios can be used to forecast the future. In
these recessionary times, past performance during previously similar times could be a
good indication as to future performance. The following section includes both the
original and restated versions of Kraft’s income statement, balance sheet, and
statement of cash flows forecasted for ten years.
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Unadjusted Income Statement
The income statement is the first financial statement forecasted because it is the
most important due to the benchmark of sales. The income statement will flow into the
balance sheet and statement of cash flows so it is necessary to use it as a starting
point. It is imperative to make as accurate assumptions as possible so management
can formulate future business plans, and analysts can more accurately communicate
their views of the firm’s prospects to investors.
The starting point was analyzing Kraft’s income statement for the previous five
years and turning them into a common size income statement, which puts every line
item as a percentage of net sales. By doing this it is easier to compare different line
items on the income statements and decide which items can be forecasted with
accuracy. After a review of this data, we felt we could accurately forecast net sales,
cost of goods sold, gross profit, operating income, and net income.
Net sales are the first line on the income statement and the benchmark for every
other line item in forecasting future performance. The sales growth rate is the main
determinant in forecasting future revenues. When looking at Kraft’s past sales growth,
their numbers show growth of 4%, 6%, -3%, 9%, and 17%. Besides for the decline in
sales growth in 2006, Kraft has been on a steady increase in sales with a large increase
in 2008. The increase in 2008 can be traced to recent acquisitions and a growing
presence in foreign markets. However, due to the current recession we don’t expect
positive sales growth in 2009. Consumers are spending more carefully, and while they
may not consume less food, there could be a shift from brand name products to lower-
priced private label brands. A look the financials during the previous recession shows a
14% decline in sales growth for 2002. Even though we predict a growth decline, we
don’t anticipate such a large decrease in sales growth. We predict a decline of 8%
sales growth for 2009 because Kraft is more diversified in international markets so the
hit won’t be as hard as 2002. In 2010, we believe Kraft will start to experience a
growth in sales of 2%. Part of the reasoning behind this was Kraft was able to bounce
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back with a positive growth in 2003, and consumers could be willing to switch back to
more “brand label” products. For 2011 we have an increase of 5% and 6.5% for 2012
and beyond. Those percentages were chosen because they are close to the average
growth rate when the firm is not in a recession. They can also be attributed to growth
in international markets, increases brand perception, and mergers and acquisitions.
The next items to forecast are cost of goods sold and gross profit. In order to
more accurately forecast cost of goods sold, we figured gross profit first because it was
more consistent than cost of goods sold over the past five years. Cost of goods sold
usually fluctuated with sales while gross profit grew on a steady incline. We used the
average of the gross profit margins that turned out to be 35%, multiplied by forecasted
sales. We then subtracted gross profit from net sales to find the cost of goods sold.
Operating income is the next item to be forecasted on the income statement. It
can be calculated as gross profit minus selling, general and administrative expenses as
well as impairment and various other expenses. Kraft has losses or gains on
divestitures every year that are very hard to predict, along with impairment costs that
also can’t be forecasted. Due to this the formula to find operating income won’t be
used. Instead, we used the operating profit margin of 10% multiplied by net sales as a
more accurate approach to forecasting. Operating income shows how the firm is doing
before interest and taxes are subtracted.
Net income is the last item on the income statement that we feel can be
accurately forecasted. Net income can be calculated as operating income minus
interest expense and taxes. Kraft also has gains and losses from discontinued
operations every year that are impossible to predict. For that reason, the formula to
find net income will not be used. Average net profit margin will instead be used as it
stays consistent and only fluctuates one percent each year. Net profit margin is 7.9%
and is multiplied by net sales to get a more accurately forecasted net income.
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Restated Income Statement:
The difference between the unadjusted and the restated Income Statement is that the
restated includes goodwill impairment expense. Since this expense is included in the adjusted
statement it causes net income to be greatly reduced. The unadjusted income statement used
a 7.9% assumption for forecasting net income. This number was not the average net profit
margin for the last 6 years but it more accurately represented the future for Kraft than the net
profit margin average, which was 2 points higher. For the adjusted income statement we used
a much lower assumption, 2.7%, because the net profit margin fell significantly when net
income was lowered. Again, just like with the unadjusted forecasting, 2.7% was not the 2003‐
2008 net profit margin average, it was just a number that made sense and fell in line with
recent year’s net profit margin. These were the only differences between the restated and
unadjusted income statement and the rest of the forecasts are explained in the above
unadjusted income statement section.
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Unadjusted Balance Sheet
The second statement forecasted is the balance sheet. This will give investors an idea of
the size of the firm over the next ten years, more specifically assets, liabilities, and total equity.
These numbers will present a good picture of how retained earnings will perform over the next
several years.
Similarly to the income statement, sales growth plays an important role in forecasting
the balance sheet. Sales are used in the asset turnover (Sales/Total Assets), in order to forecast
total assets. We used an asset turnover ratio of .59 because Kraft’s ratio has been exactly, or
close to it over the past five years. It appears that the asset turnover ratio will remain steady in
the future because even in the current time of economic turmoil, Kraft’s A/T remained
somewhat consistent.
Once total assets are forecasted, the next step is to calculate the current and non‐
current assets. We found that Kraft had a consistent ratio of current assets to total assets each
year, so we found the average over the past five years and applied it to the forecasted
statement. This provided a reasonable estimate of current assets, closely resembling the
numbers of recent years considering expected growth. Once current assets were forecasted we
simply subtracted them from total assets in order to find total non‐current assets.
Next we found total current liabilities by applying a reasonable current ratio. The
current ratio is current assets divided by current liabilities. We used a ratio of .89 to forecast
current liabilities because it was a reasonable middle point over the past five years, and there is
no reason to expect a drastic change in the near future. After that we forecasted shareholders
equity by adding the beginning retained earning balance to the difference in net income and
dividends.
Once retained earnings is forecasted we are able to complete the liabilities portion of
the balance sheet. By applying the equation assets = owners equity + total liabilities we are able
to forecast total liabilities. With total liabilities we can find non‐current liabilities by simply
subtracting current liabilities which was found previously from total liabilities.
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At this point we have the substantial parts of the balance sheet and forecasting other
accounts is simple. We determined that accounts receivable would be of use so applied an
accounts receivable turnover ratio (Sales / Accounts Receivable) of 8.74, which made sense and
was consistent with previous years of operation, in order to forecast accounts receivable. We
also used an inventory turnover (COGS / Inventory) ratio of 6.39 to forecast the inventory
account. Once again this ratio has been someone consistent over the past few years for Kraft so
little estimation was needed.
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Restated Balance Sheet
Since Kraft’s goodwill accounted for more than twenty percent of its property, plant,
and equipment, it was necessary to impair the goodwill at a twenty percent rate for five years.
This impairment affected the balance sheet by amortizing the goodwill which in turn decreased
the total assets. For the adjusted forecasting of the balance sheet, we used the same drivers as
the unadjusted forecast. The receivables and inventories forecasts remained the same as the
unadjusted forecast because the figures were not affected by the impairment. The current
assets also were unaffected by the impairment, but their weight as a proportion of current
assets to total assets increased. Since the forecast driver for current assets was a percentage of
current assets to total assets it wouldn’t make sense to use the same proportion in the adjusted
forecast because the percentage is too high. Logically it didn’t make sense for Kraft’s current
assets to increase at a greater amount after the impairment, so we used a .24 CA/CL ratio. This
was up from the 18% we used to forecast the unadjusted current assets. After we forecasted
the adjusted current assets they were very similar to the unadjusted current assets.
Total assets were also affected by the impairment. Because the impairment lowered
total assets the new asset turnover we used was .81, up from the .59 we used for the
unadjusted balance sheet forecast. Once again we used .81 because it fell in line with recent
years asset turnover and just made sense in the context of the forecasting.
Retained earnings were also affected by the impairment. This, in turn, affected owner’s
equity and total owners’ equity plus liabilities. To find the adjusted retained earnings we used
same the method as in the unadjusted. To forecast retained earnings, take the previous
periods retained earnings add in the current period’s net income minus dividends paid.
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Unadjusted Statement of Cash Flows
The final forecasted statement was the statement of cash flows. Because it requires
information from the other two financial statements as well as implied ratios and growth rates
it was the most difficult to forecast.
The first step in forecasting the statement of cash flows is to find the net income. This
number was pulled directly from the previously forecasted income statement. Once we had the
net income the next step was to forecast the cash flows from operating and investing activities.
After considering forecasting cash flows from financing activities we concluded that an accurate
forecast for such a volatile number would not be possible.
To forecast cash flows from operations the driver we used was CFFO / sales. We chose
to assume a 10.2% rate because it fit well with the recent trends in CFFO / sales, in comparison
to using operating or net income. Next we forecasted cash flows from investing activities. After
considering using change in net current assets or change in property plant and equipment, it
was clear that capital expenditures were the most accurate forecasting assumption. Over the
past five years the trends found in CFFI and capital expenditures followed similar patterns
which lead us to the conclusion that CFFI / capital expenditures would be the most accurate
forecasting method. The assumption was difficult to conclude because while this was the most
consistent method of comparison over the last five years, there were still large fluctuations.
We used the assumption of 1.03 because we feel that the CFFI is going to continue to grow over
time at a slow, yet steady pace.
The final forecast made on the statement of cash flows was expected dividends paid.
Each of the past five years Kraft has increased dividends per share by $0.02. When considering
this trend and recent changes in historical dividends paid, we chose to assume a 5% growth rate
over the next 10 years.
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Restated Statement of Cash Flows
As previously discussed in the adjusted income statement forecasting, Kraft’s net
income dropped substantially. Forecasted cash flows from operations and investing activities
were unchanged by the impairment of goodwill. The only significant change on the adjusted
statement was that future dividends paid decreased to zero. This change is due to the
drastically decreased net income, leaving any excess funds to pay back previous debts. Also, a
lack of future retained earnings makes it impossible to pay dividends. Kraft would have the
option to pay out dividends after 2015 because they will have positive retained earnings.
