Tuesday, February 19, 2013

Buffett and Heinz

Ever since the deal was announced last Thursday, I have been trying to figure out why Warren Buffett - the epitome of a value investor - would pay so much for Heinz.

Together with Brazilian private equity firm 3G Capital, the deal for Heinz at $72.50 per share values the company at $28 billion, which represents a 20% premium to where the stock was trading just a week ago.

Heinz has been on a pretty good run over the last couple of years, rising +27%,  or more than double the return of the S&P 500.

On the surface, then, it would seem that Buffett and 3G are overpaying for the company.

This too would seem to be the consensus of the media and financial blogging community, which seem to be fairly unanimous in their view that the deal values Heinz too richly.

When I look at this deal, however, I start with the initial premise that you don't get to be a multi-billionaire by overpaying for companies.

On numerous occasions in recent years Buffett and Berkshire Hathaway have paid what appeared to be a full price for an acquisition (e.g. Burlington Northern) only to have subsequent events prove Buffett's analysis correct.

So what is the Oracle seeing that most are missing?

I think the key is in the structure of the deal.

Despite's Buffett's protests against leveraged buyouts (LBO) in the past, this seems to have all of the elements of a classic LBO.

First, like many large food companies, Heinz is a slow-growing, yet largely recession-proof company. The company has achieve modest sales growth over the past decade, even in the depths of the 2008-09 downturn. This trend should continue as Heinz continues to expand in the emerging markets.

Next, the price of debt is incredibly low in today's yield-hungry market.  Even debt rated below investment-grade is available at 6% or lower.  With Buffett's cachet, I bet that the new debt that Heinz is issuing will be priced around 4%.

Finally, while the announced value of the deal is $28 billion, the equity partners are actually only contributing $8 billion in equity.  Buffett's additional contribution is $8 billion in preferred stock carrying a hefty 9% dividend, while 3G is responsible for scrounging up $7 billion in new debt, which Heinz (and not the equity partners) will be responsible for repaying.

Here's the way the new company's balance sheet will be structured:

$5 billion - existing Heinz debt
$7 billion - new Heinz debt (to be raised by 3G)
$8 billion - new Heinz preferred (owned by Berkshire)
$4 billion - Berkshire investment
$4 billion - 3G investment
-----------
$28 billion - total value

Now, let's take a look at the cash structure of the new company (all in round numbers):

$1,700 million - Operating income in 2012

Less:

$300 million - debt service on existing Heinz debt
$300 million - debt service on new Heinz debt (assuming 4% rate)
$700 million - preferred stock dividends
$350 million - taxes (based on prior year rates) 

Net: $50 million

$50 million of free cash flow on revenue of $1.7 billion doesn't give much room for error.

So here's what I think Buffett is counting on.

First, 3G has the reputation of finding ways to ruthlessly cut costs in the companies it has acquired.  While Heinz is reported to already be fairly efficient in its operations, I suspect there will be some cuts to follow.

Next, in Buffett's view, the 9% preferred dividend pays him pretty handsomely while he waits for 3G to improve bottom line results.  In a world of record-low interest rates, Berkshire will be earning 6% (if you include its equity investment), which is pretty attractive.  Note too that preferred dividends are 70% tax-free to corporate investors provided they hold the shares for at least 45 days.

Also, in the unlikely event that Heinz goes bankrupt, Berkshire's preferred shares stand high enough in the capital structure to be repaid prior to general creditors.

Finally, Buffett is renowned for thinking about how a company will look in the future, not just as it appears today.

If Heinz can grow its top line by +5% per annum for the next five years (it has actually done slightly better than this since 2007), Heinz will have revenue of around $15 billion by 2017.

Assuming it will maintain operating margins of around 15% (its historic average), the operating income will be closer to $2.2 billion five years from now.

At that time, after paying the debt service and taxes, in 2017 Heinz will have $1.1 billion available.

However, Berkshire's share of the Heinz cash flow will be much bigger than 3G's, thanks to the preferred dividend.

Berkshire will gets its $700 million dividend first, and $200 million of the remaining $400 million in earnings, or 5% of its equity investment (although they will probably reinvest this amount back into the company.

In short, while it does not appear that the deal is a "home run" for Berkshire, it also is a pretty sound investment in a low return world.