It appears to be just another case of Warren Buffett acting in character, but I believe there is more to the buyout of H. J. Heinz (NYSE: HNZ) than meets the eye.
First, let me confess that I've been a beneficiary of Berkshire Hathaway's (NYSE: BRK.A) buyout of the ketchup king. No, I don't own Heinz stock, but I believe Buffett's interest in Heinz has raised the profile of other food stocks, including High Yield Wealth recommendation McCormick & Co (NYSE: MKC). (For the record, I do own Berkshire Hathaway shares as well.)
Heinz is a dominant, well-branded food company. So is McCormick. Not long after the Heinz buyout was announced, McCormick shares began to climb, and they've been climbing ever since. In fact, they recently hit an all-time high, lifting their total return to the High Yield Wealth portfolio above 42%.
But McCormick might be rising on an atypical deal. Upon closer inspection, it appears the Heinz buyout is somewhat out of Mr. Buffett's character.
It's unusual in that Berkshire is splitting ownership of Heinz with 3G Capital, with each company putting in $4 billion in cash. Berkshire is contributing an additional $8 billion to receive preferred shares, which will pay 9%, or $720 million, to Berkshire annually.
The remainder of the buyout is financed with debt, which will double Heinz's debt load to more than $12 billion. It isn't surprising, then, that Fitch Ratings downgraded Heinz's debt to junk-bond territory, citing the heavier debt load.
In short, Mr. Buffett has just done a leveraged buyout, which he has a history of railing against.
The fact that an outside firm, 3G Capital, will run operations is also out of character. 3G has a reputation for cost-cutting and layoffs - the bailiwick of most leveraged buyout firms. 3G's most notable leverage buyout - that of Burger King - turned a tidy profit.
But 3G's success was mostly the result of financial engineering - going private, and then going public at an opportune time - and the aforementioned cost cutting. Burger King is worth no more today than it was a few years ago.
3G Capital took fees and dividends out of Burger King, and Berkshire will do the same with Heinz. This makes me wonder if we should expect to see Heinz re-emerge in the public markets a couple of years hence in an IPO, with Berkshire and 3G as the chief beneficiaries.
If an IPO is on the distant horizon, it would certainly be out of character for Mr. Buffett, who has always preached investing for the long term.
But Mr. Buffett is in a unique, if not enviable, quandary. Berkshire generates copious amounts of cash that continually swell its coffers, even when Mr. Buffett tries to empty the coffers with new investments. Berkshire's latest reported cash balance still topped $47 billion. The Heinz deal will put only a small dent in that balance.
Sitting on a huge pile of capital makes it difficult to generate high returns on capital. Berkshire reports 7.84% return on equity, which isn't particularly impressive. Then again, it is operating from a very large equity base.
As much as I respect Mr. Buffett's investing acumen, I think he's reached a point where he's making investments simply to soak up liquidity. There is nothing particularly inspiring or insightful in his most recent investments: Heinz, Archer Daniels Midland (NYSE: ADM), IBM (NYSE: IBM), or General Motors (NYSE: GM). Mr. Buffett might conjure a unique reason for making the investment, but there is nothing unique about the investment itself.
These investments simply add to the menagerie: Berkshire is already involved in insurance, banking, clothing, retailing, flight services, building products, utilities, railroads, utilities, and energy production. It's everywhere.
My suggestion, as immodest as it might be, is for Berkshire to start paying dividends. Dividends would remove excess cash, raise return on equity, and reduce reinvestment risk.
Dividends would also give Berkshire investors something tangible to spend or invest. After all, every investment is fundamentally valued on expected cash flow to investors. A company has to pay a dividend sometime.
A dividend would also mean Berkshire investors would be investing like Mr. Buffett and not with Mr. Buffett. There's a difference. You'll notice that Mr. Buffett always invests for cash flow (and I do the same). He gets direct use of the cash, not the investors.
Perhaps it's time Berkshire shareholders start investing for cash flow, too.