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Sean O'Reilly: Ketchup and mac & cheese, on this consumer goods edition of Industry Focus.
Greetings Fools, I am Sean O’Reilly, joining you from Fool Headquarters in beautiful Alexandria,
Virginia, outside the nation’s capital. I am here with the awesome Vincent Shen. How
are you today, sir?
Vincent Shen: I’m doing well, Sean. How are you?
O'Reilly: Not too bad. We got a bit of news this past week; Warren Buffett and 3G Capital
are at it again.
Shen: Yes, they are. This time they are going after one of our, probably, most beloved names
in the food industry.
O'Reilly: I grew up on Spiderman Mac & Cheese!
Shen: Spiderman Mac & Cheese, exactly! Recently, Heinz, which is owned by 3G and Berkshire
Hathaway, has announced that it will be joining with Kraft Foods in a multi-billion dollar
deal, one of the biggest of the year.
O'Reilly: The Heinz one was the legit leveraged buyout. There’s a bunch of debt, private
thing, it’s not public anymore.
Shen: Exactly. Heinz was taken private. That deal, which happened in 2013, saw 3G and Berkshire
contribute about $8.5 billion in equity, equally. Also, Berkshire took on special ...
O'Reilly: Preferred stock.
Shen: Preferred shares yes, that paid a very nice, hefty 9% yield.
O'Reilly: Warren Buffet’s always liked those preferred shares. This has been a theme over
the last 30-40 years.
Now, if we want to invest in Heinz with the combined Kraft, we can actually do that now.
3G and Berkshire are going to own 51%. Public shareholders will own 48%, and then there’s
also some special dividend in here, of some kind?
Shen: Yes, exactly. The combined company is going to have about $28 billion in sales;
absolutely massive.
O'Reilly: This company is going to take up half of every grocery store!
Shen: Exactly. Third largest in the U.S., fifth largest worldwide. They’re going to
have eight $1 billion brands and five $500 million to $1 billion brands.
As for the deal itself, Heinz shareholders -- including obviously, like we’ve discussed,
3G and Buffett -- will hold about 51% of the combined entity, and Kraft shareholders will
have 49% of the new company.
O'Reilly: Very good. Now, this is not the first consumer goods-y buyout. We’ve had
a slew of them the last few years.
You’ve got Reynolds American talking about joining up with Lorillard right now, 3G of
course bought Heinz a few years ago, PetSmart which is being bought by London-based BC Partners.
They actually just closed on March 11. I didn’t know that until recently, but that just closed,
$8.3 billion.
Whenever I see something like this I think of -- in college when we all read Barbarians
at the Gate -- about the buyout of RJR Nabisco and the sky-high valuation that thing got,
and of course they had to refinance all that debt in the early ‘90s, so it didn’t quite
work.
What do the numbers on this deal look like? Are they going to be able to pull this off
and pay down the debt and make this work?
Shen: Before the deal was announced, Kraft shares were trading at about $61 and the day
after the announcement of the deal, they were immediately up about 36%. A big part of that
is going to be the special dividend that Buffett and 3G Capital are funding for Kraft shareholders,
which amounts to about $16.50 per share.
The previous year, Kraft performance was okay. They’re trading at about 20 times pre-announcement,
but there was a big dip in their earnings for 2014.
O'Reilly: At least their EBITDA.
Shen: The special dividend payout comes out to $10 billion. Ultimately for the total deal
value, which is about $55 billion, it comes to an EBITDA of about 24 times, which is pretty
high.
O'Reilly: That’s pretty hefty, yes.
Shen: It’s generally higher for Buffett deals, which people consider ... he’s a
bargain hunter.
O'Reilly: Right.
Shen: But overall, considering his original investment in Heinz with 3G Capital, it works
out pretty well in his favor. Based on an implied Heinz/Kraft equity value of about
$90 billion ...
O'Reilly: This is getting up there, for sure.
