Berkshire acquires Heinz for 72.5 p/s

[Shane]

The market would assign the multiple it thinks is fair regardless of whether Heinz is public or not. 

 

I think what you're saying is that Heinz's current multiple would influence the multiple applied today by the market, yes?

 

This is a transformative acquisition.  I don't think that's the case!  Regardless, at $83 yesterday the market gave almost zero value to the announced cost savings!  That spelled opportunity.  $83-$16.5=$66.5.  KRFT had traded at that price earlier this year with no positive news.  Do you see my point?

 

Note: this deal should be Earnings power accretive to KRFT shareholders (by my calculations).  That's a factor in my comment above.

[KCLarkin]

This is a transformative acquisition.  I don't think that's the case!  Regardless, at $83 yesterday the market gave almost zero value to the announced cost savings!  That spelled opportunity.  $83-$16.5=$66.5.  KRFT had traded at that price earlier this year with no positive news.  Do you see my point?

 

I think your analysis is too simplistic. You are trading 1 share of Kraft for 0.49 shares of Kraft + 0.49 shares of Heinz + $16.50. Your analysis only works if 0.51 shares of Kraft = 0.49 shares of Heinz.

[Shane]

We know the combined company's earnings will be 49% owned by KRFT shareholders.  So they own that proportion of the combined earnings power + the special dividend.  I feel safe hanging my hat on that.  Terms of the deal are already out there.  What am I missing?

[KCLarkin]

We know the combined company's earnings will be 49% owned by KRFT shareholders.  So they own that proportion of the combined earnings power + the special dividend.  I feel safe hanging my hat on that.  Terms of the deal are already out there.  What am I missing?

 

If you believe Brooklyn Investor's analysis, the combined company will earn $3/share including synergies. That is a 24 P/E ex-dividend. Your estimate is 16x. You might not missing anything but your number just seems a bit low.

 

http://brooklyninvestor.blogspot.ca/2015/03/kraft-heinz.html

 

 

[Shane]

I like that blog a lot, but do disagree with some of his analysis.  He leaves out cash saved by some of the refinancing (admittedly to his credit).  Taking the EBITDA on down approach misses quite a bit if you ask me.  For instance, he uses 5% for refinancing (too high IMO) and uses D&A as a proxy for maintenance capex (overestimates IMO).  Also - yesterday's price was what I was referring to when discussing 16x.

 

Anyways - I feel like I am getting nit picky at this point.  I'm happy to have built a position at $83, time will tell if I'm correct!

[loganc]

I like that blog a lot, but do disagree with some of his analysis.  He leaves out cash saved by some of the refinancing (admittedly to his credit).  Taking the EBITDA on down approach misses quite a bit if you ask me.  For instance, he uses 5% for refinancing (too high IMO) and uses D&A as a proxy for maintenance capex (overestimates IMO).  Also - yesterday's price was what I was referring to when discussing 16x.

 

Anyways - I feel like I am getting nit picky at this point.  I'm happy to have built a position at $83, time will tell if I'm correct!

 

What do you see 2017 FCF being for the combined entity, assuming synergies and refinancing?  It appears that you have done enough to estimate this number and I am curious to compare with my rough estimate.  Thanks.

[ScottHall]

I bought a small position in this the day the deal was announced, up about 8% so far. My suspicion is that Buffett & 3G aren't near done, and this is a platform for them to do more deals in the future.

 

May be wrong, but I'll bet this beats the market quite handily over five years.

[original mungerville]

Of all the numbers, the following was the most straight-forward for me:

 

On the conference call, one of the 3G guys said by 2017 the merger would be earnings accretive relative to forecast Kraft earnings (I am assuming also for 2017) without the deal.

 

So if that is $3.70 a share (Yahoo analyst estimates for 2015 are 3.23 per share; for 2016 they have 3.46 so I just extrapolated a bit for 2017)

 

- using a 16x multiple I get $59 plus the $16.5 dividend = $85.5 

- using 20x, that is $74 plus 16.5 = $90.5

 

Now remember, these are forward multiples at 16x and 20x respectively. You've got to get to 1 Jan 2018 to have a backward looking multiple - that's 2.75 years away.

 

So I certainly would not use a 22-24x multiple now - 2.75 years ahead of time.

 

 

 

[original mungerville]

How much money is there to be made - doesn't look like much.

 

I bought at $81, with the stock at $89 already how much further does this have to go? 