However, we feel they need to wait a few more years before they start paying dividends so
they can build up a good amount of retained earnings. This will be better for Kraft because
they can then internally finance their projects.
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Valuation Ratios
Calculating simple earnings valuation ratios is a common method used to judge
the fairness of a company’s valuation of equity. These are potentially an accurate
valuation source, and if each is considered, give several different perspectives of the
company and industry. However most of the figures utilized by these ratios are not
difficult for the company to alter in order to increase overall value to entice new
investors and build confidence among current partners. The most effective way to
make use of these ratios is to use them as a benchmark to help locate any distortions
by comparing results of the entire industry. However some of these ratios do not apply
to the majority of companies in the industry, in which case they should not be
considered applicable. If the firms are included in the ratio they must be comparable.
Overall the valuation ratios are a helpful way to quickly value a firm based on minimal
variables, however a much more in depth analysis must be done to understand the true
value of any company. Our restatement of Kraft’s financial statements did not affect
most of these ratios however we have included the restated numbers whether they
alter the results or not to further demonstrate what aspects of business it affected.
Price to Earnings
The price to earnings ratio is defined as the market price of equity by earnings
per share. There are two variations of the P/E ratio: forward earnings and trailing
earnings. The inputs for these ratios vary significantly because both use different
variations of earnings per share. The variations of earnings per share used can be
volatile which can cause forward PE to be very different from trailing PE. Though the
calculations can be performed two ways, the results should be the same. Higher PE
ratios are often accompanied by higher growth, lower risk and high payout.
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Price/Earning Trailing
The trailing price to earnings method is defined as the market price of equity
divided by the current period earnings per share. P/E trailing can be a more accurate
value than P/E forward because it uses actual earnings. The information compiled was
available through Yahoo! Finance that was used to obtain the current period price and
earnings per share with the results displayed in the following table.
P/E Trailing PPS EPS P/E Trailing Industry Avg Kraft PPS Kraft 22.27 1.92 11.59 11.15 21.41 Kraft Restated 22.27 1.53 14.56 17.06 ConAgra 18.03 2.16 8.26 Heinz 33.35 2.96 11.5 Nestle 39.1 4.24 13.7
Sara Lee 8.25 ‐0.35 N/A
In order to get a suggested price for Kraft, we computed an industry average
trailing price to earnings ratio. To compute the industry average we calculated the P/E
Trailing by taking the average of Kraft’s competitors leaving out Sara Lee because this
information is unavailable. To calculate the computed price for Kraft we took the
industry average P/E ratio and multiplied it by Kraft’s EPS.
Since we are assuming a 15% margin of safety of stock price for our evaluation,
the computed stock price should be in this range to be fairly valued. The calculation
estimates Kraft price per share to be $21.41 which is well within 15% of the closing
price on April 1, 2009 meaning this price suggests that Kraft is fairly valued. However,
this ratio is derived by using historical data and is not a measure used in predicting
future value.
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Price/Earnings Forward
The forward price to earnings ratio uses a one year forward looking earnings
estimate to compute earnings per share instead of using the previous year’s earnings.
The estimated earnings are divided by the number of shares outstanding to compute
estimated earnings per share. The forward price to earnings ratio is then computed by
dividing the current price per share by the estimated earnings per share. Next the
industry average of the P/E forward was calculated by finding average of Kraft’s
competitors P/E forward. Finally, by taking the industry average of 10.97 and
multiplying it by Kraft’s forecasted EPS, we came up with their computed price of
$22.93. The forward P/E suggests the Kraft is fairly valued because the estimated
market value is very close and within the 15% range of the true value.
P/E (forward) PPS EPS P/E (forecast) Industry Avg. Kraft PPS
Kraft 22.27 2.09 10.91 10.97 22.93 Kraft Restated 22.27 0.71 32.13 7.79
ConAgra 16.73 1.5 11.13 Heinz 33.73 2.77 12.19 Nestle 39.1 N/A N/A
Sara Lee 8.22 0.86 9.59
Price/EBITDA
The price of EBITDA is calculated by dividing the market cap by earnings before
interest, tax, depreciation, and amortization (EBITDA). The lower the ratio means a
better and more efficient business regarding their profit since EBITDA presents the
operating cash flows for the firm. Moreover, a low ratio shows a greater correlation
between the value generated by firm and the market value of the assets. This ratio
determines how operating cash flows justified the market value of equity. On the other
hand, having a higher EBITDA represents poor management of operating cash flows for
the firm which means less profitability for the firm.
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Price/EBITDA (In billions)
Company Market Cap EBITDA P/ EBITDA Industry Avg Kraft PPS Kraft 32.72 6.07 5.39 5.97 36.24 Kraft Adjusted 32.72 6.07 5.39 36.24 ConAgra 8.06 1.39 5.8 Heinz 10.55 1.82 5.8 Nestle 127 14.84 8.56 Sara Lee 5.74 1.54 3.73
The table from above represents Kraft and their competitors regarding to the
Price/EBITDA for the industry. After the industry average was calculated it was
multiplied by EBITDA to find Kraft’s suggested price per share of $36.24. This price is
higher than 15% of our observed share price which suggests that Kraft is
undervalued.
Price to Book
A valuation method that is fairly helpful is the price to book ratio. This simply
compares the book value to the market value of the company, showing how Kraft and
the markets opinion differ. When compared to the average of those companies within
the industry the book price will ideally show if the company is over, under, or fairly
valued. While this is useful to know, this ratio is easily manipulated by the companies
because they maintain total control of their book value and any alterations in the book
value would be evident in the price to book ratio. Generally a lower PB ratio indicates
that a company is undervalued, but could also be caused by a flaw in the company’s
strategy or operations. The price to book ratio is fairly unimportant in the food industry
mainly due to the large amount of total assets that is made up of intangible assets in
many companies.
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Price / Book PPS BPS P/B Industry Avg P/B Kraft PPS Kraft 22.27 15.11 1.47 3.96 59.87 Kraft Adjusted 22.27 15.11 1.47 59.87 Nestle N/A N/A N/A Heinz 33.35 4.31 7.74 Sara Lee 8.25 3.3 2.50
ConAgra 18.03 10.93 1.65
As the graph above shows, the food industry has an average PB ratio of 3.96,
which is significantly higher than Kraft’s ratio of 1.47. This large separation which is
magnified well beyond the 15% window we allow when converted to show average
book value suggests that Kraft is substantially undervalued. After the in depth
investigations we have done over the past few months there have been no apparent
reasons to lead us to believe that this is the case. This out-of-the-ordinary ratio does
however give another method for analysts to catch the flaws in the company.
Dividends to Price
The dividends to price ratio illustrates how the current price per share of a
company is reflected in its dividends paid to shareholders. This is a fairly useful
valuation tool in the food industry because all companies actively pay dividends at a
somewhat consistent level. It does not take into account many of the potentially
distortable accounts in the financial statements so is not fail proof by any measure.
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Dividends / Price PPS DPS D/P Industry Avg Kraft PPS Kraft 22.27 1.16 0.052 0.048 23.96 Kraft Adjusted 22.27 1.16 0.052 23.96 Nestle Heinz 33.35 1.66 0.050 Sara Lee 8.25 0.44 0.053 ConAgra 18.03 0.76 0.042
This ratio is relatively similar within the competitive firms in the food industry
with an average of 4.83%. We would not recommend relying on these numbers in
hopes of finding valuation errors in the food industry because of the results of our
calculations for this ratio which do not lead us to believe that the company is
overvalued. Instead, Kraft’s dividend to price ratio when compared to the industry
implies that the company is fairly valued.
Price Earnings Growth
The earnings per growth (PEG) ratio is calculated by dividing the lagged price
earnings ratio by 1 plus the estimated growth rate of earnings per share. A failure to
lag the PE ratio by 1 year would result in accounting for growth two times which would
be inaccurate. This is an effective way of comparing the relative stock price, earnings,
and estimated growth rates, and to what degree they are correlated. A company that is
fairly valued will have a PEG of 1. If a company has a PEG that is greater than 1 they
are considered overvalued, whereas a PEG lower than 1 indicates that the company is
undervalued.
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Price Earnings Growth P/E P.E.G Industry Avg Kraft PPS Kraft 11.59 1.47 1.60 18.51 Kraft Adjusted 11.59 1.47 18.51 Nestle 8.26 N/A Heinz 11.50 1.48 Sara Lee 13.70 1.76
ConAgra N/A 1.55
The chart shown above lists Kraft’s and other available company’s PEGs in the
food industry. The industry has an average PEG of 1.6 which implies the industry as a
whole is comprised of consistently overvalued companies. With a PEG of 1.47 Kraft
operates below the industry average, however because it is greater than 1, placing the
calculated price at $18.51, the Price Earnings Growth valuation method considers the
company to be overvalued.
Price to Free Cash Flows
Price to free cash flows (P/FCF) is another valuation metric that gives analysts an
estimation of price per share. This model compares the firm’s free cash flows, those
being operating and investing cash flows, to the equity value in the market. The
market cap is then divided by the free cash flows to find P/FCF. Next, the industry
average is calculated by averaging the P/FCFs of the industry competitors, leaving out
the firm being analyzed. If any of the competitors P/FCF numbers are negative they
are considered outliners and are left out of the industry average. With the industry
average, we multiplied it by the firm’s free cash flows to come up with the suggested
price per share.
189
Price/Free Cash Flows (In Billions)
Company Market Cap FCF P/ FCF Industry Avg Kraft PPS Kraft 32.72 2.821 11.60 13.1278 37.03 Kraft (restated) 32.72 2.821 11.60 37.03 ConAgra 8.06 -5.417 -1.49 Heinz 10.55 0.634 16.64 Nestle 127 14.641 8.67 Sara Lee 5.74 0.408 14.07
From the table above, Kraft’s computed price per share is $37.03. When
compared to the Kraft’s April 1st stock price of $22.81, the calculated price to free cash
flows exceeds the current stock price. The P/FCF model implies that Kraft’s current
stock price is considerably undervalued.
