Kraft's disappointing third quarter has cast doubt over the future of any possible takeover move on UK confectioner Cadbury. The US food group delivered disappointing revenues and reduced its full-year organic growth targets, contrasting sharply with the strong third quarter Cadbury delivered last week. While Kraft's results have not left its expansion plans dead in the water, the US food group may have an uphill struggle to convince Cadbury shareholders and the market as a whole that its bid is viable, Katy Humphries contends.

The heat was on for Northfield-based Kraft when it delivered its third quarter results after the market closed yesterday (2 November).

Since Cadbury rejected Kraft's initial GBP10.2bn (US$16.7bn) stock-and-cash takeover approach in September, arguing that it "materially undervalued" the company, the world's second largest food maker has been on the back foot.

In order to convince Cadbury shareholders of the value of any offer, it had to prove that it is worth swapping Cadbury shares for Kraft shares and dispel Cadbury chairman Roger Carr's criticisms of Kraft's "low growth model".

In an open letter to Kraft chairman and CEO Irene Rosenfeld, Carr argued: "Your proposal is for Cadbury shareholders to exchange shares in a pure-play confectionery business for cash and shares in Kraft, a company with a considerably less focused business mix and historically lower growth."

Kraft's third quarter results will have done little to further its cause.

The maker of Philadelphia cream cheese and Terry's Chocolate Orange said that earnings fell to $826m, down from $1.36bn last year when the group booked a one-time gain from the sale of its Post Cereals business.

Significantly, revenues fell 5.7% year-on-year. Organic revenue growth was 0.5%, of which 0.7% was from volume / product mix, offset by 0.2% drop in pricing. The company also cut its forecast for full-year organic net revenue growth from 3% to 2%.

This compares poorly with Cadbury's 7% rise in third-quarter sales on a constant-currency basis.  The Dairy Milk maker's annual turnover is now expected to be "around the middle" of its 4-6% goal range.

Kraft has, however, made some good progress in improving margins and offloading unprofitable volume, particularly in Europe.

As CFO Tim McLevish emphasised during a conference call, in pruning unprofitable businesses Kraft is looking to the long-term "sustainability" of its business.

"We have business there that has a lot of price pressure and we deem it more appropriate to the health of our business, short-term and long-term, or particularly long-term, to decline participation in that particular business," he commented.

Kraft's margins increased 470 basis points, to 14.5%. Of this margin expansion, 70 basis points were due to volume / product mix improvements and the remaining 400 basis points were attributable to price increases, hedging and lower restructuring costs.

Although Rosenfeld insisted that the "heavy lifting" from a pruning standpoint was now out of the way, she did admit that more work remains to be done. This leaves Kraft open to the suggestion that it should put its own house in order before taking on the mammoth task of integrating Cadbury's international confectionery operations.

Rosenfeld said that the company remained "interested" in acquiring Cadbury, but added that Kraft would maintain a "disciplined approach" to the takeover proposal, reiterating Kraft's stance that it will not pay over the odds for the UK confectioner.

"Our criteria include accretion to cash EPS in the second year, delivering a return on investment well in excess of our cost of capital, and maintaining both our investment grade credit rating and our dividend," Rosenfeld insisted.

And herein lies one of the major barriers to a Kraft Cadbury tie-up. It appears that valuations of Cadbury differ significantly on each side of the Atlantic.

According JP Morgan analyst Pablo Zuanic, Kraft is unlikely to increase its offer to over 780 pence per share.

"We now assume a lower price on lack of competing bids, lower synergy assumptions and our growing belief Kraft could walk away," he wrote in a note.

However, this is significantly below the valuations offered by some analysts, which have in turn boosted the expectations of Cadbury shareholders.

Following Kraft's third-quarter results, brokerage Cazenove maintained its fair value range of 788-873 pence per share, which is based 13.4-14.6 times 2009 estimated EBITDA.

"We believe this disappointing organic sales growth will make it more difficult for CEO Irene Rosenfeld to reiterate the investment case in Kraft and hence it is likely to come under pressure to increase the cash proportion of the part-cash and part-Kraft shares structure of the proposal," Cazenove analyst Polly Barclay wrote in an investor note.

Indeed, news that Kraft has arranged $9bn in bridge loans for the Cadbury bid means that the US food group could be manoeuvring to do just that. If the entire loan amount was used to finance a cash offer, Kraft could raise its cash component from 300 pence to 400 pence per Cadbury share.

However, Kraft's disappointing Q3 resulted in a 2.94% drop in the group's share price, which fell to $26.73 at 5.51pm (GMT) today. This decline will act to dilute the value of the share portion of Kraft's bid.

Kraft's initial approach was priced at 745 pence per Cadbury share. However, the fall in Kraft shares make it presently worth around 732 pence, against a current Cadbury share price of around 766 pence.

According to reports, with no counter bids in the offing, Kraft plans to formalise its bid at the current price. Kraft apparently plans to keep a price increase off the table in order to retain the bargaining chip for later in the negotiation process - which will effectively turn the approach hostile.

However, as brokerage Panmore Gordon warned in a note today, Kraft must tread carefully in this regard.

"We believe Kraft and Cadbury are still far apart on valuation, so the offer when it comes will be hostile. Kraft can always increase its offer at a later date, but Kraft needs to be careful not to alienate Cadbury shareholders with an excessive low opening offer," Panmore analysts cautioned.

In a sure-fire sign that the market's enthusiasm for a Kraft-Cadbury tie up has dampened, Cadbury shares were trading down this afternoon.

Cadbury had dipped 1.42% at 4.35 pm (GMT) to 766 pence per share, suggesting that investors are dubious that any forthcoming Kraft bid will be met with success.