[original mungerville]

Hell who knows, maybe the analysts are saying slap 24x on this thing now at $3.70 per share or $89 plus 16.5 for a value of 105.5.

 

In terms of a discount rate, we'll use 6% because this is in a stable sector. And at $89 per share ex the one time dividend, the dividend rate (ie $2.20 / $89 per share is just north of 2.4%) is 2.4%. So we need to discount by 3.6% (ie 6% minus 2.4%) per year for 2.75 years - or around 10% total.

 

So let's just say this thing is worth $89 X 0.90 = $81 plus the 16.5 dividend = $97.5 right now (that's using 24x!).

 

Now, that would be a very very full valuation in my book (I don't usually pay much over 10x, often 5x, once in a while 15x).

 

So, we are at $89 at close today. I bought at $81 in a non-taxable account, but does anybody really think I should hold on at $89 (which is about a 22x multiple 1 Jan 2018 discounted at 6%) to try to get to $97 (or a 24x multiple).

 

I think I sell Monday. I certainly wouldn't be jumping up and down excited at this valuation, right?

[ScottHall]

Hell who knows, maybe the analysts are saying slap 24x on this thing now at $3.70 per share or $89 plus 16.5 for a value of 105.5.

 

In terms of a discount rate, we'll use 6% because this is in a stable sector. And at $89 per share ex the one time dividend, the dividend rate (ie $2.20 / $89 per share is just north of 2.4%) is 2.4%. So we need to discount by 3.6% (ie 6% minus 2.4%) per year for 2.75 years - or around 10% total.

 

So let's just say this thing is worth $89 X 0.90 = $81 plus the 16.5 dividend = $97.5 right now (that's using 24x!).

 

Now, that would be a very very full valuation in my book (I don't usually pay much over 10x, often 5x, once in a while 15x).

 

So, we are at $89 at close today. I bought at $81 in a non-taxable account, but does anybody really think I should hold on at $89 (which is about a 22x multiple 1 Jan 2018 discounted at 6%) to try to get to $97 (or a 24x multiple).

 

I think I sell Monday. I certainly wouldn't be jumping up and down excited at this valuation, right?

 

Well, that's up to you. How much of a premium is management worth? Are they lowballing us? Will they continue to do more value-adding deals in the future? Some things aren't so easy to model. Your thoughts on these are pretty important to whether or not you should keep holding, or at least should be. IMO.

[original mungerville]

Sure management is worth a premium and over time they would likely do another combination - but this would not occur for a couple years, but a 22x-24x multiple should already include that.

 

In terms of low-balling. They are stating $1.5 billion in cost savings, plus I estimated 200-300 million interest savings on the refi of $9 debt to investment grade, plus redeeming the Berkshire preferred of $8 billion (about $500 million).

 

That's a total cash flow/EBITDA savings of $2.2 billion or roughly a quarter of the forecast $10 billion in EBITDA (although the preferred redemption doesn't fit nicely into EBITDA savings more EPS, but anyway). So even if 3G gets cost savings of $2.5 billion instead of $1.5 billion (which I think every analyst would agree would be very aggressive), that would only move the needle on the $10 billion by 10% which may translate into EPS of 15% more.

 

Its just really hard to move the needle unless they 1) do another merger, or 2) begin a very significant international expansion in relatively short order.

 

Having said all this, relative to the average stock in the S&P 500 which is at very elevated levels, I agree that the less cyclical nature of Kraft-Heinz earnings combined with the potential for future growth should lead to outperformance. But to be clear, that isn't saying that much because the S&P 500 probably will grow less than 5% annually over the next 10 years.

 

 

 

 

[Shane]

Sure management is worth a premium and over time they would likely do another combination - but this would not occur for a couple years, but a 22x-24x multiple should already include that.

 

In terms of low-balling. They are stating $1.5 billion in cost savings, plus I estimated 200-300 million interest savings on the refi of $9 debt to investment grade, plus redeeming the Berkshire preferred of $8 billion (about $500 million).

 

That's a total cash flow/EBITDA savings of $2.2 billion or roughly a quarter of the forecast $10 billion in EBITDA (although the preferred redemption doesn't fit nicely into EBITDA savings more EPS, but anyway). So even if 3G gets cost savings of $2.5 billion instead of $1.5 billion (which I think every analyst would agree would be very aggressive), that would only move the needle on the $10 billion by 10% which may translate into EPS of 15% more.

