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Craftier than Kraft

31 March 2015 By Rob Cox

Kraft shareholders must be a pretty satiated bunch. They awoke last Wednesday to discover they’d become partners with billionaire Warren Buffett and renowned Brazilian corporate fixers 3G, while merging with the world’s leading condiments maker, Heinz.

That’s not all. Kraft owners also learned they would soon receive a juicy cash payment and still own shares in a cheese-and-ketchup conglomerate that promises, simply by dint of combining, to squeeze out another $1.5 billion in extra earnings. So elated have Kraft’s owners been by the deal they’ve bid up the stock up by nearly $26, or some 40 percent, perhaps imputing an extra premium to Buffett’s and 3G’s wiles.

What if Kraft could have done better on its own, though? A trip down not-so-distant memory lane and a skip through the numbers suggest the Velveeta-maker could have bought Heinz two years ago when it was in play, spooning more of the combined value to its own shareholders.

Instead, it is ceding control and renting its fat-free balance sheet to sharper operators. While selling to a group that includes Buffett’s Berkshire Hathaway confers a degree of cover to the Kraft board’s decision, it raises questions about what sort of management public shareholders want from companies, particularly mature ones like Kraft.

None of this is to say that Kraft shareholders are getting a raw deal. They will own 49 percent of a company generating $29 billion in annual sales and 13 brands with sales of more than $500 million each. In addition, they will receive a special cash dividend of $16.50 a share, or a total of $10 billion.

The new company will be run by a management team associated with Brazilian private equity firm 3G, which has developed a track record for efficiently running giant consumer-goods companies. When Bernardo Hees, the Heinz chief executive who will be in charge of the whole smorgasbord, puts a target of $1.5 billion of cost cuts on the board, it’s a good bet he will hit – if not exceed – it.

And although they will take three years to fully trickle down to the bottom line, those anticipated savings are worth a lot to shareholders today. At Kraft’s 30 percent tax rate, their net present value would be worth as much as $10.5 billion, with Kraft shareholders receiving $5.1 billion of that through their nearly half stake.

Consider instead, however, if Kraft had bought Heinz when the company was in play two years ago. The Buffett-3G team paid just over $23 billion for Heinz’s equity, a 20 percent premium to its share price, and assumed $4.5 billion of debt. Sweetening that wouldn’t have been hard for Kraft.

As the Heinz deal shows, Kraft had significant cost savings to exploit. It also benefits from a far lower cost of capital than 3G, which raised $9.5 billion in high-yield debt to get the deal done and sold $8 billion of preference stock to Buffett. It’s even possible that Kraft could have financed the bid and remained an investment-grade credit.

Imagine Kraft offered a 30 percent premium, or around $6 billion above Heinz’s market value. That would have left $4.5 billion of net present value for its own shareholders to feast on. It’s less than is implied by the current deal, using the same corporate finance arithmetic. It also, however, ignores that Heinz’s new owners were able to melt away $1 billion of costs without another merger.

If Kraft’s managers, however, were even just half as good as 3G at slashing costs, they could have found another $500 million in savings from a Heinz deal. At the same 30 percent tax rate, that would have represented an extra $3.5 billion. When added to the rest, the sum would be $8 billion of total value. That compares to the $5.1 billion derived from 3G’s takeover of Heinz.

There’s another important distinction in this hypothetical scenario: Kraft shareholders would have retained control of their company. In the Heinz deal, Buffett-3G name six directors compared to five for Kraft. The new owners also install the chief executive and chairman. What’s more, a special dividend, like the one 3G is offering, could theoretically have been paid by Kraft management, too.

The theory is nice, but of course two years ago Kraft had only just separated itself from Mondelez, so the timing would have been awkward. The biggest assumption, though, is that Kraft’s management and board would have had the guts, wherewithal or skills to do to Heinz what 3G can, did and presumably will do again. Kraft boss John Cahill conceded last week that he and his team probably weren’t up to the task when he said that “what we have not been thrilled about is some of our execution.”

Kraft’s quandary is one that shareholders elsewhere have to consider. Do they want stewards who will safely manage their businesses and perhaps sell out in elegant deals like this one, conferring decent returns? Or would they prefer risk-takers like the gang at 3G, and higher returns? This food deal starkly and freshly poses the M&A conundrum of whether to eat or be eaten.


This story was corrected to say five Kraft, not Heinz, directors in 12th paragraph.


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