On Valentine's Day, news crossed that Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) and 3G Capital were acquiring H.J. Heinz (HNZ) for $72.50 per share in cash. At first glance, the deal made perfect sense due to Heinz's first-tier brands and Buffett's passion for buying businesses that he understands clearly, which also happen to have a defensible "moat" surrounding them. As more details emerged, the brilliance of the structure for Berkshire Hathaway became even more apparent and I firmly believe that the partnership to acquire Heinz will be an initial volley into a much larger entry into consumer products by the Berkshire/3G partnership. Heinz shareholders should be happy that they received a very full price on this deal, at a 19% premium to the stock's all time high trading price, 14 times EBITDA and at a 30% premium to the 10-year EBITDA average. I believe this deal will be an absolute home run for Berkshire Hathaway and a great investment for 3G due to four primary reasons pertaining to structure, leverage , scalability and cost-cutting:
Berkshire's largest contribution of cash is going to be on $8 billion of preferred stock, which will be yielding 9%. This would generate $720MM pretax to Berkshire on a security that in all practicality will have very little risk when all is said and done. There is no doubt that Heinz will be a more highly levered business after the acquisition, with an estimated $12 billion in debt after tacking on about $7 billion in financing. Current debt-to equity and interest coverage ratios are quite strong, so there is definitely the capacity for the company to take on more debt. With the current debt structure, Heinz has been generating around $1 billion in free cash flow. Much of this will be absorbed by Berkshire's preferred coupon. If for any reason Heinz were to completely bomb, meaning 3G totally dropped the ball from a management perspective which would be highly unlikely in my estimation; the preferred stock could very well become the fulcrum security, which would give Berkshire ownership of a restructured Heinz. I am not aware of any 9% yielding securities with as strong credit quality as Heinz in the market, and if you can find one please feel free to comment upon it because I would gladly invest in the Heinz preferred Berkshire is receiving. Berkshire found an opportunity to invest a very large amount of capital at about 700 bps above 10 year treasuries, with very little risk of a permanent loss of capital.
Both Berkshire and 3G are putting about $4 billion apiece in common stock on this deal. Because of the high yielding preferred, the valuation on the common is actually even more expensive than what is implied at the acquisition price with the current funding structure. The reality, however, is that both Berkshire and 3G are taking advantage of a huge bubble in bonds to acquire one of the finest and largest consumer goods companies in the world, with one of the best global distribution platforms for only $4-billion apiece in common equity. This is not an extremely large investment for Berkshire or 3G even, but the companies will now have access to a distribution channel that currently generates 2/3rds of its revenue outside the United States, and 25% from emerging markets. The top-notch Heinz brand has a huge and growing competitive advantage in sauces while generating 40% of sales, but the portfolio also has another 15 brands that generate more than $100MM in sales annually. Heinz is also developing an attractive but non-core infant nutrition line that could potentially be divested to reduce leverage, or to increase the cash payout to the group of investors.
Now that Berkshire and 3G have secured the distribution system of Heinz, the companies can focus their efforts on adding other brands and companies to further leverage the system. While 3G is fully aware that Buffett is getting the better part of this deal with the preferred stock, 3G is able to combine its own pockets with the seemingly bottomless ones of Berkshire to go on the acquisition hunt in a way in which it couldn't dream of alone. Both investors understand that the brands and the distribution system are what have created a business with lasting durable competitive advantages, and now they have the perfect launching pad to commence a much larger acquisition effort. For Berkshire, this is highly attractive because it doesn't want to have to manage these businesses and it needs acquisitions with large scale due to its own gargantuan size, so 3G provides the management to make this roll-up possible and the consumer goods market is huge.
4) Cost Cutting
I believe that 3G will find ways to aggressively cut costs and that all of the talk about how great of an operator Heinz has been is a little overdone. Heinz's returns on invested capital have hovered around 6-11% over the last decade, which is better than the company's cost of capital highlighting the company's durable competitive advantages. This is lower than both General Mills (GIS) and Kellogg (K), and we don't need to even mention Coca-Cola (KO) or Pepsi (PEP), which are far superior. Operating margins haven't been trending higher but instead have been fairly steady despite the cost cutting efforts initiated by Nelson Peltz and management. SG&A costs are around 38% of revenues now as opposed to roughly 34% a decade ago. There has been a lot of cheerleading about Heinz's great financial performance and operational acumen, but I'd bet dollars to donuts that 3G will reduce SG&A costs and improve operating margins substantially. I believe one reason this is not being brought up very much in interviews or in the conference call is because generally this means layoffs, and Heinz is an icon to its hardworking Pittsburgh hometown, and therefore it is politically attractive to downplay the potential ramifications of this deal for labor. I am confident that Berkshire and 3G will be very good owners for Heinz, and I believe the equity aspect of this investment is a leveraged bet on 3G's ability to cut costs and further the expansion into emerging markets. The common equity component of the deal wouldn't make sense when you factor in the onerous preferred coupon, unless 3G had a clear plan to cut costs and/or divest non-core assets.
In summation, I believe that despite the market's rise to near all-time high levels, Berkshire Hathaway and 3G found an elephant-sized deal that they were able to acquire and scale up, without taking a lot of real risk relative to the size of the opportunity. I would not be surprised to see divestitures of non-core assets, aggressive cost-cutting and future acquisitions to leverage the distribution channel. As Berkshire shareholders we are immensely happy with this deal and I believe it works for everybody's long-term interests. The cost-cutting component could be controversial, but I would use the 3G inspired acquisition of Anheuser-Busch (BUD) as the template for this deal, minus some of the fat that was associated with that company. Once the acquisition closes, Heinz shareholders' will have been fully compensated, 3G will have a uniquely attractive leveraged buyout opportunity with scale financed at cheap interest rates, and Berkshire Hathaway will have secured $720MM in annual pretax income along with the ability to deploy large amount of capital to a management team that Buffett trusts to run the business. It will be interesting to see how things turn out.