I was not surprised to see that Warren Buffett chose to use Berkshire Hathaway's (BRK.A) considerable cash hoard to acquire another high-quality consumer brand that sees shoppers buy the same products over and over across decades. Insofar as brand quality, return on capital, and high-return growth potential, H.J. Heinz (HNZ) is a Buffett stock through and through. That said, the price that Buffett was willing to pay is pretty shocking to me.
The Deal To Be
Provided the deal goes through (and Buffett deals tend to), Berkshire Hathaway and private equity group 3G Capital will acquire Heinz for $72.50 per share in cash. That's a total deal value of about $28 billion and, as the Heinz press release noted, a 19% premium to the company's all-time high share price.
At nearly 14 times trailing EBITDA, this is a pricey deal even by the elevated standards of quality packaged food. While noted Buffett stock Coca-Cola (KO) trades above 14 times its trailing EBTIDA, only a select group of names (including Nestle (OTCPK:NSRGY), McCormick (MKC), Hershey (HSY) and Kellogg (K)) carry similar valuations.
What Berkshire Is Getting
The press release announcing the deal did not specify how much of the acquisition capital was coming from Berkshire Hathaway and how much was coming from 3G, nor how the acquisition was going to be treated under accounting rules. In the case of Berkshire, I'm not sure it matters all that much, as Buffett is a famously hands-off manager.
To the extent that Buffett favors companies with strong brand value and the capability of generating strong internal rates of return on capital, Heinz is a great fit. Heinz is best known for its line of sauces, with products like ketchup and Worcestershire sauce holding commanding category share. In recent years, Heinz has been leveraging this strength overseas, looking to introduce and expand products like ketchup to markets like China and Brazil, while also using innovative packaging to capture even more table and pantry share in established markets.
Heinz is arguably less well-known for its frozen foods lines, but it is the fourth-largest frozen food company by market share (trailing ConAgra (CAG), Nestle, and Tyson (TSN)). This has been a more troublesome business for Heinz in recent times, though, as the company has been struggling with its Ore-Ida line of frozen potatoes and shedding underperforming brands like the TGI Fridays line of frozen entrees. With companies like Kellogg and Annie's (BNNY) ramping up their efforts to address the large frozen food opportunity, this is a business where Heinz needs to roll up its sleeves and get down to some serious work.
Heinz also has a modest infant feeding/nutrition business. Heinz is well behind the likes of Nestle, Mead Johnson (MJN), and Danone (OTCQX:DANOY) in the global formula/infant nutrition market, and this business has been delivering below-peer margins, but it is the leading baby food company in countries like China and the U.K. There are sizable long-term growth opportunities in markets like Mexico, Brazil, and India, and infant nutrition can be a significant growth opportunity for the company's emerging market ambitions.
Why Pay So Much?
I freely acknowledge that there are very few bargains in packaged food and that if an investor were willing to overpay for a food company, Heinz would have been a very good choice. What I question, though, is why Berkshire Hathaway and 3G are paying so much for this company.
For Heinz to be worth $72.50 a share, the company is going to have to grow its cash flow at a long-term compound rate of roughly 9% - or triple its trailing 10-year growth rate. Now, I'm a bull on emerging market growth and I believe Heinz is a great company, but that's an aggressive assumption at best.
Certainly there are other ways to consider the value/growth equation. Perhaps Berkshire and 3G are counting on better operating leverage and higher free cash flow margins in the future. The problem with that from my perspective is that Heinz has thrived in part because of its willingness to invest in product and product packaging development and its willingness to spend on marketing in foreign markets. Cutting back here would likely boost margins, but at the probable cost of long-term growth.
The other alternative is that Buffett simply values Heinz's growth more highly than I do. I believe that Heinz will grow its free cash flow at a 5% to 6% rate, and I discount that cash flow stream at a 9% rate. If you value that cash flow more highly, and Heinz does have a pretty good history of stable/consistent growth, you can get to a higher number. Each point of discount rate is worth about $9 per share in value, so dropping the discount rate to 7.5% is enough to boost the value of Heinz from my fair value of $57 to the deal price of $72.50.
The Bottom Line
As an investor who would like to get a quality packaged food company like Nestle, Kellogg, or Heinz at a decent discount to fair value, this deal doesn't exactly help me. Still, it's a logical deal for a company that loves to acquire strong brands that can grow almost indefinitely without any additional capital being injected into the business. I do wonder whether the implied valuation suggests that Buffett is now willing to accept lower returns from his portfolio acquisitions, but I suspect that investors will react to this deal by readjusting their valuation expectations and bidding up other high-quality names in the packaged food sector.