The recently announced acquisition of H.J. Heinz Company (NYSE:HNZ) by Berkshire Hathaway Inc. (NYSE:BRK.B) and 3G Capital raised some eyebrows at first, mostly because the premium of nearly 20% doesn't make the deal look particularly cheap in terms valuation. Heinz is being valued at more than 20 times earnings estimates for the next year -- this doesn't seem excessive for a profitable company with high-quality brands, but hardly a bargain either.
Upon further examination, however, it looks like Buffett made a great deal once again.
Berkshire and 3G are putting down $4 billion each, and they are both getting a 50% equity stake in the company. Berkshire will also invest $8 billion in preferred equity yielding a juicy 9%, and Buffett is getting warrants too, but the conditions regarding those warrants have not been disclosed. JPMorgan Chase & Co. (NYSE:JPM) and Wells Fargo & Company (NYSE:WFC) will be in charge of raising around $7 billion in extra debt for a total of nearly $23 billion.
Heinz will be a more leveraged corporation after the acquisition, and 3G will be in charge of running the company. 3G has a solid reputation when it comes to managing consumer companies, and Heinz owns very valuable brands, so the company should do well over the next years. International expansion and adding more products to the distribution network are two obvious growth avenues for the company in the middle term. Buffett likely won't want to be associated with harsh cost cuttings, but 3G should make sure to keep costs under strict control.
Is this a leveraged buyout? It depends on how you see it. Buffett is not planning to flip the company for a profit in the future, and that's an important difference versus traditional LBOs. On the other hand, the new Heinz will be a highly leveraged corporation, and that additional debt is one of the ways in which equity investors expect to see increased returns, so leverage is an important component of the agreement.
To begin with, the 9% that Buffett is getting on his preferred shares is a spectacular yield, especially in times of ultra-low interest rates. Heinz has generated between $800 million and $1 billion in free cash flows per year in recent years, and the preferred dividends should amount to something like $720 million – 9% of $8 billion – so Buffet is getting a big chunk of the annual cash flows generated by Heinz.
This is not only relevant in terms of the yield that Buffett is getting, it's also very important when it comes to incentives. 3G will need to make sure that Heinz produces growing cash flows over the coming years if common shareholders are going to benefit from this deal.
When it comes to upside potential, we still don't know the details about those warrants that Buffett is getting, but if history is any guide, investors in Berkshire have reason to feel optimistic about that part of the deal.