How does a leveraged buyout work
Do Foolish investors put ketchup on their mac & cheese? Tune in to find out!
Apr 1, 2015 at 2:06PM
H.J. Heinz Co. acquired by Berkshire Hathaway (NYSE:BRK-A ) (NYSE:BRK-B ) and 3G Capital in a leveraged buyout in 2013, has announced a multi-billion dollar merger with Kraft Foods Group (NASDAQ:KRFT ). Industry Focus brings you the full scoop on the announcement, what to expect from the new entity, and where it might fit in a Foolish portfolio.
There have been a number of buyouts in the consumer goods sector in recent years, in part because of the stability of major consumer brands. Sean O'Reilly and Vinent Shen share the details of the merger and how 3G can be expected to handle the new entity's 13 brands worth over $500 million each.
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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 (NYSE:RAI ) talking about joining up with Lorillard (NYSE:LO.DL ) right now, 3G of course bought Heinz a few years ago, PetSmart (NASDAQ:PETM ) 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 OK. 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.
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.
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.
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.
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.
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?
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.
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.
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!
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!
Sean O'Reilly has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway and Chipotle Mexican Grill. The Motley Fool owns shares of Berkshire Hathaway and Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .Source: www.fool.com