Enterprise Value to EBITDA
To calculate the enterprise value to EBITDA ratio you simply divide enterprise
value by the companies EBITDA. Consideration of the enterprise value to EBITDA ratio
is a relevant method of valuation in the food industry because the ratios of the
companies involved are consistent to an extent. By focusing on the enterprise value
many possible accounting distortions including goodwill depreciation are not included
which results in a more reliable valuation. However many of those do have an effect on
the EBITDA so the ratio is still flawed. The ratio also is applicable to a larger number of
companies because the likelihood of having a negative EBITDA is much lower than that
of total earnings.
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Enterprise Value / EBITDA In Billions Enteprise Value EBITDA EV/EBITDA Industry Avg Kraft PPS Kraft 51.98 6.07 8.56 7.33 44.51 Kraft Adjusted 51.98 4.86 10.69 35.66 Nestle N/A N/A N/A Heinz 15.4 1.82 8.45 Sara Lee 8.08 1.54 5.25 ConAgra 11.53 1.39 8.3
As the chart shows, the average EV / EBITDA ratio of companies in the food
industry is 7.33, with all of those companies falling within a 2.5 spread either direction.
Kraft’s ratio of 8.56 puts them above the industry norm, however not to an extent that
would require deeper investigations based on this number alone. The EV / EBITDA
ratio does however indicate that Kraft is currently undervalued.
Conclusion
Valuation Ratio Result Summary P/E TTM Fairly Valued
P/E Forward Fairly Valued Price/EBITDA Undervalued
Price/Book Undervalued
Dividends/Price Fairly Valued PEG Overvalued
Price/FCF Undervalued EV/EBITDA Undervalued
Although we feel that these valuation ratios are not an accurate tool that should
be used in order to reach our final valuation, they are worth briefly discussing to give
one more way in which to identify an oddity we had previously overlooked. The results
were somewhat surprising to us, indicating that the company is fairly valued if not
191
slightly undervalued which conflicted with our early estimates. Only the PEG ratio
shows signs of Kraft being overvalued. The 4 ratios involving P/E and the
Dividends/Price ratio suggest fair valuing, while the Price/EBITDA, Price/FCF, and
Price/Book ratios imply that the company was undervalued. The vast variation shown
in these results is the reason that these ratios cannot be used when creating a
valuation, and therefore will not be considered in our final valuation.
192
Intrinsic Valuation Models
Intrinsic valuation models are currently the most common method used by
analysts to estimate a company’s market value price per share. These models generate
a sensitivity analysis by using weighted average, cost of capital, size-adjusted cost of
equity, and growth rates. This provides the reader with an idea of how future
variations will affect the company’s value. The intrinsic valuation models include the
discounted dividends model, residual income model, free cash flow model, abnormal
earnings growth model, and the long run residual income model. Each model provides
alternative perspectives focusing on the different variables and how possible
fluctuations will affect the value of Kraft. Because goodwill is such an issue these
models will display another picture of how the impairment of the account will affect the
company. All of the models are based on our 10 year forecast of Kraft’s financial
statements including the balance sheet, income statement, and statement of cash
flows.
Discounted Dividends Model
The first and most basic valuation model we will focus on is the discounted
dividends model. This model factors cost of equity and expected dividends, which is
found by utilizing several forecasted numbers including growth rates to value equity.
Although the theory and math used in the model is proven, it is considered the least
accurate of the intrinsic valuation models. This lack of confidence in the model is due
primarily to the fact that it is based on the assumption that the only value essential for
equity investors is the dividend payments that they receive. The model also assumes a
constant linear growth for dividend payments, and the sensitivity of the model is too
volatile.
193
The first step to the model is forecasting the dividend payment per share for the
next ten years. Looking at historical dividend payments on a per share basis, we saw a
constant increasing pattern of a two cent increase per fiscal year. Because of this we
increased our dividend payment per share two cents every year for the next ten years.
Our next step was taking the present value of all future dividend payments. This was
done by multiplying the dividend per share for each year by the present value factor for
that year. The present value factor was derived from the cost of equity. The next step
was to determine the value of the perpetuity. This was done by taking the time eleven
dividend and dividing it by the cost of equity less the growth rate. This gave us the
present value of the perpetuity at time ten. We then discounted this number back to
2009 dollars. We then summed the time 2010-2019 dividend payments to 2009 dollars
and added that number to the time zero perpetuity value. This summation gave us the
model price at 12/31/2008. The next step was to grow this 12/31/08 figure to the
valuation date on 4/1/09. This was computed by taking the 12/31 price and growing it
at the cost of equity for a quarter of a year.
Growth Rate
0.0% 1.0% 2.0% 3.0% 4.0% 6.5% 10.0%
5% 9.4 10.99 13.63 18.91 34.76 NA NA
7.0% 6.55 7.17 8.05 9.37 11.57 55.51 NA
9.0% 4.98 5.28 5.68 6.2 6.93 11.34 NA
Ke 11.0% 3.99 4.16 4.36 4.62 4.95 6.41 20.75
13.0% 3.32 3.42 3.54 3.68 3.85 4.51 7.29
15.0% 2.83 2.9 2.97 3.05 3.15 3.5 4.57
17.0% 2.47 2.51 2.55 2.61 2.67 2.87 3.39
Undervalued Fairly Valued Overvalued
P > $26.23 $19.39 < P < $26.23 P < $19.39
194
Shown above is the sensitivity evaluation calculated by using the discounted
dividends model. We decided to analyze value allowing a 15% window for error above
or below the current share price of $22.81, making any price falling between $19.39
and $26.23 acceptable. When we applied our calculated cost of equity of 11%, and
estimated growth rate of 6.5%, this model suggests that Kraft is overvalued at $6.41.
According to the model, in order for the price to fall within the fair value range, Kraft
should incur a growth rate of 10% and a cost of equity of 11%. Using these inputs the
model price results in a value of $20.75. Because of this model having such high
sensitivity to the growth rate this is the only acceptable value. We believe that the
discounted dividends model is inaccurate due to the sensitivity to the estimated growth
rate and numerous other factors; however it indicates that Kraft is currently
overvalued.
Adjusted Discounted Dividends Model
After we adjusted our financial statements to account for a greater impairment of
goodwill, we were unable to pay dividends out to shareholders because our net income
was too low. This in turn made the retained earnings too low where the dividends are
paid out from. It is not realistic for a firm to pay out dividends from excess reserve
earnings if there aren’t any. Because of this we did not compute an adjusted dividend
discount model.
195
Discounted Free Cash Flow Model
The discounted free cash flow model is another method of valuing a firm’s
equity. The free cash flow from this model uses the sum of the cash flows from
operations and investing activities. If the sum of these two cash flows is positive the
firm is creating value, and if they are negative the firm is destroying value for itself.
Since this model uses a discounted free cash flow it is more reliable than the discount
dividend model because investors are relying on firms to add value for capital gains
more than they are relying on dividend payments.
To compute the discounted free cash flow the first step was to take the
forecasted CFFO and CFFI and sum them to find the year by year free cash flow of the
firm’s assets. Using a present value factor we found the present value of the year by
year free cash flows. We then found the PV of the perpetuity at time 10 by taking the
time 11 CFFO+CFFI and dividing it by WACC-g. This number was then discounted back
to time 0 by using a present value factor. We then summed the total value present
value of the year by year cash flows and the PV of the perpetuity. This gave us the
market value of assets. We then took the market value of assets and subtracted out
the book value of debt and preferred stock to find the market value of equity. Divide
this number by Kraft’s shares outstanding and it calculates the price per share at
12/31/2008. We then had to grow this number to 4/1/2009, the valuation date. We
did this by growing the 12/31/2008 price a quarter of a year, using the cost of equity as
a driver. This number is the time consistent price at 4/1/2009. Using our estimated
WACC of 7.61% and Kraft’s growth rate of 6.5% the model gave a price per share of
$62.16, which would make the valuation date price undervalued. The free cash flow
model focuses on forecast assumptions of cash flows and has an r^2 at best of 20%.
This is why it is considered an unreliable model.
196
Growth
0.00% 1.00% 2.00% 3.00% 4.00% 6.50% 10.00%
5% 18.55 25.32 36.6 59.15 126.82 na na
7.00% 2.54 4.72 7.77 12.34 19.97 172.45 na
7.61% na 1.21 3.4 6.54 11.43 62.16 na
WACC 9.00% na na na na 0.17 12.63 na
11.00% na na na na na na 28.89
13.00% na na na na na na na
15.00% na na na na na na na
17.00% na na na na na na na
Undervalued Fairly Valued Overvalued
P > $26.23 $19.39 < P < $26.23 P < $19.39
197
Adjusted Discounted Free Cash Flow
After impairment the CFFO and CFFI for the firm was unchanged because Impairment
does not involve a transaction of cash, just like depreciation. The impairment is an
accounting number that does not involve a tangible transaction. Because of this the
only difference between the unadjusted and adjusted discounted free cash flow is the
WACC that is used in the model. The WACC for the adjusted model is estimated at
6.98%, or easily rounded to 7%. After the adjustment the model gives a stock price of
$172.45, using a WACC of 7% and growth rate of 6.5%. This makes the valuation date
stock price of $22.81 undervalued. Once again, this is not considered a reliable model
because of its lack of explanatory power.
