Description

Super Size Me! Kraft Foods Group Inc. (“KRFT”) is merging with HJ Heinz Co.("HNZ"). The process is being driven by the legendary private equity firm, 3g, and legendary investor Warren Buffett. The combination is a short at $90 a share or nearly 50% higher than were Kraft was trading in this mostly stock deal.  The stock is up huge, but nothing has actually happened yet and very small amounts of cash will actually change hands. The terms of the deal are straightforward, Kraft will issue to Heinz holders one share of Kraft for every share of Heinz such that Heinz will have 51% of the Newco. Kraft holders will also get a $16.50 special dividend funded by a new $8 billion preferred from Buffett. It is mostly what I like to call a two dogs for a cat transaction where mostly wampum changes hands. In this case, Buffett/3g special wampum. Their money or bit-coin or whatever really is greener than others. The stock is a short here and now and I believe sometime of the next two years, it will trade back to the $50-60 range where it would be more appropriately valued.

Kraft is a no growth food maker that dominates categories that would appear to be on the wrong side of every food trend over the last two decades – processed cheese, check (Kraft, Cracker Barrel, Cheeze Whiz…); Processed Meats, check (Oscar Mayer cold cuts and hot dogs, something called Lunchables which barely sounds like food and Boca meat alternatives – soy based “meat” that appears to be healthy); Sugary Beverages, check  (Kool-Aid, Country Time); Meals and Desserts with poor nutritional content, check (Kraft macaroni and cheese, Velveeta shells and cheese dinners, JELL-O, Cool Whip, Stove Top stuffing and Shake and Bake coating); High Fat condiments, check (Kraft and Miracle Whip mayo).  Don’t get me wrong, I like this artery clogging “food” in limited doses, but these are not exactly the growth areas of the food industry.  I am not sure if Whole Foods carries any of it and like it or not that is where the growth is. Reading the list of products and it feels like what a Coke 10k would look like without any of the bottled water, PowerAde and Keurig coffee and other growth areas to pin your hopes that something will come along replace the 10 year in a row decline in soda consumption. When I looked at the top line, I was actually surprised that it had managed to stay more or less flat for the past five years, though it has slightly declined every year for the past four years.  To get a sense where the revenue growth is going, Annie’s Organic sales basically doubled over the same period – albeit off a small base, but that was largely off the Mac and Cheese product eating Kraft’s lunch which also appears, not coincidentally, to be the Company’s segment with the largest revenue decline.  

The Heinz 10k doesn’t read much better: Heinz Ketchup and other high fat and/or high sugar condiments, Ore-Ida, though they do at least have the Weight Watchers brand under license. But why take my word that these two companies are on the wrong side of nutritional and regulatory trends, why not just read from the Heinz risk factors section the 10k, ”The success of the Company is dependent upon anticipating and reacting to changes in consumer preferences, including with respect to health and wellness.” That may be the most benign way of putting what I have just described above. However, these companies fit the Buffett description of business perennials. Consumers will most likely be eating these brands and their unhealthy fare forever, but perhaps just a little less every year. It is hard to gain street cred in the organic aisle overnight - especially when your core products are a big part of the reason people are switching to organic, healthier fare in the first place.  I have never looked at Heinz ketchup the same way after a nutritionist called it, “syrup.”

It should come as no surprise that Warren Buffett and legendary private equity investor, 3g, should try to merge Kraft and Heinz together. 3g cut an astounding 17% of S, G and A at Heinz over the past year. However, the volume declines at Heinz alone last year were almost 5%, maybe zero based budgeting cuts too much bone. A similar feat at Kraft could take $430 million to the bottom line.  The combined entity would have about $4.1 billion of S, G and A assuming a 17% cut in Kraft overhead that was achieved and Heinz. Heinz/3g is guiding to $1.5 billion in merger synergies – The extra $1.1 billion is roughly 25% of S, G and A which sounds reasonable but wrenching if you work at either company.  

