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Alice Schroeder on Heinz deal


Guest kumar
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Buffett brand has more beans than Heinz

 

http://www.ft.com/intl/cms/s/0/5cd29ec0-79be-11e2-b377-00144feabdc0.html#axzz2LJ0SazUs

 

....he has pulled off a leveraged buyout that leverages everyone but himself. While he has a well-established pattern of using other people’s money for Berkshire’s benefit, this sets a new bar. Generations of financiers to come will be studying his unparalleled creativity in finding low-risk ways to leverage....

 

....the way he squeezed out every advantage in this deal underlines the fact he is as red in tooth and claw as any Wall Street predator....

 

When will Alice get over obsessive rant against Warren?

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By now the “Buffett deal” has become familiar: an investment by Berkshire Hathaway that includes high-yield preferred stock and very little risk. Berkshire’s purchase last week of Heinz fits the classic pattern. Before yawning, “he’s pulled off another one”, let us pause to consider some new shading that Heinz brings to the portrait of Warren Buffett as dealmaker and capitalist. Also worth noting are subtle signals that suggest where the US economy is heading. Mr Buffett has a history of being right about such things, so let us pay attention.

 

Through the deal, Berkshire and its partner 3G Capital, the Brazilian private equity firm, will each take half of Heinz in exchange for $4bn of equity. For another $8bn, Berkshire acquires redeemable preferred stock yielding 9 per cent and warrants (options that give investors the right to buy shares at an agreed price at some point in the future). The $72.50 per share cash transaction includes $12bn of new and assumed debt, valuing Heinz at $28bn.

 

 

 

What do these details tell us about Mr Buffett as a dealmaker? The most notable point concerns his tolerance for leverage. Heinz will sport $6 of debt for every dollar of equity – a ratio that has made bondholders and rating agencies uneasy. Mr Buffett bristles at applying the term “leveraged buyout” to the deal on the grounds that he does not intend to flip the company in a sale. That is a fair point. On the other hand, the deal does bark like an LBO – otherwise, the numbers would not work for the sellers. It may seem puzzling that Mr Buffett, who has criticised LBOs for decades, signed up to such a deal, but here is the twist. The leverage – which is very real for all the other parties – is largely illusory for Berkshire.

 

Even if Heinz loses money, Mr Buffett’s holding company is paid its preferred dividend. Only in the unlikely event of bankruptcy is Berkshire at risk. Should that happen, Berkshire would be in a position to wipe out other creditors. Its power to snag a cheaply restructured Heinz essentially eliminates Berkshire’s risk. No wonder bondholders are nervous.

 

These facts make it understandable that Mr Buffett would react to the term LBO as if it did not apply to him – because it does not. In effect, he has pulled off a leveraged buyout that leverages everyone but himself. While he has a well-established pattern of using other people’s money for Berkshire’s benefit, this sets a new bar. Generations of financiers to come will be studying his unparalleled creativity in finding low-risk ways to leverage.

 

Then there are the nuances the deal brings to our picture of Buffett the capitalist. However warm and grandfatherly he may be, the way he squeezed out every advantage in this deal underlines the fact he is as red in tooth and claw as any Wall Street predator. He is also exquisitely attuned to incentives, and worked out long ago there are many forms of currency. Here, he canonised his Brazilian partner, Jorge Lemann, who will be running the highly leveraged Heinz, as a hugely admirable businessman and “human being”. Mr Lemann, if he is smart, will use his reputational currency in other deals to extract actual money.

 

Mr Lemann and 3G did not secure the same terms as Berkshire, just as any future transactions involving Heinz are unlikely to be as attractive. Thus, there is no particular reason why – contrary to some forecasts – this deal signals a turn in the economy that should spark a wave of mergers and acquisitions. That said, Mr Buffett has reminded us that, when money is cheap, takeovers follow. In that sense, leveraged deals could be seen as central bankers’ gift to acquirers.

 

Even with the leverage that supported it, the lofty valuation that Heinz commanded raised questions about whether investors are chasing growth. A chorus of response quickly pointed out Heinz’s valuable brands as justification.

 

There is little doubt that people will be enjoying the famous ketchup, Lea & Perrins and other sauces 50 years from now. Yet the pace of brand erosion in all industries is accelerating. Mr Buffett is well aware of this. So too are supermarkets, which are pushing harder than ever to close the gap between Heinz and other brands’ prices. The justifiable premium for brands is declining. This deal actually strikes a cautious note about the decades-old philosophy of investing in great brand businesses at premium prices. When Mr Buffett made investments such as in Coca-Cola in the 1980s, he was happy to make unprotected bets on growth. Berkshire never bit on Heinz until now, when a deal arrived with terms that guarantee it a 6 per cent return.

 

In a world of near-zero interest rates, that 6 per cent looks pretty attractive. Mr Buffett, evidently, does not expect rates to rise sharply any time soon. A decade ago, he demanded a first-day return of 13 per cent before he would bother to consider a deal. Now the Oracle takes 6 per cent for his money. We should pay attention. There could hardly be a stronger signal that the investing tide has changed.

 

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Guest wellmont

what she is forgetting is that his 6% return is a minimum return. he has lots of upside, and will get it. that's the genius. he protected the downside and has the framework in place for big upside.