Growth
0.00% 1.00% 2.00% 3.00% 4.00% 6.50% 10.00%
5% 18.55 25.32 36.6 59.15 126.82 na na
7.00% 2.54 4.72 7.77 12.34 19.97 172.45 na
7.61% na 1.21 3.4 6.54 11.43 62.16 na
WACC 9.00% na na na na 0.17 12.63 na
11.00% na na na na na na 28.89
13.00% na na na na na na na
15.00% na na na na na na na
17.00% na na na na na na na
Undervalued Fairly Valued Overvalued
P > $26.23 $19.39 < P < $26.23 P < $19.39
198
Residual Income Model
Unlike the discounted dividends model, the residual income model is not heavily
influenced by the estimated growth rates, making it a much more reliable option. This
model is focused on the book value of equity, total present value of estimated residual
income, and the terminal value of the perpetuity to estimate the amount of value
gained or lost.
The first step in the residual income model is finding the current year’s book
value of equity. This is just the owner’s equity on the balance sheet. Then, to find the
book value of equity for future years we took the previous year’s book value of equity,
added the current year’s net income, and subtracted out current year dividends. We
did this for each of the next ten years. Next, to find the Annual net income benchmark
take the previous year’s book value of equity and multiply it by the cost of equity. We
then took the actual forecasted net income for each year and subtracted out the
benchmark annual normal income we just calculated. This gave us annual residual
income. To find the year by year present value of residual income we multiplied annual
residual income by the present value for that year. When you sum all these present
values you get the total year by year present value of residual income. We then found
the present value of the perpetuity by using the same method as the previous models.
The next step is to sum the market value of equity at time 0, the present value
of the perpetuity and the present value of the residual income for the next ten years.
This computes market value of equity at 12/31/2008. Divide this number by the
number of shares outstanding, this gives the price per share at 12/31/08. We then
grew this number to our valuation date, 4/1/2009, by finding the future value of the
12/31/2008 price at our valuation date. Depending on which growth rate is used, at
11% Ke the price per share is either fairly valued or slightly overvalued. For this
evaluation we focued on 0% growth and 11% Ke, which comes out to a price per share
of 20.83, making Kraft fairly valued.
199
Growth
0.00% -10.00% -20.00% -30.00% -40.00% -50.00%
5% 57.44 37.93 34.03 32.36 31.43 30.84
6.50% 41.45 31.6 29.19 28.1 27.47 27.07
7.50% 34.52 28.19 26.64 25.66 25.19 24.89
Ke 8.50% 29.34 25.28 24.07 23.49 23.15 22.92
9.50% 25.33 22.79 21.96 21.56 21.32 21.16
11.00% 20.83 19.67 19.26 19.05 18.92 18.83
13.00% 16.61 16.41 16.32 16.28 16.25 16.24
Undervalued Fairly Valued Overvalued
P > $26.23 $19.39 < P < $26.23 P < $19.39
Adjusted Residual Income Model
The adjustment of Kraft’s financial statements impacted the adjusted residual
income statement by altering the net income, dividends paid, and book value of equity.
After impairment the company’s net income was much lower, no dividends were paid,
and book value of equity substantially decreased. When these changes were applied to
the sensitivity analysis the prices were lowered significantly. This makes sense because
the inputs in the model were much lower thus lowering the stock prices. All
methodology used in the adjusted model was the same as the unadjusted residual
income model. At the adjusted Ke of 20.24% and 0% growth the stock price came out
to $1.28, showing Kraft to be overvalued.
200
Growth
0.00%
-
10.00%
-
20.00%
-
30.00%
-
40.00%
-
50.00%
5% 19.4 11.09 9.42 8.71 8.31 8.06
6.50% 13 8.78 7.74 7.27 7.01 6.83
7.50% 10.28 7.55 6.81 6.46 6.26 6.13
Ke 8.50% 8.29 6.53 6 5.75 5.6 5.51
9.50% 6.78 5.66 5.3 5.13 5.02 4.95
11.00% 5.13 4.61 4.42 4.33 4.27 4.23
13.00% 3.65 3.53 3.49 3.46 3.45 3.44
20.24% 1.28 1.47 1.56 1.62 1.66 1.68
Undervalued Fairly Valued Overvalued
P > $26.23 $19.39 < P < $26.23 P < $19.39
Abnormal Earnings Growth Model
The abnormal earnings growth model includes forecasted financial estimates
including net income and total dividends. This includes our forecasted financial
statements ranging from 2009 – 2019 shown previously. In order to create a drip
method we will take into account our forecasted net income and total dividends for
Kraft. The drip method is cumulative dividends forecasted by multiplying cost of equity
by negative 1 to the previous year’s total dividends amount.
201
To calculate the AEG model it is necessary to derive normal earnings, dividends
reinvested at cost of equity, and cumulative dividend earnings. The first step in
calculating the AEG model is multiplying dividends by the cost of equity. This
represents dividends reinvested at the cost of equity. For each year we then added net
income and dividends reinvested at cost of equity to find cumulative dividend earnings.
In order to find the normal earnings we multiplied previous year’s net income by 1 plus
the cost of equity. Then to find AEG we subtracted normal earnings from cumulative
dividend earnings. This AEG number must be discounted back to time zero in order to
be relevant. Then we found the present value of the perpetuity. The next step is to
find total average net income. This is found by finding the summation of core net
income, total present value of AEG, and the present value of the perpetuity. To find
the average earnings per share we divided total average net income by shares
outstanding. To find intrinsic value per share at 12/31/08, we divided earnings per
share by the capitalization rate of 11%. This number must then be brought to the
valuation date of 4/1/09 in order to find the time consistent price at the valuation date.
At our Ke of 11% all the growth rates showed Kraft to be fairly valued.
202
Growth
-10.00% -20.00% -30.00% -40.00% -50.00%
5% 67.32 62.65 60.65 59.54 58.83
6.50% 46.38 44.14 43.13 42.55 42.18
7.50% 37.68 36.28 35.63 35.25 35.01
Ke 8.50% 31.36 30.48 21.06 29.82 29.66
9.50% 26.61 26.07 25.81 25.65 25.54
11.00% 21.42 21.18 21.06 20.98 20.93
13.00% 16.75 16.7 16.67 16.65 16.64
15.00% 13.6 13.63 13.64 13.65 13.66
Undervalued Fairly Overvalued
P > $26.23 19.39<P<26.23 P < $19.39
Adjusted Abnormal Earnings Growth Model
We calculated the adjusted AEG in the same way as the unadjusted model. The
differences in the two models are after impairment net income dropped substantially
and dividends paid decreased to zero. This reduced all inputs which lowered the
sensitivity analysis price per share substantially. All the growth rates at our Ke of
20.24% showed Kraft to be overvalued.
203
Growth
-10.00% -20.00% -30.00% -40.00% -50.00%
5% 20.89 20.19 19.89 19.72 19.61
7.00% 11.28 11.39 11.44 11.47 11.49
9.00% 6.77 7.08 7.23 7.32 7.37
Ke 11.00% 4.35 4.67 4.84 4.94 5
13.00% 2.93 3.22 3.37 3.46 3.53
15.00% 2.05 2.29 2.42 2.5 2.56
17.00% 1.48 1.67 1.78 1.85 1.9
20.24% 0.92 1.05 1.13 1.18 1.22
Undervalued Fairly Overvalued
P > $26.23 19.39<P<26.23 P < $19.39
Long Run Residual Income Model
The long run residual income model is found using the forecasted net income
and book value of equity. To find return on equity we took the current year’s net
income and divided it by the previous year’s book value of equity. Once we found ROE
for each year we took the average of the ROEs, which came out to 13.55%. We next
found the average year by year change in ROE-k. To find market value of equity we
used the following equation with BVE of 22200, average ROE of 13.55%, Ke of 11%,
and average growth rate of 2.26%.
MVE = BVE (1 + (ROE – Ke)/(Ke – G))
After we found the market value of equity we divided it by number of shares
outstanding. This gave us the price per share at 12/31/2008. To get this number to
4/1/2009 we grew it a quarter of a year. With the above inputs we got a price per
share on the valuation date of 20.03, which showed Kraft to be fairly valued.
204
K
7% 9% 11% 13% 15%
9.50% 23.47 16.58 12.85 10.5 8.89
12.00% 31.57 22.31 17.28 14.13 11.96
ROE 13.55% 36.6 25.86 20.03 16.37 13.86
15.00% 41.3 29.18 22.61 18.48 15.65
17.00% 47.78 33.76 26.15 21.38 18.1
assume 2.26% growth
G
0.26% 1.26% 2.26% 3.26% 4.26%
7% 30.3 32.9 36.6 42.28 52.1
9% 23.47 24.51 25.86 27.67 30.26
K 11% 19.19 19.57 20.03 20.62 21.37
13% 16.25 16.31 16.37 16.46 16.56
15% 14.11 13.99 13.86 13.71 13.53
assume .1355 ROE
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ROE
9.50% 12.00% 13.55% 15.00% 17.00%
0.26% 13.34 16.95 19.19 21.28 24.17
1.26% 13.12 17.1 19.57 21.88 25.06
G 2.26% 12.85 17.28 20.03 22.61 26.15
3.26% 12.5 17.51 20.62 23.52 27.53
4.26% 12.06 17.81 21.37 24.71 29.31
assume ke 11%
Adjusted Long Run Residual Income Model
The inputs for the adjusted long run residual income model were different but the
methods behind it are the same. The adjusted average ROE is 36.88%, growth of -
25.7%, Ke 20.24% and adjusted BE of $864 gave a time consistent price of just $0.84.
The adjusted price per shares were so much lower because after impairment Kraft’s
BVE fell greatly, the adjusted Ke was much higher, the ROE was higher, and the growth
rate was more negative. This adjusted long run residual income model shows that Kraft
is severely overvalued.