A radical cost cutting and leveraging up is probably the right strategy for a zero to negative growth food giant.  This deal on the face makes sense for 3g and shareholders. My only issue with the stock is that the synergies appear more than priced in and that the Buffett/3g halo has pushed the stock up to mid teens multiples of EBITDA when the peers trade for 12x and that is if all the cost cutting succeeds and the revenue decline doesn’t accelerate as its customer base ages/dies away – think cigarette customers on a much slower slope. Also this deal has more the feel of a partial exit/monetization than a takeover. The deal allows Buffett and 3g to get liquidity for HNZ equity at 4x their basis according to Matt Levine over at Bloomberg in just two years.  They may be long term holders of the combination but it is nice to take your high yield leveraged equity and merge it with investment grade Kraft to derisk the Heinz deal amidst declining sales volumes.  Kraft shareholders are getting the benefits of a 50% move in their stock to all time highs – if they sell into the hype today. Otherwise, they appear to be holding a stock/merger currency that appears to be approximately 50% overvalued.

I believe Kraft is worth approximately $50-60 for a 33-44% return from here. The nice thing about the short, it is easy to borrow, unbelievably liquid, and held by weak hands. It is not like you are shorting Tesla or Twitter with unlimited growth to dream about. Most of the sell side missed the story and are now scrambling and contorting themselves to up their price targets from the $50s and 60s to $90-100 to justify the move. One risk arb. bull (oxymoron?) came on CNBC to say that he thought the combination was worth $100 for a whopping 11% return from here. 11% is within the standard deviation for most stocks in the S and P 500. Touching $100 can happen just as easily as touching $80 on a random walk.  It is market noise and beta. While EBITDA multiples for sectors and companies change over time, a mid teens multiple which is what you are paying for both Kraft stand alone and Kraft/Heinz is usually associated with a high revenue growth business, not a declining one. By contrast, Apple, a high margin and high growth consumer name trades at 7.7x forward EBITDA and has traded as low as 4-5x EBITDA in 2013 – a fact that many VIC members remember all too well. But Apple is in the risky tech business with a $600 billion EV so law of large numbers etc. But Newco is trading at a $140 billion EV – not exactly small – assuming the stock does not drop by the full $16.5 (or $8.25 since only half of shareholders are getting it) of the special dividend once it goes X.  By contrast, fast growing and Coke takeover target GMCR trades at 14x EBITDA.  It is amazing how tightly bunched all the large capitalization food comps like Kellogg and General Mills are. They  tend to trade in a range of 11-13x EBITDA. No one is even close to 15-16X of Kraft and Kraft/Heinz. Best of all, should the market selloff, the Kraft shareholder base is turning over to arbs and Buffett/3g followers, weak hands for the near term.  If the stock sells off, they might start selling out as it is not “supposed” to go down due to the virtues of this deal. In 1997 at the height of the Buffet influenced Coke hype, that stock traded at 30x EBITDA. It was however viewed as a revenue growth story which Kraft and Heinz are not. The stock proceeded to decline by over 50% from those highs and only now after 20 years is it back to those levels in terms of price. Perennials can be expensive to hold sometimes if you don’t have float income or GenRe’s bond portfolio to dilute your interest down as Buffett did when he thought his stock portfolio was overvalued.

There are a few ways to win with this trade. If for some reason the deal breaks (unlikely but maybe this wheat futures rigging accusation at Kraft gains legs the way LIBOR fixing hit the banks or antitrust busters say no - deals break for all sorts of random and nonrandom reasons), the stock would presumably trade below the $60 (12x EBITDA by the way) where it was trading at pre deal though it would still technically be in play for another acquiror.  What if they don’t get the synergies they are planning for or if revenue and gross margin dollar declines offset S, G and A synergies, remember the top line trends in these businesses?  If EBITDA were to remain at $7 billion pro forma and trade at 12x, the stock plus the $16.5 special  dividend would trade be worth approximately $60 a share for a 33% decline or right where it was pre deal. Kraft is not a short to zero, but for those looking for ways to short an overvalued market with a put option on missed execution and or the deal breaking, Newco would seem like a safe way to do it.

