Thursday, February 21, 2013

Thoughts on 3G Capital's LBO of Heinz or "Warrant" Buffett Strikes Again

On Feb 14 (last Thursday), Berkshire and 3G Capital announced that they agreed to acquire food company H.J. Heinz Co. for $23 billion in cash ($72.50 per share, a 20% premium to where the stock closed the day before).

Well, that's what the headlines would have you believe anyway. However, that is not what is happening. My headline is a bit more accurate. I'll explain below.

Initial read

I was pretty busy last Thursday so I didn't pay a whole lot of attention to the acquisition, but as may you know I'm a big Buffett buff and I made a mental note to take a closer look at the numbers at some point in the future. I like to check in on what smart people are valuing businesses at every now and then so I have a good market reference point in my head.

My initial assumption based on the headlines alone was that the deal made sense- Buffett loves these big, high quality brand name companies and Heinz seems to make sense as a piece of the portfolio alongside Wrigley, Coke, and Gillette. I also know Buffett likes to pay a reasonable for a business (read basically any book about him and you'll see some reference to the "margin of safety" concept he learned from Ben Graham) so I assumed that he got a good deal. I haven't really followed Heinz, so I thought that maybe the stock had been neglected and possibly didn't take part in the recent market rally.

Today I revisited the story, pulled open Heinz's last 10-K and realized that I was completely wrong. This was not an old-style Warren Buffett margin of safety "be greedy when others are fearful" acquisition of a great business at a substantial discount to intrinsic value. This was much more what I've come to think of as a "new style" Warren Buffett where he gets to put capital to use at rates no mere mortal can obtain. The price paid for Heinz was not a bargain from what I can see.

The price tag was high - 25x earnings!

Looking at Heinz's 2012 10-K (see page 33 for the income statement), the company earned about $939 million of net income for the year ended April 2012. I opened another couple of 10-Ks to look at the five year history, and net income averaged a bit below $939 million for this period, so I figured it was a pretty good number. Divide the purchase price of $23 billion by $939 million and you'll see the Buffett/3G team paid about 25 times trailing earnings for the company, not a low multiple by any stretch of the imagination. For the sake of comparision, Google sells for a similar multiple, is trading at an all time high, and though I'm getting out of my league here, I think it is considered more of a growth stock. Heinz does not make technology, it makes food products.

Going a few pages further in the 10-K, I figured I'd get a rough sense of what the company's free cash flow is. Take net income of $939 million, add back $300 million of depreciation, $50 million of amortization, deduct CAPEX of $400 million and you're at roughly $900 million of free cash flow. If you pay $23 billion for the company, $900 million of free cash flow equates to roughly a 4% yield. The multiple is still about the same, roughly 25x FCF. I also checked how FCF looked over the past five or six years, and again the average was below the current $900 million number.

I didn't create a DCF model of the company because I'd seen enough at this point and I didn't have the time to put into it, but I think if you do a DCF with some reasonable assumptions, you're not going to get to a $23 billion valuation for the company assuming things continue along as they have in the past.

I believe I read in the press that the price was something along the lines of 8x book value and 14x EBITDA, again generally high multiples (though book value isn't the greatest metric for a company like this).

Berkshire didn't buy the company, it bought half of the equity in the deal, plus high-yielding preferred and warrants as a kicker

Reading past the headlines of the articles, I realized that Berkshire's investment in the company wasn't purely an equity stake (like Buffett's investments in Coke, Gilette, Washington Post etc. that he became famous for). Instead, Berkshire is going to pay $8 billion for preferred stock in Heinz yielding 9%, and invest $4 billion of equity.

In addition, 3G is only investing $4 billion of equity and financing the rest. The company is also going to roll its current $5 billion of debt.

So doing some rough math, when the deal is complete, the capital structure will be something like:

$8 billion of equity
$8 billion of preferred stock
$12 billion of debt ($5 billion existing plus ~7 billion of new debt hence the "LBO")

Oh, and if you dig around, Buffett is also getting warrants to buy shares of the company. ("Warrant" Buffett also has Bank of America warrants, had Goldman warrants, and GE warrants). Terms of these warrants weren't disclosed.

Anyway the upshot of all of this is that if the deal is approved, Heinz will become a private company 50% owned by a PE firm with a history of cost cutting. It will have twice the debt load it had previously and its debt will be downgraded by the rating agencies, but as the LBO story goes, should be able to service the debt over time with steady cash flows thrown off by the business. It will enjoy levered returns for a few years, and then 3G will likely look for an exit, possibly selling its 50% stake to Berkshire. The company may be more profitable at that time.

In the meantime, Berkshire rakes in the 9% dividends on the preferred stock. Don't forget that preferred stock dividends enjoy a very favorable tax deduction for corporate owners, so Berkshire also gets to avoid some taxes it would have been hit by had it acquired Heinz outright.

And those warrants. Berkshire can maybe exercise those warrants someday.

Berkshire's price tag - more like 18x earnings, with upside

My final thought- Berkshire's earnings stream from the company will be as follows:

-$8 billion of preferred stock at 9% yield for $720 million a year in pretax preferred dividends
-Since generally 70% of preferred stock dividends are deductible for corporations, the effective tax rate on these dividends will be approximately 10%, for after-tax preferred dividends of about $650 million.
-Plus, Berkshire's 50% share of the company's earnings. This is a harder number to take a guess at but I'll do some extremely rough late-night math. $939 million of earnings in 2012. Subtract preferred dividends of $720 million and this leaves you with about $220 million of earnings. 2012 earnings include about $300 million of pretax interest expense. Since the debt load of the company is going to roughly double, lets assume interest expense doubles, to $600 million (since the rating will fall to junk, the rate on new debt will likely be higher and the cost of rolling old debt will be higher but im not going to get too precise here). Tax effecting the additional $300 million of interest expense at 30%, you get about a $210 million hit to after tax earnings, reducing the $220 million to $10 million of after-tax earnings. Buffett gets the right to half of that, roughly $5 million
-$650+5 = $655 million of after tax earnings per year
-Buffett invested $12 billion of cash
-This results in a P/E multiple of more like 18x earnings. Better than 25, but still not cheap.

Let me know if I missed something. It's late.