On February 14, 2013, H.J. Heinz Company (NYSE:HNZ) announced that it had entered into a buyout agreement with a consortium comprised of Berkshire Hathaway (BRK.A, BRK.B) and Brazil's 3G Capital. Under the terms of the transaction, Heinz shareholders will receive $72.50 in cash for each share of Heinz stock they own. Following the transaction, Heinz will remain headquartered in Pittsburgh as a private company. The question is, did the consortium that purchased Heinz pay too much, or not enough?
Briefly, H. J. Heinz Company, together with its subsidiaries, is engaged in manufacturing and marketing a range of food products throughout the world. The company's principal products include ketchup, condiments and sauces, frozen food, soups, pickles, beans and pasta meals, infant nutrition and other food products. The company's products are manufactured and packaged for consumers, as well as food service and institutional customers. The company operates in five segments: North American Consumer Products, Europe, Asia/Pacific, U.S. Foodservice and Rest of World. Brands include: Heinz ketchup, Classico pasta sauces, Ore-Ida frozen potatoes, Smart Ones meals, and Plasmon baby food.
Finding Superior Companies
One of the keys to finding superior long-term investments is to buy companies that will be able to stay one step ahead of their competitors. Companies that have generated returns on their capital higher than their cost of capital for many years of operation usually have a competitive advantage, especially if their returns on capital have also increased over time. This line of reasoning is fundamental. In other words, having an unexpected or a temporary competitive advantage is not enough for a business to be able to declare that it has a competitive moat. Many investors believe they follow Warren Buffett's philosophy because they have found a business with a competitive advantage. However, as he mentioned in a November 22, 1999 Fortune interview: "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
Simply put, you cannot expect to obtain abnormal return (alpha) as an investor if the business you invest in does not have a sustainable competitive advantage. We define moat or sustainable competitive advantage as the difference (the performance spread) between the return on capital and the cost of capital (correctly measured, that is after transforming GAAP numbers into a rigorous computation of economic profit, after deducting the full cost of capital, and eliminating the accounting distortions). The higher the performance spread, the bigger the competitive advantage. However, the work does not stop here. You also need to practice a little bit of Competitive Intelligence in comparing the business you are interested in and its direct competitors.
Performance Spreads Of Heinz And Its Competitors
So what are the performance spreads of Heinz and its immediate American competitors: General Mills, Inc. (NYSE:GIS), ConAgra Foods, Inc. (NYSE:CAG), and Campbell Soup Co. (NYSE:CPB)? The following table shows the performance spreads of these four firms for the last five years. As shown by the size of the positive spreads, we are in the presence of four value generators, with Campbell Soup having the highest spreads, followed by Heinz.
Performance Spread (Trailing 12 months)
Value Creation Potential
Companies that are leaders in value creation, like the four fierce competitors above, bring a different mindset and take a different approach to strategy development. They strive not just to be different from their competitors (which is necessary yet insufficient), but also to be both different from and more profitable than their competitors, like Campbell Soup does. They realize that others will seek to copy their success; therefore, they strive to develop capabilities and strategic assets that are hard to match. Creating such distinctive strategies is a difficult challenge, and only a few companies in any given industry, like the ones above, are likely to be successful at implementing and sustaining them.
Equipped with the above information on performance spreads and the fact that we are in the presence of competitors that are also value creators, it follows that a breakthrough in value creation by Heinz is lean. In this competitive landscape, we have simulated the intrinsic value of a Heinz share under three credible scenarios, which we present in the following table.
On February 13, 2013, the day before the buyout announcement, the market share price of a Heinz share was $60.48 -- a premium of 19.9%. We estimate the intrinsic value of a share at $68. If we compare the cash offer to our intrinsic value estimate of $68, the premium is 7%. It seems obvious that the consortium knows how to count, and that the buyout is not guided by the hubris hypothesis of corporate takeovers. Conclusion: the offering price is adequate.
Intrinsic Value (IV) of Heinz Share based on 3 scenarios:
|Before the consortium offer||$68||$72.50||$4.50||7%|
|After the consortium offer|
|1. If Heinz maintain its actual return on capital||$68||$72.50||$4.50||7%|
|2. If Heinz increases its return on capital to the level of Campbell||$100||$72.50||$27.50||38%|
|3. If Heinz return on capital decreases to its own lowest level in the last 5 years||$62||$72.50||($10.50)||(14%)|
However, if the consortium's input on the strategic path of Heinz can increase the return on capital of the company to the level of the highest performer in the industry, i.e., Campbell, our intrinsic estimate goes up to $100. In such a case, the consortium's decision to buy out Heinz has been brilliant (an increase of 38% over the price paid). However, if the consortium's decisions derail Heinz from its strategic path and its return on capital decreases to its lowest level in the past five years, the consortium should have done something else with its money.
Based on our analysis, we believe the price of $72.50 is fair. Additionally, we see another opportunity here. Of course, after the buyout transaction, Heinz will become a private company, eliminating any future investment opportunity. So why not use this change in the industry to build a value weighted portfolio of the three remaining value creators above, to which you could add Nestle SA (OTCPK:NSRGY), an ADR (American Depositary Receipt) stock? Given the inherent value of these stocks, their track record of outstanding performance and their competitive moat, as discussed above, we believe including these stocks in the consumer staples part of your global portfolio will let you sleep at night.