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Another thing she said in the article is that Buffett won't get impacted if the company goes bankrupt, I am not sure that makes sense.  I would think that the preferred and common equity would get wiped out in that case.  Of course, Buffett could pay off the bond holders but thats additional capital which would hurt the return.  Does anyone else know what Alice is talking about?

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Guest wellmont

I haven't looked at the deal in detail yet.

Where is Schroeder getting the 6% guaranteed return from?

 

she is combing his two investments ($12b) and assuming the pref is money good and will pay the annual dividend and no bk. $720m/$12,000m

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I haven't looked at the deal in detail yet.

Where is Schroeder getting the 6% guaranteed return from?

 

The annual preferred dividend / total $12 billion investment.  Guaranteed is a bit strong, but it does seem like a reasonable near-term floor assuming 3G doesn't kill Heinz. 

 

I made a similar observation in the the original thread about the deal.  http://www.cornerofberkshireandfairfax.ca/forum/berkshire-hathaway/berkshire-acquires-heinz-for-72-5-ps/msg103947/#msg103947

 

 

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Guest wellmont

Another thing she said in the article is that Buffett won't get impacted if the company goes bankrupt, I am not sure that makes sense.  I would think that the preferred and common equity would get wiped out in that case.  Of course, Buffett could pay off the bond holders but thats additional capital which would hurt the return.  Does anyone else know what Alice is talking about?

 

~ $11b ahead of the pref. so his pref could be impaired. but I see the possibility of bk here as remote outside of exogenous black swan event. iow if hnz goes bk we have more important things to worry about. :(  the only thing that could take him there under normal conditions is over leverage. But he can turn off the $700m annual pref dividend if need be. He could only be taken into bk by the debt holders. So heinz really only has to service $10b. They will likely de-leverage via acquisition.

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Wellmont and Zarley have hit upon what Schroeder was trying to highlight.  Characterizing the $8 billion of preferred as debt may be technically correct as an accounting conclusion but pointing to it as indiction that the deal is akin to a highly leveraged MBO, as the WSJ did today, is misleading.  3G and BRK are the two parties for whom the distinction between debt and equity for $8 billion matter; to third parties the preferreds are effectively equity.  (Perhaps as well the IRS, if I understood Wellmont's suggestion.)

 

As noted above, the granting of warrants to BRK as part of the preferred structure makes this even more interesting.  3G are big boys and they reportedly pitched the idea to Buffett but I concur with Schroeder that they seem to bear disproportionate risk given BRKs ability to capture the upside, if any, through exercise of the warrants.  Has any information been reported about the number and pricing of the warrants?

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Anyone notice the following "Letter" to the FT, printed in the paper right beside Schroeder's article? Clever. More important, you could probably bet dollars to doughnuts that Mr. Dadlani has a "handle" on this board.

 

Buffett has not miscounted beans

From Mr Rajiv Dadlani.

 

Sir, I must take issue with Lex (“Attack of the killer tomatoes”, February 15), which argues: “Let us

all give Warren Buffett a stern lecture about overpaying.”

 

As Lex acknowledges, “Heinz is an excellent company”. Given this, and its shareholder base of

predominantly value investors, it would be difficult, if not impossible, to execute a take-private

transaction at anything less than a full price. And a full price it is – a premium of 20 per cent plus –

whether to Heinz’s price/earnings multiple over the past decade or to its ebitda multiple over the

past decade or to its undisturbed share price. Anything less than a full price would also run the risk of

a board wary to engage and third-party nuisance lawsuits.

 

But a full price does not mean Berkshire Hathaway is overpaying. The reason the deal math works is

because Berkshire is an insurance company. As such, Berkshire has a float that has an estimated

negative funding cost of between 2 and 4 per cent. In option terms, think of Berkshire as a seller of

put options, with the premium it collects being the float, and the exercise price being the event it

insures.

 

As Lex points out, Berkshire’s full $12bn investment carries a yield of approximately 6 per cent. Add

the estimated negative funding cost, and you get a total return (funding return plus investment

return) of between 8 and 10 per cent. An unkind person might quibble, but I would call that a solid, if

unspectacular, equity return, with a reasonable safety margin, and some scope for upside. It should

be no surprise that Berkshire shares closed up 1 per cent on news of the deal.

 

The real bet Mr Buffett is making is that 10 years from now more ketchup and baked beans will be

consumed and that consumers will pay a premium for the Heinz brand (moat). That’s pretty much

the same bet he’s making on Coca-Cola.

 

Rajiv Dadlani, San Francisco, CA, US

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Guest wellmont

They will likely de-leverage via acquisition.

 

Huh? Please explain.

 

if they buy profitable companies (with cash or stock) that don't have debt (or modest debt) they will de leverage the hnz capital structure.

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Heinz will sport $6 of debt for every dollar of equity

 

I just a quick check but 6/1 ratio is wrong, even if you count the pref. as debt.  I did not look at the filings just Yahoo, but 8 billion in equity on about 20 billion including the preferreds, which I would not include as debt. (xo comment is right on.)

 

Also, the bonds are senior in the (unlikely) case of BK, so that's another error...tut, tut Alice.

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They will likely de-leverage via acquisition.

 

Huh? Please explain.

 

if they buy profitable companies (with cash or stock) that don't have debt (or modest debt) they will de leverage the hnz capital structure.

 

They will deleverage via margin expansion. 

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