Monday, November 23, 2009

The Emotions of Hershey’s Bid

Hershey is smaller and brings less to the table than Kraft Foods in a potential takeover battle for Cadbury. But Hershey may have one distinct advantage over Kraft: a potentially irrational owner

The Milton Hershey School Trust, which controls Hershey, has exhibited a different set of priorities than, say, Warren E. Buffett, the big Kraft shareholder, who has counseled Kraft not to overpay for Cadbury. It would be a mistake to think Hershey wouldn't trump Kraft's nearly $17 billion offer for Cadbury.

Strict economics suggests Hershey should steer clear. The company has $1.7 billion of debt. If it were to add debt equal to five times operating cash flow it might be able to raise an additional $3.7 billion. That's not enough on its own to pay for Cadbury — but it's enough to put Hershey at risk financially.

Moreover, though sweets are a stable business, Hershey has never acquired a company as large and global as Cadbury. Even if a combination could handle more debt, Hershey would still have to come up with about $13 billion, though it could also reduce that by raising debt against Cadbury's earnings.

Still, such a move would require changes that might disrupt the Hershey trust, established by the company's Mennonite founder. The company could sell assets — Ferrero of Italy is said to covet some Cadbury brands. It could issue shares to Cadbury holders or bring in new investors in the way Mars did with Mr. Buffett when it bought Wrigley. If it issues too much equity, though, the trust could put its supervoting stock at risk.

The returns on this potential investment don't look especially sweet, even assuming Kraft wouldn't top a higher competing offer — and it probably would. Hershey has fewer opportunities to cut costs since it overlaps in only half as many Cadbury geographies as Kraft, Credit Suisse reckons. It would struggle to earn a return on investment higher than its cost of capital.

But Hershey's trustees and managers may not just be thinking about the bottom line. In Kraft-Cadbury, Hershey sees a combination that could leave it as a global bit player. Faced with such a picture, any response — even an irrational one — can't be discounted.