Undervalued Fairly Overvalued
P > $26.23 19.39<P<26.23 P < $19.39
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K
7% 9% 11% 13% 15% 20.24%
25.00% 0.93 0.88 0.83 0.8 0.76 0.68
30.00% 1.02 0.97 0.92 0.87 0.83 0.75
ROE 36.88% 1.15 1.08 1.03 0.98 0.94 0.84
40.00% 1.2 1.14 1.08 1.03 0.98 0.88
45.00% 1.29 1.23 1.16 1.11 1.06 0.95
assume -25.7% growth
G
-35.00% -30.00% -25.70% -20.00% -15.00%
7% 1.02 1.08 1.15 1.26 1.41
9% 0.98 1.03 1.08 1.18 1.3
K 11% 0.94 0.99 1.03 1.11 1.21
13% 0.91 0.94 0.98 1.05 1.12
15% 0.88 0.91 0.94 0.99 1.05
20.24% 0.8 0.82 0.84 0.87 0.91
assume .3688 ROE
207
ROE
25.00% 30.00% 36.88% 40.00% 45.00%
-35.00% 0.67 0.73 0.8 0.84 0.89
-30.00% 0.67 0.74 0.82 0.86 0.92
G -25.70% 0.68 0.75 0.84 0.88 0.95
-20.00% 0.69 0.77 0.87 0.92 1
-15.00% 0.7 0.79 0.91 0.96 1.05
assume ke 20.24%%
Undervalued Fairly Overvalued
P > $26.23 19.39<P<26.23 P < $19.39
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Analyst Recommendation
After an in-depth analysis of Kraft’s financial statements, in our opinion, it is
currently a fairly valued company. In order to reach this conclusion many steps were
taken to ensure that we had the information about Kraft and the food industry required
to create an accurate valuation. This included adjusting the company’s financial
statements to include the impairment of goodwill and forecasting both the current and
adjusted financial statements to estimate future performance. With these forecasted
statements we gained the ability to create valuation models that displayed the outcome
of potential changes in Kraft and the economy, and in what way those alterations would
affect the company’s success. When considering the results of these models and our
knowledge of Kraft and the food industry it is our opinion that it is a fairly valued
company.
The first step we took in our valuation was breaking down the food industry in
order to understand the business environment and the level of competition in which
Kraft operates. The food industry maintains a very competitive nature, and although
product and brand differentiation is of value the industry is driven mostly by cost
competition between existing firms. Successful companies have the ability to reduce
costs through effective utilization of economies of scale and a low cost distribution
system. Kraft is a leader in both categories while also participating in extensive
marketing to create brand recognition which is the reason that it is one of two dominant
competitors, along with Nestle, in the food industry. The separation in scale of
operations between these two companies and their competitors has eliminated the
possibility of an emerging company stealing large portions of the market share in the
near future.
Our next phase of valuation was a more extensive analysis of Kraft by
discovering its accounting policies, flexibility, strategy, and the level of disclosure the
company chooses to reveal in its annual reports. We found that the company has
successfully created value through an exceptional risk management strategy, an
209
effective pension plan policy, and several other accounting principles. In this process
we also first came to realize that Kraft has a massive goodwill account in comparison to
its competitors and most other businesses. This gave us reason to restate its financial
statements with the impairment of the account to understand how reliant the company
is on goodwill.
The next step included applying several ratios to show the profitability, growth,
liquidity, and capital structure of Kraft before and after adjusting its financial statements
with the impairment of goodwill in comparison to the industry. We found that it is an
industry leader in capital structure analysis, and operates at or near the industry norm
in terms of growth, liquidity and profitability. We realized that the company has a
growing level of treasury buybacks, however we believe that that Kraft can support
these actions and it will not have a detrimental effect on future performance. In this
process the impact of impairing goodwill became more apparent when directly
compared to the unadjusted ratios. We also calculated Kraft’s cost of equity and capital
with and without goodwill impairment to prepare us for our final valuation.
The final step was the actual valuation of Kraft Foods. We first applied the
commonly used valuation ratios used by many analysts for use as a benchmark. The
results given by these ratios were very inconsistent, varying from showing vast
understatement to implying that the company is greatly overstated. This wide array of
results made these ratios unusable in our valuation. Our final valuation relied on the
intrinsic valuation models. Of the five models we used, two implied that Kraft is
currently overvalued; however we feel that these models are much less significant in
comparison to the others and had only a small impact on our final valuation. The other
three, and in our opinion the most important models all agree that the company is
currently listed at a fair price of $22.81. Although the adjusted models implied that the
company would be overvalued after impairing the goodwill account, we feel that the
level of goodwill reported is proportional when considering the amount of mergers and
acquisitions in which Kraft participates. After considering the valuation models along
with knowledge acquired in our analysis, we feel that the company is fairly valued.
210
Appendices
Sales Manipulation Diagnostics: Total Net Sales (Millions) 2004 2005 2006 2007 2008Kraft $32,168 $34,113 $33,256 $36,134 $42,201Heinz $8,415 $8,912 $8,643 $9,002 $10,071ConAgra $14,522 $14,567 $11,579 $12,028 $11,606Sara Lee $11,029 $11,115 $11,175 $11,983 $13,212Nestle $69,919 $73,009 $78,766 $89,926 $101,391Industry Avg. $27,211 $28,343 $28,684 $31,815 $35,696
% change 2004 2005 2006 2007 2008Kraft 4.274% 5.476% 6.046% 0.712% 8.397%
Heinz 0.780% 6.269% 6.664% 4.142% 11.876%
ConAgra ‐25.741% 2.769% 1.354% 2.734% 10.198%
Sara Lee 7.600% 0.780% 0.540% 7.230% 10.256%
Net sales in millions 2003 2004 2005 2006 2007 2008Kraft 29,248 30,498 32,168 34,113 34,356 37,241Heinz 7,566 7,625 8,103 8,643 9,001 10,070ConAgra 13,253.60 9,842.00 10,114.50 10,251.40 10,531.70 11,605.70Sara Lee 10,250 11,029 11,115 11,175 11,983 13,212Industry 60,318 58,994 61,501 64,182 65,872 72,129
Industry Sales Change 2004 2005 2006 2007 2008
Industry Sales Change ‐2.19% 4.25% 4.36% 2.63% 9.50%
211
Expenses Manipulation DIAGNOSTICS:
Asset turnover 2004 2005 2006 2007 2008Kraft 0.54 0.59 0.60 0.53 0.67
Kraft Adjusted 0.64 0.72 0.78 0.93 0.88
Nestle 1.05 0.89 0.97 0.93 1.03
Heinz 0.91 0.82 0.82 0.92 1.00
Sara Lee 0.73 0.75 0.78 0.83 1.08
ConAgra 0.96 1.14 0.97 1.02 0.85
Industry Average 0.81 0.82 0.82 0.86 0.92
CFFO/NOA(RAW) 2003 2004 2005 2006 2007 2008
0.41
0.40
0.35
0.38
0.33
0.42
0.24
0.20
0.47
0.47
0.43
0.04
0.54
0.62
0.42
0.45
0.21
0.25
0.46
0.61
0.54
0.57
0.56
0.63
0.60
0.48
0.49
0.43
0.46
0.49
CFFO/OI
2003 2004 2005 2006 2007 2008Kraft 0.70 0.87 0.73 0.82 0.82 1.08
Heinz 0.77 0.91 0.86 0.96 0.73 0.76
ConAgra 0.56 0.52 0.96 1.41 1.35 0.15
Sara Lee 1.12 2.01 1.43 3.04 0.88 2.33
Nestle 1.08 1.30 1.54 1.07 0.96 0.94
212
Change in CFFO/OI 2004 2005 2006 2007 2008Kraft 23.6% ‐16.1% 12.8% 0.2% 31.6%
Heinz 17.3% ‐5.4% 12.6% ‐23.9% 3.2%
ConAgra ‐6.3% 83.2% 47.4% ‐4.4% ‐89.1%
Sara Lee 80.2% ‐28.8% 112.4% ‐71.2% 166.2%
Nestle 20.3% 18.0% ‐30.4% ‐10.7% ‐1.2%
CFFO/NOA (CHANGE) 2004 2005 2006 2007 2008
‐1.0% ‐12.1% 8.8% ‐13.7% 26.0%
‐15.7% 132.2% 0.1% ‐8.8% ‐90.4%
13.2% ‐32.3% 6.9% ‐52.4% 16.8%
32.1% ‐12.4% 5.4% ‐0.6% 12.8%
‐20.8% 2.4% ‐11.3% 6.5% 5.5%
Total Accruals/Sales (raw) 2003 2004 2005 2006 2007 2008
0.02
0.04
0.02
0.02
0.03
0.03
0.04
0.06
0.05
0.05
0.03
0.03
(0.01)
(0.03)
0.05
