Krafty Buffett Manufactures a 20% Return. How?

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Warren Buffett has teamed up with his Brazilian friends again. 3G and Berkshire Hathaway have announced a merger deal with Kraft and Heinz, a company which they took private in 2013.

I am not a financial analyst, although I have run a fair number of spreadsheets for real estate deals. Alas, I am woefully unprepared to analyze the complexities of a $42 billion merger. I will just give it my best shot – my ballpark/back of the envelope. I would love to hear from serious securities analysts about how they believe the deal is valued.

What I really want to know is what does Mr. Buffett get for his investment and is it worth it? In my estimate, he gets a cash yield of 20% by the third year if 3G delivers the promised expense reductions. If Kraft’s sales can grow (they have been stuck around $18 billion for a while now), then its gravy – or melted Velveeta, as the case may be.

The first thing to know about the transaction is that it really began two years ago. Berkshire bought $8 billion of preferred stock in Kraft yielding 9%. The New York Times reported that Berkshire has received about $1.1 billion in dividends since that investment was made. The preferred stock can be redeemed in 2016.

The deal announced Tuesday has Kraft shareholders receiving 49% of a new combined entity with Heinz. This is a private company, so anyone who bid the Kraft stock up by 35% after the deal was announced was taking a real flyer on the idea that owning half of a private company is somehow significantly more valuable – even though the true price is not known. But the Heinz value is a different conversation. We’re just talking about how Mr. Buffett benefits directly from Kraft.

In addition to the merged stock, Kraft shareholders will receive a special dividend of $10 billion. Assuming Berkshire is putting up half of this cash (which is what the news agencies seem to be reporting), then the total is now $13 billion that Berkshire has invested: $8 billion in preferred stock plus $5 billion representing half of a special dividend to Kraft shareholders.

3G and Berkshire bought Heinz for $28 billion. The market cap of Kraft on Tuesday before the deal was announced was $36 billion. The new entity will be 51% Heinz and 49% Kraft, but lets use 50/50 for easy math. Now, assuming Berkshire was/is half of the Heinz acquisition, they will ultimately own 25% of the new entity.

So, where do the costs stand now? Heinz is giving up 50% of its ownership for $14 billion (based on the $28 billion 2013 price) to receive 50% of Kraft for $18 billion. So the net “cost” to Heinz’s $4 billion. If Berkshire is half of this number, then Buffett’s “cost” is $2 billion. But since, it’s stock that’s being swapped, there is no true cash outlay and the fact that Kraft shares by 35% Wednesday matters not a whit to Heinz.

So Buffett has still invested a total of $13 billion of Berkshire’s cash in the deal of which he will own slightly more than 25%.

He will receive $720 million per year in dividends through 2016. Kraft generated $2 billion in cash flow last year. If Berkshire takes 25% of this number, they will pick up $500 million. If 3G generates the kind of cost cutting they promise ($1.5 billion), Berkshire will pick up a further $350 million. So for an investment of $15 billion, Berkshire will receive $1.5 billion in cash flow. That’s a 10% return. Except that $2 billion is in stock, so real cash is $13 billion – an 11.5% return.

Now, lets say that 2017 rolls around and Heinz-Kraft can either return to the public markets in a new IPO, or Berkshire can use its AAA credit rating to go to Europe and sell some sub 1% Euro-denominated bonds. They raise $8 billion and Berkshire’s preferred stock is redeemed.

Now what happens? Berkshire has $5 billion of hard cash still invested after the redemption of preferred stock. Cash flow increases in the range of $700 million as the 9% interest cost disappears. Berkshire is now getting $500 million in cash flow, plus $350 million is new cash flow from cost cuts, and another 25% of $700 million in interest savings – $175 million. Let’s call it $1 billion of cash per year on $5 billion. 20%.

That’s assuming Kraft sales stay essentially flat. Any growth will push Berkshires internal rate of return even higher.

Lacking Diversity, Omaha Population Crawls to 1,000,000

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One of my great frustrations with the World Herald is its lack of context when frequently reporting stories about Omaha that are nothing more than thinly veiled boosterism.

Today, we learned that Omaha’s metro population will hit 1,000,000 by 2023 under reasonable demographic projections. The City surpassed 900,000 this year. With growth around 1% per year – a trend which has continued for many years now – Omaha can reach this pinnacle.

As a real estate developer, this is fair reassurance. 10,000 people per year translated into roughly 2.2 households per year, leads to solid housing demand in the 4,000 to 5,000 annual range.

It’s also a much better program than some metro areas of similar size – areas that are flat or declining: Akron, Dayton, Albuquerque.