Shen: Exactly. Then the fact that Heinz had -- currently private -- implied value of about
$45 billion based on the numbers in this deal; the fact that Berkshire and 3G only contributed
about $8.5 billion, plus the $8 billion for the preferred shares. Now they’re looking
at their value in Heinz being over $30 billion.
O'Reilly: That’s a win.
Shen: That’s a pretty solid return in just two years’ time.
O'Reilly: Yes, that’s definitely a win. Part of this big component, and what I wanted
to make our listeners aware of, is the game plan once they get in there. 3G Capital is
extremely well known for using what’s called zero-based budgeting. I’m not sure I’d
want to work at Kraft right now!
Basically, you slash costs that are so minute, like no more free coffee, cheaper printer
toner, everything. If you’re a manager you have to justify spending plans, from scratch,
every single year.
Shen: Yes, exactly. The budgeting that they do with these cost-cutting measures, it doesn’t
revolve on numbers relative to your previous year’s budget. Everything is done from scratch.
In some instances, companies that have used zero-based budgeting have gone down to the
level of how much soap their employees use in the restrooms, to special permission to
print color copies.
It handles low-level stuff like that, and it handles stuff that affects the management
teams, like their use for example of corporate jets, how the fly -- first class, economy
O'Reilly: Everybody’s flying Southwest at Heinz now!
Shen: Exactly! They’re expecting about $1.5 billion in cost savings at the combined entity
by 2017, or 2016.
O'Reilly: That’s so much! But that’s partially how they’re paying for this. That’s the
game plan. You do an LBO, you go in there, and you cut costs.
Shen: That’s definitely one of their views, I think, also on why it might be worth the
added valuation that they had to pay for the company, because they think that this is possible,
that it’ll be a good return. These companies have some of the most well-known, loved brands.
O'Reilly: 3G, if you had to pick a horse that could pull this off, they would be the guys.
There’s a reason Buffett teamed up with them, because their record with Burger King
was awesome. They bought that company out for, what $4 billion? Only $4 billion, folks,
not a big deal!
But they put a 33-year-old young CEO in. Before he actually made any decisions, he worked
at a Burger King for a couple months. He cleaned the bathrooms. He concluded that they should
simplify the menu; people were getting confused.
They’re not afraid to get their hands dirty and actually get into the operations, the
nitty-gritty, and they’re able to execute.
Shen: Yes, they’ve shown that they definitely have very good strategic acumen. It’s really
interesting, what you mentioned with the new CEO that they installed for Burger King.
Berkshire and Warren Buffet’s enjoyed some very solid returns working with 3G Capital.
He also put some money into the Hortons merger with Burger King, too.
O'Reilly: Oh, he did? This is Daniel Schwartz we’re talking about, folks. Very sharp.
Shen: They have a history of working together. There have been quotes from Buffett indicating
that he was interested in doing a friendly takeover, and here it is. Now it’s Heinz
Kraft.
O'Reilly: Boom.
Yes, Buffett seems to have always been a fan of managers that can go in there and do the
dirty work that he’s not so great at. He did that with ... his first buyout was this
company called Dempster Mill Manufacturing. He’s, I don’t know, 30 at the time, 35?
He had his little Buffett Partnership, and this is a little windmill maker in Western
Nebraska. He’s not good at firing people and cutting costs and everything, and he found
a guy that could do it and, boom, it worked.
Shen: Yes.
O'Reilly: He’s been pulling this trick for 50 years, is what I wanted to point out!
Shen: He’s go the over-arching vision, and the guy’s amazing; obviously he can run
all the numbers and he needs somebody to execute and handle the operations. That works for
him.
For these two companies, they have a lot of synergies obviously. They can do a lot of
O'Reilly: Put the ketchup and the cheese on the same delivery truck. You’re good to
go!
Shen: Yes, you could put the Heinz ketchup on the Oscar Meyer hot dog.
O'Reilly: Awesome.
Shen: The fact is, Heinz also has a bigger global footprint. I think they do about 60%
of their sales outside North America, whereas Kraft is much more domestically focused.
