Wednesday, April 1, 2015

Buffett on the Kraft Heinz Deal

Berkshire Hathaway (BRKaalready owned roughly half of Heinz as a result of a deal that took the company private back in 2013. Well, now Berkshire and 3G Capital have put a deal together that will combine Kraft (KRFT) with Heinz.

Berkshire and 3G together will own 51 percent of the newly combined Kraft-Heinz under the terms of the deal.

Berkshire had already invested $ 4.25 billion in Heinz common stock and will invest another ~ $ 5.25 billion in Kraft common stock to complete the new deal.

Warren Buffett explained it the following way on CNBC:

"SO WE WILL HAVE $ 9.5 BILLION ROUGHLY IN THE COMMON STOCK. AND WE'LL OWN 320 ODD MILLION SHARES OF THE NEW COMPANY. BUT OF COURSE, THE STOCK YOU'RE LOOKING AT WILL GO EX-DIVIDEND [AT] $ 16.50 [PER SHARE] AT SOME POINT BEFORE WE RECEIVE OUR SHARES IN THE NEW COMPANY."

The $ 9.5 billion works out to Berkshire paying slightly less than $ 30 per share for Kraft-Heinz combined.

Buffett certainly views this as a VERY long-term investment:

"...THE SHORT TERM DOESN'T MAKE MUCH DIFFERENCE TO US BECAUSE WE WILL BE IN THIS STOCK FOREVER. THIS IS A BUSINESS WITH US, IT'S NOT REALLY A STOCK. AND IT'S A COMPANY THAT WE WILL OWN 26 AND A FRACTION PERCENT OF. SO IT'S WHERE THE NEW KRAFT/HEINZ COMPANY IS 10, 20, 50 YEARS FROM NOW THAT COUNTS TO BERKSHIRE HATHAWAY AND I LIKE THE BRANDS."

Berkshire also still has the preferred stock investment in Heinz but most likely not for long:

"...AND THEN WE HAVE $ 8 BILLION OF PREFERRED. ALTHOUGH I'M AFRAID THAT WILL GET CALLED AS SOON AS THEY CAN CALL IT."

The $ 8 billion of preferred stock pays a 9% dividend and was a part of the Heinz deal. Those preferred shares can be called at a premium after June 7, 2016.*

Boil this down and Berkshire paid a bit less than $ 30 per share for a stock that currently trades for ~ $ 88 per share. Of course, as Buffett points out, the $ 16.50 per share special dividend that will be paid before deal is completed should be accounted for to make a meaningful comparison.

Once paid the market price will, of course, adjust downward to reflect that special distribution.

Clearly that's quite a big discount to the current market price. Yet, that the shares were bought at such a discount to what it currently trades at isn't really what matters all that much. What's truly impressive is getting control of two rather large high quality franchises at what seems like a very fair price compared to current intrinsic value -- with value that should increase at a nice clip over time -- and the ability to put quality management in place. I'm guessing, though it already seems a fine deal compared to current value, what Berkshire paid for Heinz and Kraft will look rather very good against the value that will be created over many decades.

It's what the business will be worth many decades from now that matters.

It's worth pointing out that, at least by my math, the current market price seems to represent a rather full current valuation.

Naturally if this were more of a short-term bet that gap in price paid to the current market price would be more relevant. Well, plainly this is no quick trade so such a short-term gain means little since Buffett plans to hold it "forever". In fact, if that rather high market price were to persist it simply means that potential future share repurchases won't make much sense nor do much good for continuing shareholders. Almost all Buffett's investments are longer term in nature but any business that's purchased outright it's even more so. He makes it pretty clear that this investment, even though Berkshire will only own 26 percent plus of the common stock, is more like the purchase of a business outright versus a typical stock investment.
(Though certain stocks in the Berkshire portfolio tend to be held indefinitely if not "forever" while most others, at least, are held for a very long time. Mistakes get made that require a quick adjustment and sometimes the capital is needed elsewhere because the opportunity costs are high enough. Otherwise, short-term bets aren't really in the Berkshire playbook.)

More relevant is what was paid compared to what a reasonable estimate of what the two businesses are capable of earning on a normalized basis.

Heinz was earning roughly $ 1 billion per year before the company went private. Kraft as a stand alone company should earn $ 2 billion this year if expected earnings multiplied by current shares outstanding proves at least a reasonable guide.
(Heinz net income is currently lower due to the additional debt that was taken on as well as the preferred stock. It will take some time for the added debt to be paid down, along with the preferred shares, before this all falls to the bottom line for common stockholders.)

So, for roughly $ 9.5 billion, Berkshire now owns 26 percent plus of those earnings (and, for the time being, until they're likely called, will be getting that nice dividend payment from the preferred shares).

Seems like a more than reasonable price to pay for a business that should be around for a very long time.

If any of the expected annual cost savings come to fruition that'll only improve the picture.

Adam

No position in KRFT. Long position in BRKb established at much lower than recent prices. 

* See note 6, page 9 of the 2nd Quarter 2013 10-Q. Warrants were also included in that deal.
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