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Archive for February 20th, 2013

Another Note on the Purchase of Heinz

Wednesday, February 20th, 2013

I need to correct one thing that I wrote yesterday: 3G and Berkshire Hathaway each own 50% of Heinz, once the transaction is done.  I mistakenly thought that both sides were putting up equal amounts of capital, when they are only putting up equal amounts of common equity.

So when you look at the financing of the $23 billion purchase price for Heinz it should look like this:

FinancingAmount
Common Equity 3G$4.0B
Common Equity BRK$4.0B
Warrants BRK$0.1B
Preferred Stock BRK$8.0B
New debt for HNZ (to be raised by JPM and WFC)$7.1B
Total Consideration$23.2B

The equity interest of BRK is equal to that of 3G, and if things go well with Heinz, whatever the form of the warrants are, Buffett can add to his equity interest by paying a fixed price.  We don’t know the terms of the warrants — how much stock it covers, what is the strike price, how long does it last, and any other provisions.  What we do know is that though Berkshire claims to be the passive investor here, it possesses the right to become the dominant investor economically, even if it does not take control as a result.  This is a major reason to reject the thesis that BRK is 3G’s banker.  Far better to say that 3G is Buffett’s highly paid servant.  They will do the dirty work, the grunt work, and Buffett will benefit more under most scenarios.

Also, Wells Fargo & JP Morgan will be raising the debt portion of this offering.  I see it looking something like this: an entity allied with Berkshire and 3G floats bonds and raises cash.  The cash goes to shareholders, along with the cash from BRK and 3G, paying off HNZ shareholders at $72.50/share.  The debt attaches to Heinz and not BRK or 3G.  Another way would be a bridge loan prior to the merger that gets paid off by a debt offering and special dividend after the merger.

This of course makes the bond market jumpy.  The long debt of Heinz has sold off, whereas the shorter debt has not.  Here is an example of one that is in-between.  The bond market fears a lot of long-dated issuance, and a possible downgrade to junk.  $7 Billion of new debt is a lot, when you only have $5 Billion of debt, and another $8 Billion of preferred stock coming.  That is a quadrupling of common stock leverage.

What we don’t know:

  • The exact mechanics of how the debt portion of the deal gets done.
  • The terms of the warrants.

Now think for a moment about this from the perspective of 3G: Heinz has $1B of net income.  Buffett gets $720 million of preferred stock dividends. New debt might absorb $200 million in interest after tax.  That leaves around $80 million of profits, half of which go to Berkshire, for your $4 billion outlay, a 1%/yr return.  But consider if active management raises income to $2B, profits become $1,080 million half of which go to Berkshire, and returns to you are 13.5%/yr, leaving aside dilution from BRK option exercise.

What I am trying to show is that the tables are skewed here in favor of Buffett, again.  He has set up a deal where his partner will be very motivated to cut costs, realize synergies, etc., because they don’t make much if they don’t, while he makes out fairly well under most scenarios:

  • Heinz does very well — BRK exercises warrants gets majority of economics and control
  • Heinz muddles — BRK receives preferred dividend, does well.
  • Heinz does badly — BRK receives preferred dividend, does well. Might have to write down equity stake.
  • Heinz does very badly — BRK preferred dividend halted, buys remainder of Heinz by converting his preferred stock to equity.  3G loses it all.  Buffett brings in competent management for his now wholly-owned subsidiary.

It’s a lot easier for Buffett to win relative to 3G.  3G needs strong demand to win.  Buffett doesn’t.

Final note: I am not that impressed with William Johnson, the present CEO — earning  a <4%/yr return on your stock over 15 years does not even double capital for those who were willing to hang on so long.

Yes, sales have grown, but what matters to corporations if profit, not volume.  On thing thing I learned in the insurance industry — it’s easy to get sales. What is hard is getting profitable sales.  Yet how many CEOs gain bonuses partially off of sales and other meaningless criteria — far better to use something like five-year increase in fully converted tangible book value per share.  It better measures how value has  grown for shareholders.

Other things to read:

Full disclosure: long BRK/B and WFC

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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