O'Reilly: That’s an interesting global play.
Shen: Exactly. Hopefully that allows the combined entity to sell Kraft goods in the international
markets. They’ll have plenty of opportunities to reduce redundant facilities and also cut
some of the workforce as well, most likely, to streamline things.
O'Reilly: Before we move on, I just wanted our listeners to know about this. What were
you telling me about 3G’s connections to the world’s richest people, and how they
raise their money?
Shen: Sure. That was something that I saw that was particularly interesting. Private
equity companies, when they raise their funds for some of these buyouts, they go to a large
number of wealthy investors.
Whereas, 3G Capital has the connections to basically the ultra-wealthy families and individuals
in the world, so they go to a base of maybe three dozen of these ultra-wealthy families
and individuals; people like William Ackman, even tennis star Roger Federer.
They get big investments from a smaller number of these ultra-wealthy investors who work
on these deals. Things are working pretty well for them, and the people who are investing
with them, of course.
O'Reilly: Arguably very well. Let’s bring it back around to investing. Are you going
to buy into this thing, once all is said and done?
Shen: For the new entity?
O'Reilly: Yes.
Shen: The thing is, they do have some headwinds. Consumer tastes in this country, and I also
think abroad in some areas, are changing. People don’t want processed foods. They
don’t want to pay more for processed foods.
O'Reilly: They want Chipotle. Just say it!
Shen: Exactly. They want sustainably sourced, healthy ... that’s definitely not their
strong suit, but the fact is changes like that don’t happen overnight, and I do think
that the combined entity will have time.
Heinz Kraft will have time to make the adjustments, release new products. You don’t develop
the brand portfolios that these companies have and expect that they’re just going
to completely fall out of sight in a few years.
O'Reilly: Right, there’s no way.
Shen: They have plenty of time and plenty of consumer shopping awareness, essentially,
to right the ship.
O'Reilly: Yes.
Shen: Previously, especially for Kraft, it’s seen earnings growth maybe in the mid-single
digits; nothing that impressive.
O'Reilly: A good year is 4%!
Shen: Exactly. That’s another reason why people are questioning, “Was it really worth
paying the billions and billions for this deal? Maybe they overpaid.” But I think
that all in all they’ll be able to leverage their brands, their names, the more efficient
operations in order to make things work.
O'Reilly: Yes, I don’t think buying shares in this thing you’ll get rich overnight,
but the Foolish takeaway here for me is that there’s a reason consumer goods companies
have been the subject of so many leveraged buyouts, going back to the ‘80s with RJR
Nabisco paying billions upon billions of dollars for cigarettes and Oreo cookies.
The reason is their predictable cash flows with these brands. You cannot kill Oreo. There’s
just no way. There’s no way that Heinz ketchup is going anywhere.
That’s not to say we should all go out and try to do a leveraged buyout or anything,
but it just seems like CG companies with these timeless brands make for great cornerstones
of any kind of Foolish long-term portfolio.
Shen: Yes. There are people who have looked, historically, at M&A transactions and just
like you said, some of these consumer companies with really strong brands, they tend to do
well because they have that stickiness.
O'Reilly: It’s the one thing that can actually work with an LBO!
Shen: Yes.
O'Reilly: Very good.
Before we go, I have a couple of special announcements. For those of you that have questions and want
to write in to the Industry Focus team, in particular the consumer goods edition in our
case, you can now email us at IndustryFocus@Fool.com. We would love to answer your questions on
the air.
That is it for us, Fools. Before we go I wanted to make our listeners aware of a special offer
available to all Industry Focus listeners for a subscription to The Motley Fool’s
top performing Stock Advisor newsletter. Just head over to focus.fool.com to learn more
about this special offer.
As always, people on the program may have interests in the stocks they talk about, and
The Motley Fool may have formal recommendations for or against these stocks, so don’t buy
or sell anything based solely on what you hear on this program.
For Vincent Shen, I am Sean O’Reilly. Thanks for listening, and Fool on!