Friday, October 18, 2013

Life at Heinz post-Buffett

Earlier this year Warren Buffett's Berkshire Hathaway teamed with Brazilian private equity 3G to buy Heinz for $28 billion.

The acquisition was not cheap. The purchase price represented a +28% premium to where Heinz had been trading in the markets.  And while there was no denying the iconic status of Heinz ketchup and its numerous other consumer products, many puzzled as to whether the famed value investor had overpaid.

I wrote about the acquisition on Random Glenings on February 19, 2013.

I argued that the key to the deal for Buffett was the 9% preferred dividend that Berkshire will receive in the coming years.

I also noted that the management team at 3G had the reputation for ruthlessly cutting costs to achieve financial objectives which would eventually help the deal prove profitable.

Here's an excerpt from my blog post:

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.

The current issue of Fortune magazine carries a long piece about Heinz in the aftermath of the buyout (tip of the hat to Adam Lashinsky, editor of Fortune, who titled the piece "The Best Case Study You'll Ever Read" on LinkedIn).

Life at Heinz has been apparently brutal under 3G's management.  Costs have been ruthlessly cut, starting with the layoff of 11 of the top 12 senior managers at Heinz.  Here's an excerpt:

What is this new Heinz? So far, according to testimony from current and former executives, it is a place in which every cost, no matter the size, is attacked and reduced or eradicated. That applies to human costs as well; in August, Heinz announced the layoffs of some 350 of the 1,200-strong full time staff at Heinz's Pittsburgh headquarters and a total of 600 across North America....

 The layoffs were only the beginning. Heinz's corporate jet is being sold, the aviation department shuttered, and the company's two corporate buildings are being combined into one. Individual offices are being done away with altogether. Instead, even top executives including Hees now work only inches from each other at white industrial tables with one shared filing cabinet per table. They are encouraged to wear shirts with the Heinz logo imprinted on them. They must stay at hotels at the level of Holiday Inn when traveling, and are expected to work even longer hours than they already did. It is an approach borrowed from the likes of Wal-Mart, but refined over the course of many years.

According to the Fortune article, Buffett declined to comment on Heinz, noting that his role in the deal had been mostly to provide financing.