Kraft-Cadbury Was a Good Deal Despite Recent News

Much ado has been made about the Kraft-Cadbury deal. The consensus seems to be (especially after the overlooked pension shortfall) that Kraft overpaid for Cadbury and, even worse, used its own undervalued stock to do so. Recently, Kraft revealed CEO Irene Rosenfeld's compensation for 2009 was $26.3 million, up 41% from 2008. The compensation committee "heavily weighted the significant effort and the ultimate acquisition of Cadbury" to determine the payment. To some, the Kraft-Cadbury deal is the perfect example of empire building, suggesting that Rosenfeld executed the Cadbury deal to increase revenue (which generally determines CEO compensation) without much attention to the price. This criticism reflects the common conception that most M&A destroys value and is driven by ego and compensation. In my opinion, this view is misguided, both for M&A generally and Kraft specifically.

The economic argument for the Cadbury acquisition is strong. Kraft paid only 11.8x 2011 expected earnings and there is substantial room for margin improvement. For a thorough discussion of the economics of the acquisition, see Pershing Square's presentation on the deal.

But more generally, Kraft-Cadbury is a perfect example of why the common conception that only 20% of M&A creates value for shareholders is wrong. As Robert Bruner argues in his 2004 review of M&A performance published in the Journal of Applied Corporate Finance ("Where M&A Pays and Where It Strays"), M&A is local in the sense that its really impossible to generalize on the performance of M&A given the diversity of deals and difficulty in tracking performance. Academic research on specific types of deals suggests that the Kraft-Cadbury deal is actually much more likely to create value than other M&A.

1. Focused acquisitions are significantly more likely to create value through opportunities for cost savings, asset reductions, and other efficiencies. The Kraft-Cadbury deal was certainly focused and is projected to unlock $675 million in synergies.

2. M&A using excess cash generally destroys value. Kraft did not buy Cadbury simply because it had excess cash and not enough investment opportunities, hence its need to sell its frozen pizza division to raise cash.

3. Hot and cold M&A markets are a strong determinant of performance. M&A during periods of high valuations--think Time Warner/AOL--are much more likely to destroy value. Kraft certainly did not acquire Cadbury in a "hot" M&A market.

4. Deals that are greater than 10% of the buyer's market value produce 2.4% higher returns for the buyer than deals less than 10% of the buyer's market value. The market value of Cadbury is significantly greater than 10% of Kraft's market value.

Bruner concludes that there are generally "good big deals" and "bad big deals" indicating that there is less middle ground (deals that are neither substantially value creating or value destroying) than one might expect. All things considered, it seems to me that Kraft-Cadbury is much more likely to be a "good big deal" than a "bad big deal."

Full Disclosure: I do not currently own Kraft stock, though that might change over the coming months.