Kraft's Risky Play for Cadbury

Corporate brinkmanship is making a comeback. Only days after Irene Rosenfeld, chief executive of Kraft (KFT), went public with her $16.7 billion bid for confectionary giant Cadbury (CBY), the British company's chairman, Roger Carr, blasted back in a Sept. 12 letter explaining why the cash-and-share offer was "unappealing." Cadbury's U.S.-born CEO Todd Stitzer is expected to voice similar opposition to the deal when he addresses shareholders in London on Sept. 16.

After quickly rejecting Kraft's initial approach on Sept. 7, Carr clarified in his letter that merging into Kraft would undermine Cadbury's strategy to become the world's leading pure-play candymaker, instead burying it inside "Kraft's low-growth, conglomerate business model."

Such hesitations might be worn down if Kraft ponied up more money—potentially, a lot more. Indeed, the war of words between Kraft and Cadbury marks the reemergence of high-stakes dealmaking after more than a year of scant merger-and-acquisition activity. "The battle lines are being drawn," says Martin Deboo, analyst at Investec Securities in London.

No question, Kraft sees a lot of potential upside. If the deal goes through, the world's second-largest food company hopes to squeeze out $625 million in cost savings from the combined companies. Buying Cadbury's fast-growing emerging-market operations, particularly in Brazil, India, and China, also could beef up Kraft's sluggish growth in developing countries and bolster its position in chewing gum. The linkup would give the company 15% of the global confectionary market, equal to McLean (Va.)-based rival Mars.

Kraft's Precarious Debt Situation To obtain those benefits, Kraft will likely have to raise its bid. Since the proposed takeover was first announced, Cadbury's shares have traded well above Kraft's initial $12.31-per-share offer. Analysts reckon the price will have to rise by at least 10% to entice Cadbury shareholders. But any increase will put added stress on Kraft's already heavily leveraged balance sheet. Piling on more debt to pay for the deal could even cost Kraft its investment-grade credit rating—which would raise its borrowing costs and make the deal less appealing to shareholders. "Kraft is constrained over how much debt it can raise," says Investec's Deboo.

The potential financial implications are already resonating. Standard & Poor's (MHP) estimates that Kraft had $24.7 billion in total adjusted debt on its books as of June 30, 2009, giving it a debt-to-pretax profit ratio of 3.6. Even at the current proposed price for Cadbury, that ratio would rise to 4.1—on the edge of the investment-grade comfort zone for rating agencies—and a higher bid would raise the ratio accordingly.

For that reason, both S&P and Moody's Investor Services (MCO) have put Kraft's long-term ratings under review, and could downgrade them if a deal goes through. "The increased leverage that would result under the proposed transaction [for Cadbury] would be considerable," says Moody's senior analyst Brian Weddington. Kraft declined to comment on its debt situation.

Merger Benefits vs. Possible Downgrade If Kraft's rating does get lowered below investment grade, analysts say funding a bid for Cadbury could be expensive—if not impossible. That could hurt the company's share price, which has already fallen by 6.5% since the Cadbury takeover attempt was announced, if investors get more concerned about Kraft's leverage. One early warning: According to data provider Markit, spreads for Kraft's five-year credit default swaps—a key indicator of a firm's creditworthiness—widened by 65 basis points, or 66%, in the four days after it announced its interest in Cadbury.

"The key question is whether Kraft can hold on to its investment-grade rating," says Charles Pick, analyst at JMFinn Capital Markets in London. "Many British investors won't want to hold on to Kraft [shares]."

Despite the possible downgrade, the expected benefits from a merger may encourage Kraft to push ahead with a deal no matter what. The takeover would create a company with more than $50 billion in annual sales and a global footprint spanning both Western and emerging economies. It would push Kraft's yearly revenues toward those of larger rivals Unilever (UN) and Nestlé (NESN.BE). The deal also would allow the U.S. company to keep pace with Mars, which bought Wrigley last year for $23 billion.

Cadbury executives still say the company's focus on chocolate, gum, and candy gives it higher margins and better growth prospects than those of its suitor. But for many Cadbury shareholders, including a large U.S. investor pool, the opportunity to cash in if Kraft raises its offer may prove to be too tempting. According to market estimates, Cadbury's price tag could rise to more than $20 billion, or 50% above its market value before Kraft expressed interest. That could entice even the most reticent shareholders to part with their stakes.

Before it's here, it's on the Bloomberg Terminal.