The Heinz (HNZ) deal, much like the Burlington Northern Santa Fe one, has been somewhat of a head-scratcher. At the time Buffett pulled the trigger on Burlington Northern, it looked like he was paying full price. The purchase price was $34 billion for a company that recently earned $1.7 billion the year before (2009), or a whole 20x earnings. The railroad would go on to earn $2.9 billion in 2011 and will likely show a much higher figure for 2012, validating the $34 billion price as a good deal.
Heinz is little different in terms of the valuation. The offer price values the company at over 20x earnings, but it comes with a little more financial creativity. Buffett will be putting up some $12.12 billion in equity, $8 billion of which is preferred that will pay a 9% dividend. The private equity company 3G will bring in another $4.12 billion and debt will double to $12 billion to complete the financing of the deal.
The fact that Buffett is sharing on the acquisition is unusual. Even more uncharacteristic is the loading of debt onto the company. When Buffett acquired Burlington Northern the railroad did see debt increase 16% to $11.2 billion. In the case here it’s a full 100%, but Buffett gets a 9% dividend and that somewhat balances the risk-return tradeoff.
Profit margins at Heinz have been in the high single digits over the past 10 years. Just over 2.25% of sales have gone to interest payments. Even though interest rates are low at the moment, Heinz is likely to see its investment grade rating cut and overall interest expense higher. But just as these expenses may increase, others may come down. 3G will be actively managing Heinz and will be using its own special sauce in driving profits – cost cutting.
Burger King, which is principally owned by 3G, recently saw its 2012 operating expenses drop 21% from the year before. Sales did fall some 15%, but profits were up 33% for the year. Heinz isn’t in as difficult a situation as Burger King. Revenues and profits have moved upwards through the recession. If such cost-cutting opportunities are present in Heinz, the 20x price to earnings Buffett is paying could look like a steal in a couple years’ time.
One of the most appealing features of Heinz like in many of the gems in Berkshire’s portfolio is its return to equity. Heinz has consistently hit a return on equity above 30% over the last seven years. Those are the kind of streaks only companies like Coca-Cola can match. As I mentioned earlier, Heinz has a profit margin in the high single digits, which is much lower than what Coca-Cola puts up, but asset turnover is much higher with Heinz bringing up its overall return on equity. Like Coca-Cola, Heinz is a strong brand in a consolidated industry. For these reasons it should come as little surprise what Buffett likes about the business. Only time will tell if the price he paid was too high or too good.