0.05
0.02
(0.07)
213
0.06
0.07
0.06
0.06
0.0400
0.05
0.04
0.04
0.04
0.02
0.02
0.01
Total Accruals/sales (change) 2004 2005 2006 2007 2008
98.0% -41.6% -21.2% 37.1% 11.5% 29.9% -13.8% -1.4% -38.1% 11.0%
303.2% -251.9% 12.8% -67.4% -520.5% 18.7% -18.7% 11.9% -37.0% 29.6% 5.6% -13.7% -59.5% 10.0% -24.1%
Liquidity Ratios:
Current Ratio
2004 2005 2006 2007 2008Kraft 1.08 0.93 0.79 0.63 1.03Nestle 1.21 1.16 1.09 0.83 0.99Heinz 1.46 1.41 1.34 1.21 1.25Sara Lee 1.06 1.17 1.08 1.31 1.16ConAgra 1.71 1.89 1.62 1.87 1.67Industry Average 1.36 1.41 1.28 1.30 1.27
Quick Asset Ratio 2004 2005 2006 2007 2008
Kraft
0.42 0.42 0.39
0.34
0.54
Nestle
0.57 0.88 0.80
0.56
0.62 Heinz 0.92 0.84 0.72 0.66 0.67Sara Lee 0.52 0.63
214
0.47 0.89 0.72
ConAgra
0.66 0.63 0.51
0.58
0.28
Industry Average
0.66 0.72 0.67 0.67 0.57
Inventory Turnover 2004 2005 2006 2007 2008Kraft 5.88 6.53 6.09 5.87 7.56
Nestle 5.15 4.65 5.07 4.86 5.07Heinz 4.60 4.54 5.17 4.68 4.64Sara Lee 4.32 4.56 4.66 7.19 6.68ConAgra 4.31 4.39 4.11 3.79 4.60Industry Average 4.60 4.53 4.75 5.13 5.25
Receivables Turnover
2004 2005 2006 2007 2008
Kraft 9.08 10.08 8.6 6.95 8.97
Nestle 7.35 6.38 6.75 7.22 8.18
Heinz 7.7 8.16 8.63 9.03 8.67
Sara Lee 5.72 5.45 6.39 9.17 8.86
ConAgra 10.49 11.27 9.81 14.69 13.03
Industry Average 7.81 7.81 7.89 10.03 9.68
Working Capital Turnover
2004 2005 2006 2007 2008
Kraft 46.35 ‐59.74 ‐14.99 ‐5.69 131.06
Nestle 13.97 15.41 34.84 ‐14.23
Heinz 7.37 8.42 12.61 17.52 15.36
Sara Lee 34.15 13.19 22.48 8.93 21.11
ConAgra 6.78 6.82 6.34 5.17 4.77
Industry Average 15.57 10.96 19.07 4.35 13.75
Gross Profit Margin
2004 2005 2006 2007 2008
Kraft 0.37 0.36 0.36 0.33 0.33
215
Nestle 0.58 0.58 0.59 0.7 0.57
Heinz 0.37 0.36 0.36 0.38 0.37
Sara Lee 0.68 0.63 0.53 0.39 0.38
ConAgra 0.22 0.21 0.24 0.26 0.23
Industry Average 0.46 0.45 0.43 0.43 0.39
Operating Profit Margin
2004 2005 2006 2007 2008
Kraft 0.14 0.14 0.14 0.12 0.09
Nestle 0.13 0.13 0.14 0.14 0.14
Heinz 0.16 0.15 0.13 0.16 0.16
Sara Lee 0.09 0.08 0.04 0.05 0.02
ConAgra 0.1 0.09 0.08 0.1 0.06
Industry Average 0.12 0.11 0.09 0.11 0.09
Net profit margin
2004 2005 2006 2007 2008
Kraft 0.083 0.077 0.092 0.072 0.073
Nestle 0.064 0.094 0.1 0.106 0.173
Heinz 0.096 0.084 0.075 0.087 0.084
Sara Lee 0.115 0.065 0.05 0.042 ‐0.006
ConAgra 0.061 0.044 0.046 0.064 0.08
Industry Average 0.084 0.072 0.068 0.075 0.083
Asset turnover
2004 2005 2006 2007 2008
Kraft 0.54 0.59 0.6 0.53 0.67
Nestle 1.05 0.89 0.97 0.93 1.03
Heinz 0.91 0.82 0.82 0.92 1
Sara Lee 0.73 0.75 0.78 0.83 1.08
ConAgra 0.96 1.14 0.97 1.02 0.85
Industry Average 0.91 0.9 0.88 0.92 0.99
Return on Asset
2004 2005 2006 2007 2008
216
Kraft 0.04 0.05 0.06 0.04 0.05
Nestle 0.07 0.08 0.1 0.1 0.18
Heinz 0.09 0.08 0.07 0.07 0.08
Sara Lee 0.08 0.05 0.04 0.03 ‐0.01
ConAgra 0.06 0.05 0.04 0.06 0.07
Industry Average 0.07 0.07 0.06 0.07 0.08
Return on Equity
2004 2005 2006 2007 2008
Kraft 0.09 0.09 0.1 0.09 0.11
Nestle 0.16 0.22 0.2 0.23 0.38
Heinz 0.67 0.4 0.25 0.38 0.46
Sara Lee 0.56 0.24 0.19 0.21 ‐0.03
ConAgra 0.19 0.13 0.11 0.16 0.2
Industry Average 0.4 0.25 0.19 0.24 0.25
NS/cash from sales
2003 2004 2005 2006 2007
Kraft 1.00 1.01 1.00 1.01 1.04
Heinz 0.99 1.01 0.99 0.99 1.00ConAgra 1.00 1.00 1.00 0.99 0.97Sara Lee 1.02 0.99 0.98 1.01 0.96Nestle 0.97 0.99 0.99 1.03 1.00
NS/cash from sales change
2004 2005 2006 2007 2008
Kraft 0.3% ‐1.0% 1.9% 2.2% ‐4.7%Heinz 2.1% ‐1.7% 0.0% 1.0% 1.7%ConAgra 0.0% ‐0.2% ‐0.3% ‐2.6% 4.1%Sara Lee ‐2.3% ‐1.6% 2.9% ‐4.4% 5.7%
217
Nestle 2.0% ‐0.1% 3.8% ‐2.3% 0.5%
INTERNAL GROWTH RATE 2004 2005 2006 2007 2008Kraft 0.02 0.02 0.03 0.01 0.02
Nestle 0.04 0.04 0.06 0.06 0.18
Heinz 0.05 0.04 0.02 0.03 0.04
Sara Lee 0.05 0.02 0.01 0.00 0.00
ConAgra 0.02 0.01 0.00 0.03 0.04
Industry Average 0.04 0.03 0.02 0.03 0.06
SUSTAINABLE GROWTH RATE
2004 2005 2006 2007 2008Kraft 0.05 0.04 0.05 0.03 0.06
Nestle 0.08 0.09 0.12 0.13 0.35
Heinz 0.24 0.15 0.11 0.18 0.20
Sara Lee 0.25 0.10 0.08 ‐0.01 ‐0.01
ConAgra 0.07 0.02 ‐0.01 0.09 0.11
Industry Average 0.14 0.08 0.07 0.08 0.14
Capital Structure Ratios:
218
Debt to Equity Ratio 2004 2005 2006 2007 2008Kraft 1.00 0.95 0.95 1.49 1.84Nestle 1.19 1.09 0.93 1.11 0.93Heinz 4.21 3.06 3.75 4.45 4.60Sara Lee 4.05 3.91 4.93 3.66 2.85ConAgra 1.94 1.63 1.57 1.58 1.56Industry Average 2.85 2.42 2.80 2.70 2.49
Debt service Margin 2004 2005 2006 2007 2008Kraft 3.02 1.35 1.79 1.14 0.51Nestle 0.49 0.57 1.00 1.34 0.46Heinz 8.07 2.66 1.88 19.31 2.54
Sara Lee 1.89
1.20
1.93 0.23 0.41
ConAgra 1.40 2.68 7.32 2.19 2.58Industry Average 2.96 1.78 3.03 5.77 1.50
Z-Scores 2004 2005 2006 2007 2008 Kraft 2.20 2.01 2.42 1.60 3.32ConAgra 1.84 2.00 1.80 2.08 1.68Heinz 6.08 6.23 8.04 7.82 7.71Sara Lee 2.37 2.23 1.92 2.40 2.24Nestle 2.23 2.06 2.14 2.11 2.48Industry Avg 2.94 2.91 3.26 3.20 3.49
Times Interest Earned 2004 2005 2006 2007 2008Kraft 0.00 0.00 0.11 0.14 0.32Nestle 0.06 0.05 0.05 0.06 0.07Heinz 0.15 0.17 0.28 0.23 0.23Sara Lee 0.00 0.00 0.00 0.00 0.00ConAgra 0.20 0.23 0.29 0.18 0.36Industry Average 0.10 0.11 0.16 0.12 0.17
219
Cost of Debt & Weighted Average Cost of Debt:
Current Liabilities. Amount Int Rt. Weight Weighted Int. A/P 3373 0.0048 0.082514 0.000396Short Term Debt 897 0.0048 0.021943 0.000105Current Portion of Long Term Debt 765 0.062 0.018714 0.00116Accrued Marketing 1803 0.062 0.044107 0.002735Accrued Employment Costs 951 0.062 0.023264 0.001442Other Current Liabilities 3255 0.0048 0.079627 0.000382Total Current Liabilities 11044 Long Term Liabilities Long Term Debt 18589 0.062 0.454743 0.028194Deferred Income Taxes 4064 0.0287 0.099418 0.002853Accrued Pension Costs 2367 0.062 0.057904 0.00359Accrued Post Retirement Healthcare Costs 2678 0.062 0.065512 0.004062Other Liabilities 2136 0.062 0.052253 0.00324Total LT Liabilities 29834 Total Liabilities 40878 Cost of debt 0.04816
Long Term Liabilities
Amount Interest Rate Weight Weighted Interest
Rate U.S. Notes 15130 0.061700 0.78467 0.048414 Euro Notes 3970 0.059800 0.205892 0.012312 Debenture 182 0.113200 0.009439 0.001068 Total 19282 0.061795
Amount Interest Rate Weight
Weighted Interest Rate
Pension Plan U.S. 160 0.061000 0.661157 0.040331 Pension Plan non
U.S. 82 0.064100 0.338843 0.02172
220
Total 242 0.06205
Weighted Average Cost of Capital:
Weight Weighted Interest
Rate Debt 0.546658108 0.026326925
Equity 0.453341892 0.038639347
Before Tax WACC 6.49662721%
Weight Tax Shield Weighted Interest
Rate Debt 0.546658108 0.718 0.018902732
Equity 0.453341892 0.038639347
After tax WACC 0.057542079
Weight Weighted Interest
Rate
Debt 0.648055 0.031210165 Equity 0.351945 0.02999708
Adjusted Before Tax WACC 0.061207246
Weight Tax Shield Weighted Interest Rate
221
Regressions
3‐Month
72 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.4273808
R Square 0.1826544 Adjusted R Square 0.170978
Standard Error 0.0525553
Observations 72
ANOVA
df SS MS F Significance F
Regression 1 0.043207191 0.043207191 15.6430815 0.000180902
Residual 70 0.193344477 0.002762064
Total 71 0.236551668
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.0042039 0.006266683 0.670828953 0.50453698 ‐0.008294632 0.016702376 ‐0.008294632 0.016702376
X Variable 1 0.6449528 0.163067258 3.95513356 0.0001809 0.319725397 0.97018017 0.319725397 0.97018017
Debt 0.648055 0.718 0.022408899 Equity 0.351945 0.02999708
Adjusted After Tax WACC 0.052405979
222
60 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.4273808
R Square 0.1826544 Adjusted R Square 0.170978
Standard Error 0.0525553
Observations 72
ANOVA
df SS MS F Significance F
Regression 1 0.043207191 0.043207191 15.6430815 0.000180902
Residual 70 0.193344477 0.002762064
Total 71 0.236551668
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.0042039 0.006266683 0.670828953 0.50453698 ‐0.008294632 0.016702376 ‐0.008294632 0.016702376
