I need to correct one thing that I wrote yesterday: 3G and Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) each own 50% of H.J. Heinz Company (NYSE:HNZ), 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:
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|Common Equity 3G||$4.0B|
|Common Equity BRK||$4.0B|
|Preferred Stock BRK||$8.0B|
|New debt for HNZ (to be raised by JPM and WFC)||$7.1B|
The equity interest of Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) is equal to that of 3G, and if things go well with Heinz, whatever the form of the warrants are, Warren 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 Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) and 3G floats bonds and raises cash. The cash goes to shareholders, along with the cash from BRK and 3G, paying off H.J. Heinz Company (NYSE:HNZ) shareholders at $72.50/share. The debt attaches to H.J. Heinz Company (NYSE:HNZ) 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 H.J. Heinz Company (NYSE:HNZ) 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 — Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) 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 Warren 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:
- 8K from Berkshire Hathaway on the deal. Terse, but gives more detail than most.
- Matt Levine’s take on the deal. Well done.
- Reuters Summary take on the deal.
- Alice Schroeder’s take on the deal. Best I saw; worth the read.
- DealBook’s take on the deal, from my friend, Peter Eavis.
- Is Buffett overpaying for Heinz? Stephen Gandel’s take on the deal. Also well done.
Full disclosure: long BRK/B and WFC
By David Merkel, CFA of Aleph Blog