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How To Value The Kraft-Heinz Merger As A Dividend Growth Investor

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  • I analyze herein if the $16.50 special dividend makes sense in a "Dividend Capture" strategy.
  • The current price shows that buying for a quick gain is not a prudent move.
  • I explain why the longer-term value of this company is worth holding for, and safer than most realize.

When selling might seem like the right thing to do.

It has been said that there are many roads to Babylon. Many ways to participate in the stock market, in other words. So let's say you are an income, or dividend growth investor. Before now, I'm certain that you already knew that owning Kraft Foods (KRFT) was an intelligent use of your capital, and it must have pleased you greatly when you heard about the merger with Heinz.

KRFT data by YCharts

After hitting a year high of $91.32, we've come down just a bit to a somewhat more affordable $85.75 per share. If you sold after the run up, I don't see any reason to feel bad about that. Congratulations on your significant gain.

Let's talk about the folks who are still here.

What I've encountered with a few long-term holders of this company is some confusion over what the new company will be worth, and whether it makes sense to continue holding in the face of what has been an enormous capital gain on the shares.

So let's take a look at this upcoming deal between Kraft Foods and Heinz, currently a part of Berkshire Hathaway (NYSE:BRK.A ), (NYSE:BRK.B ). What I hope to do here is give you something of an idea of what you might have after the dust settles. And if you are not an owner currently, I'd like to help you get a picture of what you might be getting for yourself if you were to buy in today.

The terms of the deal are that if you own a share of Kraft, you will get two things, actually: You get a share that is worth approximately 49% of the new company's value, and a $16.50 dividend payment. So, let's say you were a buyer today. If you own a share at the May 21 close of $85.75, does that mean you're getting a dividend yield of at least 19.24%? Yes, but you are sacrificing 51% of your equity in the new business to get it.

Price is what you pay. Value is what you get. - Warren Buffett

There is no doubt in my mind that Berkshire Hathaway will gain the most out of this offer, but they are being very generous to their long-term holders here as well, in my opinion. For the rest of you, try to hang in there, this math is on the challenging side to grasp, because it takes into consideration some things that haven't actually happened yet.

Welcome to the art of the arbitrage.

The largest risk to pricing a proposed merger is that the merger could somehow not happen. I'm going to go ahead and say that as confidence goes, I could never be more confident than I am in anything that Warren Buffett is involved with. So I'm going to go ahead and proceed here with that confidence, and assume that this merger is going to happen. The unknowns are the precise closing date and the approximate price of the new, combined company.

Most of the articles I've looked into, such as this piece from the New York Times. give an estimated market cap of about $80 billion of the combined business. So let's go with that. And they seem to be leaning towards closing the deal some time during the second half of the year. That seems pretty safe to go with, and the second half could be essentially any point after June.

So here's how we work this out. The value of all of the Kraft shares today is equal to 100% of the market cap, which is about $50.76 billion today. $80 billion is 1.576 times greater than that.

1.576 x $85.75 (May 21st market close of Kraft) = $135.15.

"Dividend Capture" investors should probably pass on this deal.

Kraft shareholders will own 49% of the new company, so multiply that figure by .49 = $66.22. This is the future estimated value of your 1 new share of Heinz/Kraft after the deal closes.

Your $66.22 share value plus $16.50 dividend = $82.72. So in other words, if you buy today, you are paying a premium of about 3.6% for that total value. I would say if you are here for the dividend, there are probably better offers out there to look into. May I suggest Mattel (NASDAQ:MAT ) in that case?

And this advice is once again based

on two factors: The taxation of the special dividend, and what you are receiving being less than the difference in today's price. If you were buying strictly to capture the dividend, maybe for your IRA for example, even with no tax consequences you're going to end up slightly behind after everything is taken into account. Consider this purchase to be already tapped into.

Longer term, how buy and hold investors will do.

If you continue to hold, due to various synergies that will be created, it is estimated that the combined market cap will be pushed upwards of $100 billion by 2017. This part is very speculative, and there are so many moving parts here that I couldn't say that with certainty. Right now only the people inside the deal could tell you what Heinz is worth, so that's a pretty big unknown. If I were to try to pin down an approximate margin of safety here, this is how I would do it:

$100 billion is a 25% rise in price over $80 billion. Multiply that $66.22 share price we came up with earlier by 1.25, and that gives a share price of about $82.78. Assuming dividend growth rates stay consistent, we add another year and a half worth of regular dividends earned during that time, Something like $3.23 per share for a 2.6% yield on that future price, spread over a year and a half. We're just sort of eyeballing it now, we can't make this estimate very precisely. It's sort of like Indiana Jones trying to guess the approximate amount of sand to replace that gold bust with. It's not perfect.

Dr. Jones ended up being nearly squashed by a huge boulder. We are in somewhat safer territory. Here is what you have in the future now: $82.78 + $3.23 + $16.50 = $102.51, basically a total gain here of about 19.5%.

That's. interesting.

Warren is trying to buy you out of the deal, before he buys you out of the real deal.

Now, if you were to stick with this holding, I'm sure good things will come of it. What Buffett is offering you today with this monster dividend is a chance to avoid waiting two years to see your total return materialize. That is very fair, generous by many measures. Just a few closing thoughts here about why.

Up to this point, I have not talked about the current price/earnings ratio of the stock. The stuff I already covered is frankly more than confusing enough for most of the home gamers. But it is necessary to think about this for the long term. In order to figure this, go ahead and subtract your $16.50 dividend from today's price. That will be $69.25, or about 43 times the trailing year's earnings of $1.61/share.

43 times earnings is on the high side, even for a quality company like Kraft. Price is what you pay, value is what you get. The higher the price, the less value. Berkshire Hathaway has the ability to wait indefinitely. You might be able to get a better deal in the meantime by taking your winnings today, but.

This is what you will really give up by selling here:

Real long-term value investing is about understanding the business, and the real business that needs to be understood here is Berkshire Hathaway. Buffett doesn't trade stocks, he acquires quality businesses. He is interested in owning Kraft, and he or his successor if it takes long enough, is going to make that happen for Berkshire Hathaway. That is your real margin of safety. If Heinz/Kraft shares hit a stumbling block and drop sharply, Berkshire will move in.

Keep in mind here, he has every incentive to do that, as his associates will already be holding 51% of the new company and would love to take it off your hands cheaply. It's entirely up to you if you're going to let him do that.

My recommendation for long-term investors is to buy Kraft Foods, up to a 10% allocation size in your portfolio. If you already own it, continue to hold. For dividend growth investors, I recommend the same. Kraft has been achieving 9.5% per year growth with its current dividend. There is little reason to doubt that the new company will grow it as fast or faster.

And if you are looking for other ideas for companies that Warren might be interested in, have a look here .

Disclosure: The author is long KRFT, BRK.B, MAT. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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