X Variable 1 0.6449528 0.163067258 3.95513356 0.0001809 0.319725397 0.97018017 0.319725397 0.97018017
48 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.484852923
R Square 0.235082357
Adjusted R Square 0.218453713
Standard Error 0.051514999
Observations 48
ANOVA
df SS MS F Significance F
Regression 1 0.037517215 0.037517215 14.137193 0.0004786
Residual 46 0.122074578 0.002653795
Total 47 0.159591793
223
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0% Upper 95.0%
Intercept 0.004245395 0.007725607 0.54952254 0.5853051 ‐0.011305 0.0197962 ‐0.011305 0.0197962
X Variable 1 0.654739759 0.17413542 3.759945893 0.0004786 0.3042233 1.0052562 0.3042233 1.0052562
36 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.50994516
R Square 0.26004407
Adjusted R Square 0.23828066
Standard Error 0.05685881
Observations 36
ANOVA
df SS MS F Significance F
Regression 1 0.038629182 0.038629 11.94868 0.0014876
Residual 34 0.109919418 0.003233
Total 35 0.1485486
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.00892224 0.01007064 0.885966 0.38186 ‐0.01154376 0.02938825 ‐0.0115438 0.02938825
X Variable 1 0.69829032 0.202011464 3.456687 0.001488 0.287753633 1.10882701 0.2877536 1.10882701
24 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.545946
R Square 0.298057
Adjusted R Square 0.26615
Standard Error 0.062075
Observations 24
ANOVA
224
1 Year
72 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.447828646
R Square 0.200550496
Adjusted R Square 0.189129789
Standard Error 0.051976796
Observations 72
ANOVA
df SS MS F Significance F
Regression 1 0.047440554 0.0474406 17.560252 7.99782E‐05
Residual 70 0.189111114 0.0027016
Total 71 0.236551668
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.002933459 0.006154533 0.4766338 0.6351074 ‐
0.009341371 0.0152083 ‐0.00934137 0.015208289
X Variable 1 0.641905776 0.153181357 4.1904954 7.998E‐05 0.336395197 0.9474164 0.336395197 0.947416355
60 Months
SUMMARY OUTPUT
Regression Statistics
df SS MS F Significance F
Regression 1 0.035995734 0.035995734 9.34156952 0.005784722
Residual 22 0.084772281 0.003853285
Total 23 0.120768015
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.011326 0.0142376 0.795486296 0.43483005 ‐0.018201159 0.04085279 ‐0.018201159 0.04085279
X Variable 1 0.728415 0.238324765 3.056398129 0.00578472 0.234160056 1.22267067 0.234160056 1.22267067
225
Multiple R 0.4800323
R Square 0.230431
Adjusted R Square 0.2171626
Standard Error 0.0496827
Observations 60
ANOVA
df SS MS F Significance
F
Regression 1 0.0428679 0.0428679 17.366863 0.00010392
Residual 58 0.1431656 0.0024684
Total 59 0.1860334
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.003737 0.0065846 0.5675369 0.5725398 ‐0.0094435 0.0169174 ‐
0.0094435 0.0169174
X Variable 1 0.6693254 0.1606115 4.1673568 0.0001039 0.34782659 0.9908243 0.3478266 0.9908243
48 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.4845552
R Square 0.2347937
Adjusted R Square 0.2181588
Standard Error 0.0515247
Observations 48
ANOVA
df SS MS F Significance F
Regression 1 0.0374711 0.0374711 14.114509 0.0004831
Residual 46 0.1221206 0.0026548
Total 47 0.1595918
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0043533 0.0077353 0.5627801 0.5763174 ‐0.011217 0.0199235 ‐0.011217 0.0199235
X Variable 1 0.6530295 0.1738201 3.7569281 0.0004831 0.3031479 1.0029112 0.3031479 1.0029112
226
36 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.5092612
R Square 0.2593469 Adjusted R Square 0.237563
Standard Error 0.0568856
Observations 36
ANOVA
df SS MS F Significance F
Regression 1 0.0385256 0.0385256 11.905433 0.00151331
Residual 34 0.110023 0.003236
Total 35 0.1485486
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0089937 0.010084 0.8918822 0.3787249 ‐0.0114994 0.0294868 ‐0.0114994 0.0294868
X Variable 1 0.695692 0.201625 3.4504251 0.0015133 0.28594068 1.1054433 0.2859407 1.1054433
24 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.5453442
R Square 0.2974003 Adjusted R Square 0.2654639
Standard Error 0.0621039
227
Observations 24
ANOVA
df SS MS F Significance
F
Regression 1 0.0359164 0.0359164 9.3122819 0.0058497
Residual 22 0.0848516 0.0038569
Total 23 0.120768
Coefficients Standard Error t Stat P‐value Lower 95% Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.011429 0.014263 0.8013045 0.4315253 ‐0.0181506 0.0410086 ‐0.0181506 0.0410086
X Variable 1 0.7261317 0.2379509 3.0516032 0.0058497 0.2326518 1.2196117 0.2326518 1.2196117
2 Year
72 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.4478623
R Square 0.2005807 Adjusted R Square 0.1891604
Standard Error 0.0519758
Observations 72
ANOVA
df SS MS F Significance
F
Regression 1 0.0474477 0.0474477 17.563558 7.987E‐05
Residual 70 0.189104 0.0027015
Total 71 0.2365517
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0030263 0.0061566 0.491555 0.6245718 ‐0.0092526 0.0153053 ‐
0.0092526 0.0153053
X Variable 1 0.6420113 0.1531921 4.1908899 7.987E‐05 0.3364793 0.9475434 0.3364793 0.9475434
228
60 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.4801839
R Square 0.2305766 Adjusted R Square 0.2173107
Standard Error 0.049678
Observations 60
ANOVA
df SS MS F Significance
F
Regression 1 0.042895 0.042895 17.381123 0.0001033
Residual 58 0.1431385 0.0024679
Total 59 0.1860334
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0038017 0.0065874 0.5771164 0.5660943 ‐0.0093844 0.0169877 ‐
0.0093844 0.0169877
X Variable 1 0.6690663 0.1604834 4.1690674 0.0001033 0.3478238 0.9903088 0.3478238 0.9903088
48 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.4845375
R Square 0.2347766
229
Adjusted R Square 0.2181413
Standard Error 0.0515253
Observations 48
ANOVA
df SS MS F Significance
F
Regression 1 0.0374684 0.0374684 14.113165 0.0004833
Residual 46 0.1221234 0.0026549
Total 47 0.1595918
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.004361 0.0077359 0.5637367 0.5756715 ‐0.0112106 0.0199327 ‐
0.0112106 0.0199327
X Variable 1 0.6521759 0.1736011 3.7567492 0.0004833 0.302735 1.0016168 0.302735 1.0016168
36 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.5089227
R Square 0.2590023 Adjusted R Square 0.2372083
Standard Error 0.0568988
Observations 36
ANOVA
df SS MS F Significance
F
Regression 1 0.0384744 0.0384744 11.884085 0.0015262
Residual 34 0.1100742 0.0032375
Total 35 0.1485486
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0089599 0.0100838 0.888547 0.3804899 ‐0.0115328 0.0294525 ‐
0.0115328 0.0294525
X Variable 1 0.6940933 0.2013423 3.4473301 0.0015262 0.2849166 1.10327 0.2849166 1.10327
230
24 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.545083
R Square 0.2971154 Adjusted R Square 0.2651661
Standard Error 0.0621165
Observations 24
ANOVA
df SS MS F Significance
F
Regression 1 0.035882 0.035882 9.2995915 0.0058781
Residual 22 0.084886 0.0038585
Total 23 0.120768
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0114286 0.0142673 0.8010376 0.4316766 ‐0.0181599 0.0410171 ‐
0.0181599 0.0410171
X Variable 1 0.7249082 0.237712 3.0495232 0.0058781 0.2319237 1.2178926 0.2319237 1.2178926
5 Year
72 Months
SUMMARY OUTPUT
231
Regression Statistics
Multiple R 0.4477724
R Square 0.2005001 Adjusted R Square 0.1890787
Standard Error 0.0519784
Observations 72
ANOVA
df SS MS F Significance
F
Regression 1 0.0474286 0.0474286 17.554735 8.016E‐05
Residual 70 0.189123 0.0027018
Total 71 0.2365517
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0033149 0.0061642 0.5377625 0.5924466 ‐0.0089793 0.0156091 ‐
0.0089793 0.0156091
X Variable 1 0.6412292 0.1530439 4.1898371 8.016E‐05 0.3359927 0.9464657 0.3359927 0.9464657
60 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.4798421
R Square 0.2302484 Adjusted R Square 0.2169768
Standard Error 0.0496886
Observations 60
ANOVA
df SS MS F Significance
F
Regression 1 0.0428339 0.0428339 17.348985 0.0001047
