Warren Buffett (Trades, Portfolio)'s Kraft Heinz Co. (KHC, Financial) mistake has attracted a lot of negative attention over the past couple of weeks.
Just to recap: At the end of February, Kraft Heinz announced it was taking a $15.4 billion writedown of its acquisitions of Kraft and Oscar Mayer. In turn, that caused Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) to write down $3 billion. Kraft's stock slumped after the announcement, costing Buffett several billion dollars in lost equity value as well as the billions he will now lose from the company's dividend reduction.
Kraft plans to slash its dividend 36% to 40 cents per share each quarter, reducing its annualized rate from $2.50 per share to $1.60 per share.
Buffett overpaid
Buffett has since admitted he overpaid for the company when he originally teamed up with 3G Capital in 2013 to take over Heinz, which later combined with Kraft.
The Oracle of Omaha might have overpaid, but, at the time, the deal made a lot of sense.
When 3G and Berkshire bought Heinz with a transaction value of $28 billion, both partners put in a little more than $4 billion of common equity. To help fund the deal, Buffett and his Berkshire Hathaway shareholders also contributed $8 billion, in the form of preferred stock earning an attractive 9% annual return.
This was a handsome income stream for Berkshire Hathaway until 2015, when Heinz merged with Kraft. The enlarged business immediately sold junk bonds so it could redeem the expensive preferred shares. Berkshire Hathaway reinvested a portion of the profits from the preferred stock back into the company.
Investment returns
The conglomerate's total investment was $9 billion. It still owns 26.7% of the business, which is worth $10.5 billion, excluding dividend income. The company paid a total dividend of $2.50 per share in 2018, $2.45 per share in 2017, $2.35 per share in 2016 and $2.25 per share in 2015.
I estimate these dividends alone could have produced a total cash flow of $3.1 billion since 2015 for Buffett (although it is likely to be substantially lower due to the timing of the transaction in 2015). If you add the two years of 9% annual returns from the preferred shares used to fund the original Heinz deal (around $1.4 billion), Berkshire Hathaway has booked total income from its investment in Kraft Heinz of $4.5 billion since 2013, which implies the conglomerate's total return is around $15 billion since 2013, a total return of approximately 67% (based on the $9 billion currently invested).
Now the question is, has this been a good or a bad investment for Berkshire Hathaway shareholders?
A bad deal?
According to my calculations, and based on the above figures, Buffett's investment in Kraft has generated an average annualized return of 8.9% for investors over the past six years.
My research shows the S&P 500 generated an average annual total return of 12% per annum over the same timeframe.
So based on these calculations, it looks as if Buffett's investment in Kraft Heinz lagged the market, although I do not think an average annualized return just under 9% is a disappointment at all. In fact, I believe this is the sort of return most investment managers would be quite happy to achieve, even if they bought at the wrong price.
I should make it clear these are rough calculations, but I think they show quite clearly that while Buffett has admitted to making a mistake with Kraft Heinz, he has still pocketed billions of dollars in profit from the investment.
It is more than likely he will continue to pocket hundreds of millions of dollars every year in dividends from the company for the foreseeable future. Kraft Heinz might have been a bad trade, but Buffett will still come out on top.
Disclosure: The author owns shares of Berkshire Hathaway.
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