 

Its just really hard to move the needle unless they 1) do another merger, or 2) begin a very significant international expansion in relatively short order.

 

Having said all this, relative to the average stock in the S&P 500 which is at very elevated levels, I agree that the less cyclical nature of Kraft-Heinz earnings combined with the potential for future growth should lead to outperformance. But to be clear, that isn't saying that much because the S&P 500 probably will grow less than 5% annually over the next 10 years.

 

IMO this is a stock with a muted downside and potential for positive upside surprises.  Not in a hurry to sell, but would if a better idea came along.  Why go to cash when you could earn 7-10% a year in a stock that will likely be a buffer in a down market?

[original mungerville]

Sure management is worth a premium and over time they would likely do another combination - but this would not occur for a couple years, but a 22x-24x multiple should already include that.

 

In terms of low-balling. They are stating $1.5 billion in cost savings, plus I estimated 200-300 million interest savings on the refi of $9 debt to investment grade, plus redeeming the Berkshire preferred of $8 billion (about $500 million).

 

That's a total cash flow/EBITDA savings of $2.2 billion or roughly a quarter of the forecast $10 billion in EBITDA (although the preferred redemption doesn't fit nicely into EBITDA savings more EPS, but anyway). So even if 3G gets cost savings of $2.5 billion instead of $1.5 billion (which I think every analyst would agree would be very aggressive), that would only move the needle on the $10 billion by 10% which may translate into EPS of 15% more.

 

Its just really hard to move the needle unless they 1) do another merger, or 2) begin a very significant international expansion in relatively short order.

 

Having said all this, relative to the average stock in the S&P 500 which is at very elevated levels, I agree that the less cyclical nature of Kraft-Heinz earnings combined with the potential for future growth should lead to outperformance. But to be clear, that isn't saying that much because the S&P 500 probably will grow less than 5% annually over the next 10 years.

 

IMO this is a stock with a muted downside and potential for positive upside surprises.  Not in a hurry to sell, but would if a better idea came along.  Why go to cash when you could earn 7-10% a year in a stock that will likely be a buffer in a down market?

 

I don't disagree - this is why I bought in the first place. However, you could buy Berkshire which has more diversification and do the same return. My main point is that I wouldn't get too excited about this thing at this valuation. 

[Zorrofan]

Sure management is worth a premium and over time they would likely do another combination - but this would not occur for a couple years, but a 22x-24x multiple should already include that.

 

In terms of low-balling. They are stating $1.5 billion in cost savings, plus I estimated 200-300 million interest savings on the refi of $9 debt to investment grade, plus redeeming the Berkshire preferred of $8 billion (about $500 million).

 

That's a total cash flow/EBITDA savings of $2.2 billion or roughly a quarter of the forecast $10 billion in EBITDA (although the preferred redemption doesn't fit nicely into EBITDA savings more EPS, but anyway). So even if 3G gets cost savings of $2.5 billion instead of $1.5 billion (which I think every analyst would agree would be very aggressive), that would only move the needle on the $10 billion by 10% which may translate into EPS of 15% more.

 

Its just really hard to move the needle unless they 1) do another merger, or 2) begin a very significant international expansion in relatively short order.

 

Having said all this, relative to the average stock in the S&P 500 which is at very elevated levels, I agree that the less cyclical nature of Kraft-Heinz earnings combined with the potential for future growth should lead to outperformance. But to be clear, that isn't saying that much because the S&P 500 probably will grow less than 5% annually over the next 10 years.

 

IMO this is a stock with a muted downside and potential for positive upside surprises.  Not in a hurry to sell, but would if a better idea came along.  Why go to cash when you could earn 7-10% a year in a stock that will likely be a buffer in a down market?

 

I don't disagree - this is why I bought in the first place. However, you could buy Berkshire which has more diversification and do the same return. My main point is that I wouldn't get too excited about this thing at this valuation.

 

You raise some very good points but at the same time I find it hard to believe that 3G and WEB are doing this to earn 5% to 7% over the next 5 years......

 

cheers

Zorro

 

[Shane]

Their cost basis is way below today's price.  They will earn higher returns than KRFT shareholders.

[Zorrofan]

Their cost basis is way below today's price.  They will earn higher returns than KRFT shareholders.

 

i realize that however there is the opportunity cost of not redeploying your capital, which is what original mungerville was referring to. WEB also added $5 billion for this deal. I am simply saying that I am fairly confident that this will grow more than many seem to be expecting.  I could be wrong but only time will tell...