Residual 58 0.1431995 0.002469
Total 59 0.1860334
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0039908 0.0065995 0.6047142 0.5477274 ‐0.0092196 0.0172012 ‐
0.0092196 0.0172012
232
X Variable 1 0.6661296 0.159927 4.1652112 0.0001047 0.346001 0.9862582 0.346001 0.9862582
48 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.4839758
R Square 0.2342326 Adjusted R Square 0.2175854
Standard Error 0.0515436
Observations 48
ANOVA
df SS MS F Significance
F
Regression 1 0.0373816 0.0373816 14.070457 0.0004918
Residual 46 0.1222102 0.0026567
Total 47 0.1595918
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0044576 0.0077465 0.5754354 0.5678013 ‐0.0111353 0.0200505 ‐
0.0111353 0.0200505
X Variable 1 0.648449 0.1728708 3.7510608 0.0004918 0.3004781 0.9964199 0.3004781 0.9964199
36 Months
233
24 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.5446637
R Square 0.2966586 Adjusted R Square 0.2646885
Standard Error 0.0621366
Observations 24
ANOVA
df SS MS F Significance
F
Regression 1 0.0358269 0.0358269 9.2792601 0.0059239
Residual 22 0.0849412 0.003861
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.5083483
R Square 0.258418 Adjusted R Square 0.2366068
Standard Error 0.0569212
Observations 36
ANOVA
df SS MS F Significance
F
Regression 1 0.0383876 0.0383876 11.847933 0.0015482
Residual 34 0.110161 0.00324
Total 35 0.1485486
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0090742 0.0101004 0.8983994 0.3752911 ‐0.0114523 0.0296007 ‐
0.0114523 0.0296007
X Variable 1 0.6901752 0.2005109 3.4420826 0.0015482 0.282688 1.0976624 0.282688 1.0976624
234
Total 23 0.120768
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0116532 0.0143082 0.8144423 0.4241204 ‐0.0180202 0.0413265 ‐
0.0180202 0.0413265
X Variable 1 0.7218745 0.2369764 3.0461878 0.0059239 0.2304156 1.2133334 0.2304156 1.2133334
10 Year
72 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.4476677
R Square 0.2004064 Adjusted R Square 0.1889836
Standard Error 0.0519815
Observations 72
ANOVA
df SS MS F Significance
F
Regression 1 0.0474065 0.0474065 17.544468 8.051E‐05
Residual 70 0.1891452 0.0027021
Total 71 0.2365517
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0035983 0.0061725 0.5829602 0.5617935 ‐0.0087124 0.0159091 ‐
0.0087124 0.0159091
X Variable 1 0.640047 0.1528065 4.1886117 8.051E‐05 0.3352841 0.9448099 0.3352841 0.9448099
235
60 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.4794763
R Square 0.2298975 Adjusted R Square 0.2166199
Standard Error 0.0496999
Observations 60
ANOVA
df SS MS F Significanc
e F
Regression 1 0.0427686 0.042768
6 17.31465
2 0.0001061
Residual 58 0.1432648 0.002470
1
Total 59 0.1860334
Coefficient
s Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0042062 0.0066137 0.635986
2 0.527287
1 ‐0.0090325 0.017444
9
‐0.009032
5 0.017444
9
X Variable 1 0.6632787 0.1594003 4.161087
8 0.000106
1 0.3442043 0.982353
2 0.344204
3 0.982353
2
48 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.483553
R Square 0.2338235 Adjusted R Square 0.2171675
Standard Error 0.0515574
Observations 48
236
36 Months
ANOVA
df SS MS F Significance
F
Regression 1 0.0373163 0.0373163 14.038388 0.0004982
Residual 46 0.1222755 0.0026582
Total 47 0.1595918
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0046115 0.0077607 0.5942154 0.5552794 ‐0.0110099 0.0202329 ‐
0.0110099 0.0202329
X Variable 1 0.6451913 0.1721987 3.7467837 0.0004982 0.2985733 0.9918093 0.2985733 0.9918093
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.5079706
R Square 0.2580342 Adjusted R Square 0.2362117
Standard Error 0.056936
Observations 36
ANOVA
df SS MS F Significance
F
Regression 1 0.0383306 0.0383306 11.824213 0.0015629
Residual 34 0.110218 0.0032417
Total 35 0.1485486
Coefficients Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0092597 0.0101225 0.9147597 0.36676 ‐0.0113118 0.0298312 ‐
0.0113118 0.0298312
X Variable 1 0.6868533 0.1997459 3.4386354 0.0015629 0.2809208 1.0927858 0.2809208 1.0927858
237
24 Months
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.5444521
R Square 0.2964281 Adjusted R Square 0.2644476
Standard Error 0.0621468
Observations 24
ANOVA
df SS MS F Significanc
e F
Regression 1 0.035799 0.035799 9.269015
3 0.0059471
Residual 22 0.084969 0.003862
2
Total 23 0.120768
Coefficient
s Standard Error t Stat P‐value Lower 95%
Upper 95%
Lower 95.0%
Upper 95.0%
Intercept 0.0119542 0.0143578 0.832597
2 0.414019
4 ‐0.0178219 0.041730
4
‐0.017821
9 0.041730
4
X Variable 1 0.7194439 0.2363089 3.044505
8 0.005947
1 0.2293692 1.209518
6 0.229369
2 1.209518
6
Method of Comparables:
Price Earnings Growth P/E P.E.G Industry Avg Kraft PPS Kraft 11.59 1.47 1.60 18.51 Kraft Adjusted 11.59 1.47 Nestle 8.26 Heinz 11.50 1.48
238
Sara Lee 13.70 1.76
ConAgra N/A 1.55
P/E Trailing PPS EPS P/E Trailing Industry Avg Kraft PPS Kraft 22.27 1.92 11.59 11.15 21.41 Kraft Restated 22.27 1.92 11.59 21.41 ConAgra 18.03 2.16 8.26 Heinz 33.35 2.96 11.5 Nestle 39.1 4.24 13.7
Sara Lee 8.25 ‐0.35 N/A 11.15
P/E (forecast) PPS EPS P/E (forecast) Industry Avg. Kraft PPS
Kraft 22.27 2.09 10.91 10.97 22.93 Kraft Restated 22.27 0.71 32.13 7.79
ConAgra 16.73 1.5 11.13 Heinz 33.73 2.77 12.19 Nestle 39.1 N/A N/A Sara Lee 8.22 0.86 9.59
Price / Book PPS BPS P/B Industry Avg P/B Kraft PPS
Kraft 22.27 15.11 1.47 3.96 59.87 Kraft Adjusted 22.27 Nestle N/A N/A N/A
239
Heinz 33.35 4.31 7.74 Sara Lee 8.25 3.3 2.50
ConAgra 18.03 10.93 1.65
Price / EBITDA In Billions Market Cap EBITDA P/EBITDA Industry Avg. Kraft PPS Kraft 32.72 6.07 5.39 5.11 31.00 Kraft Adjusted 32.72 6.07 5.39 31.00 Nestle Heinz 10.55 1.82 5.80 Sara Lee 5.74 1.54 3.73
ConAgra 8.06 1.39 5.80
Enterprise Value / EBITDA In Billions Enteprise Value EBITDA EV/EBITDA Industry Avg Kraft PPS Kraft 51.98 6.07 8.56 7.33 44.51 Kraft Adjusted 51.98 6.07 8.56 44.51 Nestle N/A N/A N/A Heinz 15.4 1.82 8.45 Sara Lee 8.08 1.54 5.25 ConAgra 11.53 1.39 8.3
Price Earnings Growth P/E P.E.G Industry Avg Kraft PPS Kraft 11.59 1.47 1.60 18.51 Kraft Adjusted 11.59 1.47 Nestle 8.26 Heinz 11.50 1.48 Sara Lee 13.70 1.76
ConAgra N/A 1.55
Enterprise Value / EBITDA
240
In Billions Enteprise Value EBITDA EV/EBITDA Industry Avg Kraft PPS Kraft 51.98 6.07 8.56 7.33 44.51 Kraft Adjusted 51.98 6.07 8.56 44.51 Nestle N/A N/A N/A Heinz 15.4 1.82 8.45 Sara Lee 8.08 1.54 5.25 ConAgra 11.53 1.39 8.3
Price/Free Cash Flows (In Billions)
Company Market Cap FCF P/ FCF Industry Avg Kraft PPS Kraft 32.72 2.821 11.60 13.1278 37.03 Kraft (restated) 32.72 ConAgra 8.06 ‐5.417 ‐1.49 Heinz 10.55 0.634 16.64 Nestle 127 14.641 8.67 Sara Lee 5.74 0.408 14.07
Dividends / Price PPS DPS D/P Industry Avg Kraft PPS Kraft 22.27 1.16 0.052 0.048 23.96 Kraft Adjusted 22.27 1.16 0.052 0.048 23.96 Nestle Heinz 33.35 1.66 0.050 Sara Lee 8.25 0.44 0.053 ConAgra 18.03 0.76 0.042
241
Valuation Ratio Summary:
Valuation Ratio Result Summary P/E TTM Fairly Valued
P/E Forward Fairly Valued Price/EBITDA Undervalued Price/Book Undervalued
Dividends/Price Fairly Valued PEG Overvalued
Price/FCF Undervalued EV/EBITDA Overvalued
242
Intrinsic Valuation Models:
243
244
245
Adjusted AEG Model
246
247
References
1. Kraft 10-k 2003-2008
2. ConAgra 10-K 2003-2008
3. Sara Lee 10-K 2003-2008
4. Heinz 10-K 2003-2008
5. Nestle Financial Statements 2003-2008
6. Yahoo Finance
7. Morningstar.com
8. Wall Street Journal; “Wheat’s Lingering High Prices, Felt in Bakeries, Grocery
Aisles”
Tom Polansek; February 2, 2008
9. Wall Street Journal; “Testing if the Magic Ingredient Works”
Matthew Dalton; February 3, 2008
10. Wall Street Journal; “Rise of Private-Label Products Gives Retailers Clout”
By PAUL ZIOBRO and ANJALI CORDEIRO; December 3, 2008
11. Wall Street Journal; “Edible, Affordable Indulgences for 2009”
By Melody Lan; January 17, 2009
12. Financial Statement Analysis by Palepu and Healy 2008