The most likely scenario is that the deal goes through and Newco trades at 12x EBITDA with the $8.5 billion in proforma EBITDA with all synergies. With $30 billion in net debt and preferred including the almost $2 billion in upfront costs to get the synergies that 3g outlined on the call (Buffett is senior to the common so his downside risk is almost zero as I doubt the company will ever trade below the 4x debt/preferred even in a no synergy $7 billion in EBITDA scenario). In this case the EV is $102 billion and the equity value is $72 billion or $58.82 a share, plus the $16.5 special dividend gets you to $75.32 a share in value or an 18% decline versus the 14-15x EBITDA the combination is currently trading at. It is also worth noting that rarely have these business traded above 12x EBITDA and they often have traded closer to 10x. Every multiple point decline knocks about $7 off the value. At $90 dollars, Kraft shareholders are paying 23.8x Heinz trailing EBITDA and 20.7x forward EBITDA. Kraft standalone is also trading at 16.8x forward and 17.35x trailing EBITDA should the deal break. These are high multiples for no growth businesses.

Given the relatively high pro forma leverage, a dividend cut would appear possible should things go wrong. I would argue that at current levels, Kraft might want to issue stock to buy a high multiple/high growth player in the organic market or to pay down debt. Buffett and 3g have made a lot of money on this deal, why not deleverage the combined entity while the stock has a high value?

So what is a no/negative growth food merchant of death worth once these costs are taken out? The combined company looks like it has about $1 billion or so in ongoing combined Capx. Maybe there is fat here, but I doubt much and the product lines and geographic reaches are so different – especially since Kraft spun out its international operations into Mondelez.  An interesting side note is that Kraft spun out its international operations because they weren’t getting the market value or synergies from them. One of the rationales for this deal is to go global again… hmm 3g really does have pixie dust.. So EBITDA – Capx = $7.5 billion a year for as far as the eye can see. Let’s see what a 5 year dcf values the company. I used a range of unleveraged free cash flow discount rates of 8-12%. Maybe these perennial brands deserve a lower discount rate but it is hard to use much lower rates when the “g” in “r – g” is negative. One could argue that higher discount rates might be required given the growth prospects, but for now let’s just leave it as is. I also added the near terms cost of synergies into the debt. 3g on the call estimated that the cost of synergies would be 1.25x the synergies or just under $2 billion. This calculation gets you to just under $30 billion of net debt without even addressing pension and health care liabilities for these two old line companies – Kraft had $1-2 billion in adjustments for these items in 2014 alone.  My DCF value plus the $16.50 special dividend payable only to Kraft holders gets a range of value of $43.07 a share to $68.59 which is a bone chilling 24-52% drop from current levels for a safe Buffett type stock. This reminds me and feels like Coke before the long decline. You need to go as low as a 7% discount rate to get to current values.

Where could I be wrong? Let’s say EBITDA exceeds expectations and goes to $9 billion and trades at 16x that number, the stock could trade at $109.62 for an unfortunate but not likely 22% loss from here.  In an overvalued market, Heinz/Kraft gives you the chance to short a large liquid names trading 2-4 full EBITDA multiples over all of its peers that is looking at negative revenue growth for two companies that are on exactly the wrong side of recent food trends.

Catalyst

Revenue continues to decline, synergies come in at less than expected, the company trades at peer group multiples or worse yet DCF values, the wheat futures investigation gains traction, antitrust regulators block the deal, and my favorite – sometimes value is its own catalyst. Kraft shareholders wake up to how much they are overpaying for Heinz, even Heinz’s own merger deck says that the transaction won’t be accretive for Kraft shareholders until 2017!