Cadbury and Kraft – public policy should focus on debt, not nationality

After months of wrangling over price, thinly veiled political intervention and the continued enrichment of investment bankers, it looks almost certain now that the ownership of another iconic British brand will fall into the hands of foreign buyers.

Cadburys-gorilla Kraft and Cadbury have agreed on a value of £11.5bn – or 840p a share – for the British company, a number that is likely to please most shareholders given that only four months ago Cadbury’s shares were trading at 568p.

On the one hand, this is no different from the hundreds of mergers and acquisitions that take place around the world every year. Some turn out well, but many do not – and in the latter case the management and shareholders of the merging companies usually suffer.

The outlook for Kraft and Cadbury is an uncertain one, with trends to consolidation in the industry alongside complimentary market positions potentially offset by high integration costs and a clash of business and operational cultures (and our chocolate may start to taste of cheap cheese!).

But these are all matters for shareholders. So should the progressive Left even have a view on deals like this, and does policy have a role to play? The answer is unequivocally yes. The financial crisis has demonstrated that in the event of a significant corporate failure, governments – and ultimately taxpayers – find themselves under pressure to provide financial support potentially running into tens of billions of pounds; and the resulting unemployment, often concentrated in particular towns and cities, places enormous strain on social security and public services.

The crucial point is that transactions in the private sector do not occur in a vacuum, and it is usually when things take a turn for the worse that the broader societal impact becomes clear, but as we operate in what is primarily a market economy, it is difficult, and perhaps even undesirable, for a government to intervene on purely commercial grounds.

Further bluntly “protecting” jobs by seeking guarantees from a buyer is not a particularly progressive policy – it ignores the forces of competition and globalisation that all companies, UK owned or otherwise, face. Indeed, Cadbury itself has a record of aggressive cost-cutting.

The biggest risk to Cadbury workers is not that Kraft is an American company that will seek out profits at the expense of British jobs, it is that Kraft is funding the acquisition with £7bn of debt, taking the group’s debt to EBITDA (Earnings before interest, taxes, depreciation and amortization – a measure of earnings) ratio to nearly four times.

The cost of financing the massive mountain of leverage means that much of the cash generated by the business will be spent not on investment and training, but on interest payments. And if rates rise or sales drop, the group will be forced to cut jobs – and at worst may even fail.

Therefore the right approach is to enact public policy that demands financial prudence as part of any deal, domestic or cross-border. This could simply be a cap on the amount of leverage a buyer of a British business can apply. Just as we should probably have stopped Northern Rock lending 125 per cent of the value of someone’s home, we should stop companies picking up British businesses when there is a risk that the terms of the acquisition could lead to job losses.

This is not the government trying to second guess what best represents shareholder value. It is the government protecting its, and our, interests.

Bill Kristol-Balls

Excellent article.

You only have to look at the asset stripping of Man Utd by the Glazer family to see what the future holds for Cadbury.
Mark

I think you’ve put your left foot in your mouth. Kraft has a strong AA- credit rating and Cadbury is BBB, only two pegs away from “junk bond” status. Which means that investors view Cadbury as the weaker credit risk. Kraft can borrow all those billions to launch the take-over but its superior credit rating will remain unchanged. Thus the combined entity is safer, the takeover removes credit risk rather than increases it. Therefore if the article is about boosting corporate finances, the takeover should be supported.
Varun

Mark – thanks for your comment. A few points of information: Kraft is rated BBB, Baa2 and A- by the three main ratings agencies (Fitch, Moody’s, S&P). This is pre-acquisition – the acquisition debt is likely to increase borrowing by a third, which will significantly impact the group’s rating. The article above links to an interesting FT analysis of Kraft’s debt, if you’d care to have a look. Indeed today’s debt markets are indicating fears of a drop in Kraft’s rating to below investment grade. Also, as I’m sure you appreciate, the quantum of debt is very important regarding financial stability. Kraft has nearly $20bn of debt; Cadbury has less than a tenth of this. Yet it will now likely be owned by a highly geared entity with a significant interest coverage requirement. And crucially, the earning’s requirement placed on both companies post acquisition will be challenging, particularly when compared to the group’s (rising) cost of capital. And the point is that if times get tough, or credit markets freeze (as they have just done) the group could find itself in real bother. So no, I don’t think one would necessarily support the takeover if the financial risks were properly understood.
http://twitter.com/gsdog7/status/7956110833 gsdog7

RT @leftfootfwd: Cadbury and Kraft – public policy should focus on debt, not nationality: http://is.gd/6BGwB
http://twitter.com/tobinwebb/status/7957741892 Tobin Webb

RT @leftfootfwd: Cadbury and Kraft – public policy should focus on debt, not nationality: http://is.gd/6BGwB
Mark

Varun, some good points. But credit risk isn’t the problem here. Many UK deals from London private equity houses are far more leveraged. But capping is clumsy since the cash flow can vary a lot, as can future performance.

The progressive idea would be to ensure a takeover shows due concern for employment and ensured pensions are protected.
Varun

Thanks Mark. A final comment from me: UK corporate pensions in takeover scenarios are perhaps the most secure in the world, with the powers of The Pensions Regulator beefed up considerably in the last few years. It can even act retrospectively to hold a company to account. And I’m not sure how a takeover could show ‘due concern’ regarding jobs in any meaningful fashion without risking court action for discrimination. And these aren’t progressive or innovative policy positions in my view – they are already the status quo.

Of course private equity transactions are highly leveraged – their business is borrow lots, cut costs, use cash to pay down debt then sell quickly to make lots of money. And in the last few months many of these businesses have found themselves struggling to stay above water – precisely due to their debt burdens and the difficulty of refinancing in stressed market conditions (I wouldn’t merely call this ‘credit risk’ – it is a genuine operational consideration). When the negative externalities of failure are as significant as could be with Cadbury, leverage caps (applied on a case by case basis, using deal specific metrics that take into account cash flow variance) could be a valuable, and practical, intervention.
Mark

Cap leverage and firms would quickly find a way around it, whether just issuing equity, resorting to convertible instruments or other more structured items. You could oblige acquirors to state the number of job losses up front, so staff know what’s happening. But we can only ponder, after all the PM is closely linked to a private equity house so nothing is going to change in the wake of this bid.
http://twitter.com/homeownertips/status/7966806646 stevie b

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http://www.leftfootforward.org/2010/01/politics-summary-wednesday-january-20th/ Politics Summary: Wednesday, January 20th | Left Foot Forward

[...] to allow ministers to intervene in high-profile deals where the national interest is at stake. Left Foot Forward said yesterday: “we should stop companies picking up British businesses when there is a risk [...]
http://www.touchstoneblog.org.uk/2010/01/web-links-for-20th-january-2010/ Web links for 20th January 2010 | ToUChstone blog: A public policy blog from the TUC

[...] Cadbury and Kraft – public policy should focus on debt, not nationality Varun Chandra writes on Left Foot Forward that Kraft's heavily leveraged buyout bodes badly for the Cadbury's business in the UK: "The cost of financing the massive mountain of leverage means that much of the cash generated by the business will be spent not on investment and training, but on interest payments." Related posts (automatically generated):Cadbury deal shows little or nothing has been learnedPre-Budget Report LIVE: Online coverage from noonLet’s talk PBR – live coverage this Wednesday [...]
Liz McShane

Mark – there was guy from HSBC markets on Newsnight the other night saying that he thought all those credit rating agencies – Fitch, S&P, Moody etc were a load of rubbish and that the ratings were meaningless….