In 1988, the private equity firm of Kohlberg Kravis Roberts was on the prowl to take over a company after making hundreds of millions of post-tax dollars quickly from the leveraged buyout of Reynolds Tobacco. It wanted to buy The Kroger Company, a large American grocer that looked small enough to be taken over by activist investors. Because KKR wanted to oust the then-existing management at Kroger, the management team sought a creative strategy to keep out KKR so that they could keep their jobs. At the time, KKR did not engage in the golden-parachute strategy of paying off executives handsomely to relinquish control of the company and go away.
In one of the riskiest financial engineering moves in corporate American history, Kroger took on $4 billion in debt to issue a $48.50 special dividend to shareholders (it was set to come in the form of an August 1988 $40 dividend and a debenture of $8.50 that would go to shareholders in December 1988). This strategy did two things to keep Kroger out of KKR’s hands: (1) It sought to spur investor enthusiasm in Kroger’s stock that would result in a higher market value to put the size of the company beyond KKR’s reach, and (2) it burdened the company with very high debt that would be undesirable to an activist suitor because few financial engineering moves exist once there is no longer room to increase a company’s debt. The debt burden was so high that Kroger had to cancel its quarterly dividends and suspend growth initiatives, devoting all earnings to debt repayment.
The strategy drove KKR away, and here is why I find that story relevant to Kraft’s upcoming $16.50 dividend payment: The decision to reinvest $48.50 per share in a massive dividend back into Kroger stock led to very lucrative long-term returns. It is a massively large application of the BP dividend reinvestment principles that we just discussed. Someone that bought Kroger stock and reinvested the $48.50 per share dividend would have eight times as many shares of Kroger today as owned in 1988. Someone that sat on the dividend, and reinvested future Kroger dividends, would have barely doubled the share count by today. Keep in mind that Kroger’s dividend yield is only 1% today, so dividend reinvestment hasn’t been a big part of the company’s story beyond the 1988 event. And, of course, you would have to adjust for the opportunity cost of what someone would have done with that $48.50 per share dividend if they didn’t buy Kroger stock—if it went into Coca-Cola stock, for instance, things also worked out quite well.
Still, someone who bought Kroger in 1988 and reinvested the Kroger $48.50 per share dividend would have compounded at 15.5% from then until today. A $25,000 Kroger investment at the announcement of the dividend would have a value of $1.4 million today. That one-time Kroger dividend was so lucrative that Kroger outperformed Procter & Gamble over the past quarter century for heaven’s sake, which is quite an accomplishment given that P&G has many natural advantages in its business model that don’t exist for Kroger in the grocery business. The lesson is that the reinvestment of abnormally high dividends into businesses that subsequently grow can lead to very lucrative results. I would keep that case study in mind if I were trying to think through the best way to handle Kraft’s upcoming $16.50 per share dividend payout.
Now, I am not so enamored by the data that I would buy Kraft right now for the purpose of capturing this dividend. The enthusiasm for the Buffett/3G takeover has made the valuation quite high, and I would rather do something like own BP or Chevron where you get a 5% or 4% annual dividend at a fair or better price that can take advantage of these same principles without needing as many things to go right.
Still, it’s intriguing to observe how quickly the fortunes have changed for Kraft shareholders in the past years. For the past five years, Kraft has been meandering along, growing revenues at 2%, as the company has acquired and discarded businesses, triggering large tax liabilities in an effort to own junk foods with high revenue growth. Still, it’s amazing to think about how great the past six years have been from a shareholder perspective if you bought shares of Kraft during the financial crisis.
Just six years ago, you could have bought shares of Kraft for $21 per share. Someone with 300 shares of Kraft back then would own 300 shares of Mondelez today and 100 shares of Kraft Foods. The Mondelez stock went up to $40 per share. The 100 shares of Kraft is now at $84 per share, and will feature a $1,650 dividend in the next year. Plus, you are going to get to merge with Heinz, and have your business be run by a management team that, for better and worse, provides great short-term returns. And don’t even get me started on the returns if you owned Kraft before the Altria and Philip Morris International spinoffs. Who would have thought that buying shares of Altria in 2007 would lead to shares of Altria, Philip Morris International, Mondelez, Kraft-Heinz, and $16.50 per share dividend payouts? And Altria is still sitting on a 27% ownership position in SABMiller, so the final chapters of the corporate spinoffs may not be written yet.
Even if you just purchased Kraft foods last year, you’re still going to collect a $16.50 dividend on a $50 per share investment and get to combine with Heinz, another company that has delivered returns north of 15% annually since 1988. The reason why I don’t pound the table insisting that you buy Kraft Foods right now is because there is a significant difference between paying $50 and $80 per share for Kraft Foods stock, and the 3G management team has yet to prove it possesses the ability to manage a company beyond cost cutting. Specifically, revenues at Heinz have declined by 11% cumulatively since the 3G/Buffett takeover of the company, and it is not unreasonable to suggest that the merger with Kraft Foods is an admission by 3G that it has trouble answering the “What’s Next?” question after it can no longer provide returns through cost cutting alone.
The reason why I would advise something like Chevron is because you get dividends plus clear investments on the horizon. In 2017 and 2018, Chevron will be increasing its liquefied natural gas production substantially when the Gorgon Project in Australia starts running, so that you can clearly see how shareholders will be able to build wealth in the coming years due to reinvesting a 4% dividend into a business that will be growing its daily production of oil and oil equivalents and will also likely benefit from higher commodity prices over the long run. I don’t see that path to clear revenue growth at Kraft and Heinz, and that’s why I’d be hesitant to pay $80+ per share to initiate a position now.
For someone that already owns Kraft, history suggests that reinvesting the $16.50 dividend and holding for the long run will be a financially rewarding decision as the brands are stable and the company will be profitable many decades from now. That said, I am not so enamored by the prospects that I would buy the stock with fresh capital today because there is a revenue growth issue that hasn’t been solved when the company is deliberating trying to grow revenues, and is unlikely to be solved in the short-term by men whose toolbox is only filled with cost-cutting tools. For fresh capital, I’d still prefer certain high-quality oil stocks that are either discounted in value like BP or offer a decent price like Chevron and have clear plans for production growth so that the value of high dividends reinvested will have clearly beneficial implications within five years from now.
Originally posted 2015-05-09 00:00:15.