Hershey (NYSE:HSY) currently trades at approximately 25 times last years earnings and provides investors with an approximate 2% dividend yield. Hershey is an example of a wonderful business with an exceptional product.
Heinz (NYSE:HNZ) is also a wonderful business with an exceptional product, yet even after the Buffett offer announcement, the stock only trades at 19 times forward earnings and yields nearly 3%.
HNZ has a slightly higher debt load which explains some of the difference in valuation, however, we are talking about the price of HSY at market versus HNZ with a deal premium.
I do not understand why anyone who owns shares of HNZ would sell to Mr. Buffett at the current offer price. When you look around in an effort to find a place to reinvest the after tax proceeds, in an investment with a comparable risk versus return profile, you find HSY.
The two companies, HNZ and HSY, if they were kept public, would likely grow earnings at a similar clip over the next decade (post sale, HNZ will very likely grow cash flow faster than HSY due to cost savings initiated under private equity management), yet investors who trade into HSY will receive a full 100 basis points per year less than they would from HNZ, even if they purchased HNZ today, after the Buffett offer has been announced.
Selling HNZ to Mr. Buffett at the current price makes no sense to me. According to business week, HNZ CEO Johnson will net about $100 million from the sale. Maybe this is some sort of personal goal of the CEO, and it is a very fine business accomplishment, but I don't even understand why Mr. Johnson would want to sell 100% of his HNZ shares. And even more difficult to understand, why would he sell them at such a low comparable valuation?
Let's look at Mr. Johnson's HNZ position. Being objective, Mr. Johnson knows more about HNZ than I do and likely more about the business than Mr. Buffett, so I concede that there could be lurking challenges facing the business that Mr. Johnson understands better than the market. However, if we look at the history of the business and use history as our guide towards the future, I suggest that Mr. Johnson could potentially experience greater personal benefit through keeping his shares and hiring an excellent replacement CEO to continue carrying the torch at HNZ.
If Mr. Johnson sells his 1.38 million shares at $72.50, he walks away with a cool $100 million pre-tax, much less after Federal taxes and depending on where he lives, state and other taxes.
Since we don't know Mr. Johnson's tax basis or his tax rates, we will use a hypothetical example and figure Mr. Johnson ends up netting $70 million. After the sale, he can gain from being able to diversify his holdings, but he could meet the same objective by simply selling a portion of his stock to the market.
Mr. Johnson will lose after the sale, because he will no longer be able to invest in the one company that he knows the most about, HNZ. And if he refused to sell, he would very likely be able to retain influence over his investment with a post retirement board seat.
Mr. Johnson will probably hire excellent financial advisors who will diversify the proceeds from the sale of his HNZ stake into stocks, bonds, hedge funds, real-estate, private equity, etc. And he will probably hold on to a sizable amount of cash, which isn't paying very much at the moment. If his advisors do an excellent job and generate him a 7% annual total return, which becomes 6% when you strip out the cash, he makes $4.2 million annually on the new portfolio.
Heinz is currently paying him $2.06 in dividends, so if he kept the entire 1.38 million shares, he's getting around $2.84 million in current dividends, taxed at the rate on dividends. After accounting for just 3% appreciation in the value of his equity at the pre-deal price of $60 per HNZ share, his total wealth benefit from ther HNZ stake is $5.3 million per year.
If Mr. Johnson refuses to sell HNZ, he is potentially over $1 million per year better off, with no dividend increases and only 3% HNZ appreciation.
If HNZ appreciates 5% and raises the dividend 10%, $4.1 million in appreciation and $3.1 million in dividends, Mr. Johnson's total wealth benefit from the HNZ stake is $7.2 million which dwarfs the $4.2 million he could potentially make on his new portfolio.
Granted, since these are not actual figures, we are dealing in hypotheticals, but one thing is clear, the deal is not a great one for the sellers, not even for the CEO.