A limit to Kraft’s sweet tooth

September 8, 2009

Cadbury’s swift rejection of Kraft’s $16.7 billion offer has set off widespread speculation that Kraft will bump up its bid to ensure that it becomes king of candy land.

There is a limit, however, to how much Kraft can pay if it is committed to its investment-grade ratings. The company’s ratings sit two to four notches above speculative, or junk, territory, and every dollop of extra debt to pay for the acquisition would pressure the company’s ratings, making this and future financing much more expensive.

During the last merger and acquisition boom, ratings often became secondary for many firms, since the difference in the cost of financing for investment-grade companies and junk-rated companies had narrowed.

The credit crisis and the re-pricing of risk, however, mean the consequences of losing a sterling credit rating is much greater.

Risk premiums for BBB-rated debt for example, stood at 313 basis points on average over comparable Treasuries while BB-rated junk debt sat at 568 basis points last week, according to Standard & Poor’s. In January 2007, the difference between these two categories was 68 basis points.

Moody’s Investors Service warned on Tuesday that it could downgrade Kraft’s ratings one notch should a deal be consummated.

This is something that Lazard, Kraft’s lead financial adviser, and Citigroup and Deutsche Bank who will arrange the financing, will have to take into consideration when formulating a sweetened bid.

And if additional debt is necessary to win over Cadbury shareholders, the derivatives market and corporate bond markets are already positioning for it. Kraft’s credit default swaps widened out more than 25 percent on Tuesday, to 49.7 basis points, while the company’s bonds weakened, with the risk premium of its most actively traded bond rising 23 basis points, according to MarketAxess.

The sticking point of the original offer is said to be not just the price of the offer, but its allocation of stock and cash. Roughly 60 percent would have come from Kraft’s U.S. listed shares and the rest in cash — an issue for shareholders who would prefer more cash.

But the U.S. food conglomerate can’t pay for Cadbury out of its pocket. According to its second quarter filing, Kraft had only $1.7 billion in cash and cash equivalents.

That leaves piling on more debt. Kraft is already carrying $18.5 billion in debt and the rejected offer would have swelled that total to $27.5 billion for a total net debt to EBITDA ratio of about 3 to 1, according to Credit Suisse.

But that ratio swells to nearly 4 to 1 when Cadbury’s pension obligations are included, putting Kraft “dangerously close” to the zone where ratings agencies would be concerned.

And that’s the current offer. The Credit Suisse analysts say a sweetened bid could go as high as a 51 percent premium compared with the original’s 31 percent premium.

That leaves Kraft with little room to maneuver, as it’s caught between wanting the cheaper financing of investment-grade ratings and keeping shareholders happy.

Such a predicament also underscores how the landscape has changed since the credit crisis. Debt ratios matter more, as do ratings, so while dealmaking is making a comeback, it’s likely to be far more sober than the mania of the boom years.

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