The recent $23 billion buyout of Heinz (HNZ) by legendary value investor Warren Buffett and 3G Capital has turned the market's attention towards consumer goods. What is it about this sector that so attracts "buy-and-hold" funds? And is it positioned for strong returns in the years ahead? In this article, I provide my thoughts on takeover activity in the consumer goods market.
Berkshire Hathaway's (BRK.B) offer wasn't just at around a 20% premium to the recent closing value -- it was at a 20% premium to the all-time high. Thus, the Heinz takeover goes against one of the central tenets that Buffett has long preached, namely, to "think like a contrarian". Contrarian investing essentially means to "buy when there's blood on the streets", or, less graphically, to "buy low and sell high". By buying at a high, Buffett is starting to look more towards growth than value.
Heinz Takeover: An Easy Growth Story
The ketchup, frozen food, and condiments marketer now trades at a respective 22.3x and 19.1x past and forward earnings. By contrast, the industry average PE multiple is 20.5x and, worse yet, Heinz's average 5-year average PE multiple is 16.7x. Essentially, Buffett is paying $1.34 for earnings power that investors previously only paid $1 for. The deal thus leaves much to be questioned on the value side, especially since the return on invested capital is around 70 bps below the industry average. Furthermore, free cash flow has barely budged from $900 million in October 2008 to $1 billion today. It should have been a sharp recovery following a macro trough.
However, on a growth standpoint, Heinz makes sense. Ultimately, Heinz delivers consistent returns with minimal downside risk. Growth is forecasted for 6.6% annually over the next 5 years, and this comes on top of a 2.8% dividend yield. The beta is only 0.5, which indicates that the stock has around half the volatility of the broader market. At the same time, Heinz provides strong upside by being leveraged directly towards positive consumer trends. McKinsey & Co. has estimated that world consumption will grow from $38 trillion in 2010 to $64 trillion by 2025 -- nearly 70% of which will come emerging markets. Buy-and-hold funds thus essentially look towards markets, like food and beverages, for consistent and sustainable streams of free cash flow.
Based on the positive secular tailwinds in consumer goods, it also should not be surprising then that Berkshire Hathaway has had Coca-Cola (KO) essentially as its top holding at a $15.6 billion stake. Moreover, Berkshire Hathaway has had a strong history of being involved in the food & beverage industry. Its $585 million takeover of Dairy Queen, a chain of frozen yogurt and ice cream restaurants, has benefited Berkshire shareholders handsomely over the years.
Why Nestlé's (NSRGY.PK) Stock Has Taken Off
Food & beverage investors, in general, have been handsomely rewarded. But this is particularly true for Nestlé investors. Over the past 5 years, the stock has returned 45.4% to shareholder, which is more than 2,400 bps greater than the return on the S&P 500 over the same time. Moreover, the capital gain came on top of a 2.5% dividend yield.
Nestlé has been able to create tremendous value for shareholders ultimately through adding scale via takeovers. One Seeking Alpha contributor recently argued that "The Future Is In Brands", and I couldn't agree any more. Fortunately, Nestlé's strategy has been to gain exposure to key niche markets.
Just at the end of last year, it closed its acquisition of Pfizer Nutrition for around $11.9 billion. This deal was particularly aimed at gaining exposure to emerging markets, which represent around 85% of the company's expected sales. To get the infant food company, Nestlé had to aggressively edge out Danone in negations. Danone was similarly interested in "enter[ing] new countries" and saw Pfizer Nutrition as an ideal candidate for achieving that goal.
Earlier, Nestlé had acquired Skinny Cow, a brand of low-fat frozen snacks. This helped the company gain exposure to the health conscious female market. Interestingly, the creators of Skinny Cow ice cream bards, Marc Wexler and Sam Pugliese, have now recently launched a new company, Be Active Holdings (JALA.OB), which is marketing a low calorie yogurt bar, called "Jala Bars". The product has already been rolled out to retail stores across New York, Connecticut, New Jersey, Rhode Island, and several other areas. If it picks up momentum, it could end up becoming "Skinny Cow 2.0" and gain increased takeover speculation.
Nestlé certainly has plenty of opportunities after its strong annual report came out two days ago. In 2012, the company grew sales by 10.2% and more than doubled free cash flow to ~9.9 million CHF. Operating profit margins also increased by 20 bps. By the numbers, the results were impressive. However, what got me even more excited, was the company's focus on brand strategy.
In the report, Nestlé stresses how, "[a]ll of" the company's "food and beverage brands, regardless of category or eating occasion, should offer consumers not just the best taste and pleasure but also the best nutritional profile". This kind of focus on (1) emerging markets and (2) health products hedges against increased political scrutiny on energy drinks and soda.
Buying shares of companies similar to Nestlé and Heinz makes sense from a growth standpoint. This includes everything from emerging companies like Be Active Holdings to large companies like Unilever (UL), which owns Ben & Jerry's. General Mills is (GIS), of course, also active in dairy products, and it contains a tremendous catalyst in Greek yogurt. Small-cap stocks can provide greater growth, whereas established producers can provide some consistency for a nice mix of reward and hedging. With the macroeconomy recovering, consumer good producers will have a major opportunity to identify and target key demographics that provide even higher upside. While the only attractive way to gain exposure to Heinz will soon be through buying shares of Berkshire (which I have done), Nestlé is a strong alternative. Its interest in health and emerging market categories should carry momentum going forward.
Disclosure: I am long BRK.B. We seek business from all of the firms in our coverage, but research covered in this note is for subscribers and prospective clients, repeat or new, who may now or in the future have a position in any company mentioned herein that may be sold or increased. The distributor of this research report, Gould Partners, manages TakeoverAnalyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.