But let’s not get the confetti out yet. Look at some more vibrant areas: Des Moines is growing by 10,000 people a year from a base that is only in the 500,000 person range. Denver grows at 45,000 people per year, Minneapolis at 35,000 per year and Kansas City at 15,000 per year. Denver’s rate is double Omaha’s and never abated during the recession.

What do these cities have that Omaha doesn’t?

Minneapolis has a large number of universities that continually replenish the youth culture. Denver has beautiful mountains and lots of sunshine. These are convenient answers. A look below the demographic hood reveals a City of Omaha that is seriously lacking a diverse population, particularly in the arenas of business and political leadership.

Dynamic urban regions need smart people, plenty of capital, and the creativity and ingenuity that is fueled by a population that is diverse.

I was at a business function yesterday morning with some of the City’s top professionals. Women made up less than 20% of the audience and I don’t think I saw more than one or two people of color.

Skilled and entrepreneurial young minorities want to move to places like Atlanta, Washigton DC, LA and Chicago – cities that have emerged from checkered racial histories to become cultural melting pots that offer more political and business opportunities for people of color.

Perhaps Omaha can make this leap. There are some encouraging signs:

Omaha’s election of Jean Stothert as mayor and Deb Fischer as Senator is a major leap forward. Omaha cast an electoral vote for Barack Obama in 2008, so there’s hope for greater minority representation. Even gay folks find Council Bluffs more hospitable with Iowa’s permission of same sex marriage.

But until Omaha empowers more minority businesses and political leaders, the city risks being a place where creativity is stifled by an echo-chamber of white guys in blue blazers, khaki pants, and oxford shirts who continue to be the power brokers. Omaha’s population growth can’t accelerate without diversity.

Thoughts on the Omaha Apartment Market – March 2015

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The apartment market will continue to experience healthy demand in 2015, but increasing construction costs and higher property taxes are producing strong headwinds. Supply will exceed demand by 300 units this year: not enough to cause discomfort for owners and developers, but enough to reduce occupancy rates by 1-2%. Vacancy, especially in the core submarkets, will stay below a tolerable rate of 6%.

The biggest challenge this year for developers won’t be demand, it will be construction costs. It is likely that many projects that receive building permits will be delayed due to cost overruns.

The Omaha metro area will have 1,500 units permitted in 2015, but not all will be started due to costs outstripping rents. This is the same number as 2014 but slightly higher than needed.

The market will experience 2% rent growth, but gross income will be up by 3% by passing through more expenses – especially water and sewer fees.

There are additional threats to the apartment market on the horizon:

Home buying will pick up this year as people gain more confidence in the jobs market. The “people don’t want/can’t afford houses” story has become a tired cliche.

The biggest challenge to existing properties is the property tax re-assessment which occurred this year for the first time in 5 years. Real estate taxes for multifamily units (especially B and C properties) are set to increase 20% to 50%. New taxes kick in in 2016 – a hellish wake up call for those who aren’t prepared.

The agricultural economy is down. I don’t think people realize how much the farm business filters into Omaha. With commodities down, you’ll see lending decline, cutbacks at Claas, less vehicle spending and shopping trips to Omaha etc.

The sewer separation project is another problem. Every massive infrastructure project run by the government has been over budget. The previous rate increases are already reducing demand as people conserve water. With less water use, The City is going to be forced to raise sewer fees again in 2 years.

Here is my wild card… a major corporate downsizing or defection will occur. We’ve heard about Yahoo! and Woodmen, but there are others in transition: First Data, ConAgra, CHI Hospitals, Gavilon, Kelloggs, and Gordman’s are all searching for ways to cut costs.

Crime is a major factor in choosing where to (or where not to) live. The gun violence rate is appalling for a city of our size. This poses a very challenging environment in which to continue to attract residents to emerging neighborhoods in east Omaha. Marginal developments at the fringes of downtown may struggle from oversupply and perceived lack of safety.

Do I have any optimistic trends? Yes!

  • Entrepreneurs are creating jobs shed by corporates at a healthy rate. Omaha has a diverse economy and has a creative group of young people that used to leave the city but are now choosing to stay.
  • The education “industry” is strong and growing as UNO adds sophistication and UNMC is enhancing it’s services and growing in prestige.
  • The PayPal spin off from Ebay could unleash some advancement in electronic payment systems.
  • Companies like Home Instead and Right at Home growing with the elderly trend.
  • The Omaha 1% annual population growth story has been intact for years – nice and steady – and it will continue.
  • More disposable income will result from tighter labor markets and moderate gas prices.
  • The Fed is unlikely to raise rates. The dollar is too strong.