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.

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