Heinz: Intangibles Create Problem Scenario for Shareholders

Heinz: Intangibles Create Problem Scenario for Shareholders
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Heinz: Intangibles Create Problem Scenario for Shareholders

I’ll keep trying until I get it right.  Aside from the terms of the warrants, most of the deal terms are known in terms of quantities, if not prices.  What I present benefits considerably from a comment I received.  Here it is:

Good analysis, though I think we know a bit more about how the debt portion will work than you imply. It appears to be very standard LBO mechanics: The sponsors (BRK and 3G) set up an acquisition vehicle, which drops down a shell subsidiary (Merger Sub), which, at closing, merges with Heinz, leaving Heinz behind as the surviving entity. This allows Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) and 3G to own and control the acquisition vehicle (referred to in the Merger Agreement as “Parent”), which will be a passive holding company, and Heinz will be below it.

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The new debt raised by Wells Fargo & Company (NYSE: WFC) and JPMorgan Chase & Co. (NYSE: JPM) will be primarily at this holding company level, though presumably the bank loans and revolving loan will be fully secured by H.J. Heinz Company (NYSE:HNZ)’s subsidiaries and their assets, while new high-yield notes would be unsecured. From the 8-K with the Merger Agreement:

“J.P. Morgan and Wells Fargo have committed to provide $14.1 billion of new debt financing for the transaction, consisting of $8.5 billion of USD senior secured term loan B-1 and B-2 facilities, $2.0 billion of Euro/ British Pounds senior secured term loan B-1 and B-2 facilities, a $1.5 billion senior secured revolving facility and a $2.1 billion second lien bridge loan facility. The obligation of J.P. Morgan and Wells Fargo to provide this debt financing is subject to a number of customary conditions, including, without limitation, execution and delivery of certain definitive documentation. The final termination date for the debt commitment is November 13, 2013. Additionally, Parent also intends to roll over certain of the Company’s current outstanding indebtedness that is not subject to acceleration upon a change of control and that either does not contain change of control repurchase obligations or where the holders do not elect to have such indebtedness repurchased in a change of control offer. ”


Note that the reference to a bridge loan is common in these deals, but my expectation — consistent with past practice — is that while there is a committed bridge there is no actual intention to fund a bridge loan to the acquisition vehicle (Parent), and instead the idea is to market high-yield notes. But the committed bridge is there so BRK and 3G can close the acquisition, as in this agreement, consistent with market practice, there is no condition that the financing from the banks actually be in hand (a “financing out”), and, according to the disclosure, the banks’ conditions have been tied to the acquisition conditions — there won’t (or shouldn’t be) be situations where they can refuse to fund but 3G and BRK are still obligated to close. You can see Section 7.13 of the Merger Agreement to see some of the obligations of Heinz to prepare financials and market the debt (very common in LBO deals). So I think we can fairly safely say that the new debt belongs to Heinz, not 3G and BRK. There won’t be any support from the investors.

Note also that the above is why I am unsure about your calculations above about the “new debt” are slightly off — though I could be wrong and I welcome any correction. At least some portion of the new debt will be used to simply refinance the old debt (see Section 7.13(b)(ix) of the Merger Agreement, which requires Heinz to obtain payoff letters of its existing bank debt), though some Heinz debt will roll. But this would still mean that new debt would be more in line with $14bn, not $7bn.

That said, maybe the best way to think of this would be a pro forma cap table for the acquired company, showing what the total debt of the acquired Heinz would be.

In that case I still think you come out with an even more leveraged picture than you have above, though I think all of your points about Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s upside remain. And it also highlights to me another benefit BRK got from this, which was 3G’s expertise in packaging and structuring this deal, which is designed as essentially a regular way LBO. The only unique aspect is the 50/50 common equity ownership of the acquired entity (though PE shops do “club” sometimes) and Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s “mezzanine” financing of preferred and warrants, though I’ve seen sponsors do “sponsor loans” to fund acquisitions when they have extra cash and charge even more than 9%.

Final note on the warrants: It’s not clear that Berkshire would get control of the new entity even if they exercise the warrants. Buffett on CNBC repeated that 3G would have “day-to-day control,” despite the 50/50 equity ownership. This tells me that 3G has been given operational control regardless of the equity stake in the joint venture/LLC Agreement, and we simply don’t know if the exercise of warrants even given Berkshire greater than 50% equity ownership would change that. It might, but it might not. It’s very common in real estate deals for one party to put up 70-90% of the equity but cede day-to-day control to a minority partner, who, after satisfaction of a hurdle rate, takes a big commission or even splits the economics 50/50 for “finding and executing” a deal. Buffett undoubtedly has lots of experience in these kinds of structures and this one is tailored to this particular situation.

Hopefully these are helpful comments. I am a big fan of your blog.

PS — One correction to [what I said above]. I mistakenly said the bonds would likely be unsecured; given that the committed bridge loan is going to be second-lien secured, I’d expect the bonds to be second-lien secured bonds as well. This actually further supports the notion that this is a very leveraged transaction — the bond market is “hot” right now, so the idea that this deal needs secured bonds implies that the guys on JPM’s and WFC’s high yield desk already view this as a very leveraged deal.

I’m not sure how I could have missed that one filing at the SEC that listed the deal terms for debt.  As it is, I decided to sit down and calculate out what the balance sheet of Heinz might look like post-deal.  Here’s what it looks like as of the last 10Q:

Last 10Q Chart

That leaves a tangible net worth of negative $2.63B.  Given that they are paying $23.4B or so for Heinz, that means Intangibles & other noncurrent assets will be $26.1B.  Now here’s what the balance sheet would look like if none of the existing debt is refinanced:

Intangible and non current assets chart

And here is what it looks like if the debt is refinanced in entire:

Debt is refinanced chart

In this latter scenario, I wonder what assets back the pledge for securing the bank debt.  There are not enough tangible assets to do so.  That said, I know that the real value of H.J. Heinz Company (NYSE:HNZ) resides in its brands, not its tangible assets.

After the deal completes, H.J. Heinz Company (NYSE:HNZ) will not produce a lot of profits for the common stockholders, because Warren Buffett’s preferred stock and the additional debt will eat up most of the gross profits.  3G will have an incentive to increase the gross profits as a result, or else their $4B investment will not be worth much.

This is an aggressive deal.  Much as I think Warren Buffett got the better deal vs 3G, it is by no means certain that increasing profits at Heinz will be easy.  10 years out, this will be a case study for many business schools.

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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