 

cheers

Zorro

[Shane]

Hope your right!

[KCLarkin]

It's hard to look at the results they achieved with BUD and BKW and believe we will only get 6-8%, even given the elevated valuation.

[original mungerville]

Zorrofan,

 

I understand your point, looking at it from Buffett's perspective is a really good idea. And I thought of that as well - it didn't get me anywhere, not necessarily because there is nothing there but maybe because I can't think about it correctly.

 

Having said this, you have to be very careful with this "Buffett put in an extra $5 billion and he is looking for better returns" angle at this point.

 

At $89 per share - Kraft's market cap is $52 billion. After the one-time dividend of $10 billion, its at $42 billion. This is the value of current Kraft shares which right now represent half of newco. So the implication is that newco's market cap is $84 billion at present.

 

Now let's play with some numbers on Heinz. 3G and BRK put in $4.5 billion each in common a couple years ago for a total of $9 billion. Buffett has been giddy about the progress, so let us make an aggressive assumption (which for the sake of the point I am making is a very conservative assumption) that that doubled in value in the last two years to $18 billion in common equity value for Heinz stand-alone (this does not include the $8 billion preferred or the Heinz debt as this whole analysis is on common equity grounds). So we are assuming Buffy has already made a 100% return on his common.

 

Now, 3G comes up with this idea of a Kraft merger. They make the announcement, take the $18 billion Heinz common value, add $10 billion total for the one time dividend, and, in a matter of 3 days, this is now worth $42 billion of newco. $28 billion became $42 billion or a 50% increase just because of this deal. And remember, I was reasonably conservative with the 50% increase for the deal because I assumed the Heinz common Buffet bought had already increased 100% pre-deal.

 

So Buffett is, with this deal, starting at a +50% advantage to us (again that's after making the very conservative assumption - for the purposes of this argument - of a prior increase of 100% in the value of Heinz). So if you think you are going to get a 5-10% return annually from this price, multiply that by 1.5 for Buffett's return from this deal or 7.5 to 15% annually which meets his rate of return.

 

Maybe now you could say, hey he made his 50% he should sell. Well its not that simple because a) he publicly committed to the deal which is part of the rise in value of the stock of newco, and b) he would have huge capital gains now (ie he owns half of $42 billion or $21 billion on an investment of $4.5 originally for Heinz common plus his $5 billion contribution to the one time dividend; so his capital gain would be $21 billion - $9.5 billion or $11.5 billion; 20% tax on that would be 2.2 billion.

 

So, how far do you want to take the "Buffett is going to get a good return so I am" argument based on these numbers?

 

 

 

 

 

 

 

 

[original mungerville]

It's hard to look at the results they achieved with BUD and BKW and believe we will only get 6-8%, even given the elevated valuation.

 

Well, if you look at my math in the above post, at $89 per share right now, 3G and Buffett are currently up 150% on their initial investment in Heinz. Maybe deduct 150% returns from BUD and BKW, then see what the remaining annual return is - this could be our return I guess from here. Any idea what that number is?

[original mungerville]

Now, 3G comes up with this idea of a Kraft merger. They make the announcement, take the $18 billion Heinz common value, add $10 billion total for the one time dividend, and, in a matter of 3 days, this is now worth $42 billion of newco. $28 billion became $42 billion or a 50% increase just because of this deal. And remember, I was reasonably conservative with the 50% increase for the deal because I assumed the Heinz common Buffet bought had already increased 100% pre-deal.

 

Just thinking about this further, Buffett just had to add $5 billion in common equity to get this deal done and what he gets in return is his portion of the gain in market value from $28 billion to $42 billion - so that's 50% of $14 billion or $7 billion.

 

So Buffett's incremental return on that incremental $5 billion he just added for this deal is $7 billion or 140%. No wonder he is smiling (despite this deal meaning his lucrative $8 billion preferreds yielding 9% will now get called at the first call date). He is therefore starting with massive returns already relative to someone buying in at $89 per share.

 

[Shane]

Good points - I don't think it is safe to assume they have something extra up their sleeves.  They have already locked in extraordinary returns.

[james22]

Another take:

 

http://davidstockmanscontracorner.com/thank-you-fed-warren-and-jorge-are-thrilled-by-another-play-in-the-casino/

[KCLarkin]

Look at BUD after the merger. They created enormous shareholder value after the expected synergies were theoretically priced in. Past performance is no guarantee but I think a 3G premium is well deserved.