What Does Warren Buffett See in H.J. Heinz Company (HNZ)?

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Legendary value investor and Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) CEO Warren Buffett has the kind of problems the rest of us only dream of having. Problems like, "What brand names can I spend $30 billion on this year that would turn a solid profit with a reasonable margin of safety?" The answer, or $13 billion worth of it, at least for Berkshire’s end, is H.J. Heinz Company (NYSE:HNZ).

I love a good mystery, don't you? Let's see if we can follow the Oracle of Omaha's trail of breadcrumbs and unlock the hidden value of Heinz.

H.J. Heinz Company (NYSE:HNZ)Buffett’s file on Heinz goes back to 1980. Heinz has been incredibly consistent over that time. The last 5 years have marked the company’s strongest performance to date, with a return-on-equity of 31.7% and an astounding 40.9% annual growth in emerging markets. The company still has plenty of room to run, too. Heinz has a 59% market share in the U.S. ketchup market, but only a 26% international market share.

Heinz’ dividend growth rate has increased by 6.4% over the last 5 years. This trend will no doubt accelerate after the company is taken private. Heinz is, after all, the only large scale food company that can boast 30+ quarters of organic growth.

The structure of the deal is extremely favorable to Berkshire. Berskhire will also invest $4.12 billion in Heinz common equity, another $8 billion in preferred shares, and an additional $100 million in warrants, the details of which are undisclosed. 3G Capital will contribute $4.12 billion of equity, the rest to be financed by $7.1 billion in debt, courtesy of Buffett’s favorite banks, Wells Fargo & Company (NYSE:WFC) and JPMorgan Chase & Co. (NYSE:JPM)).

Still, the deal has many traditional value investors scratching their heads.

The Berkshire/3G acquisition is the largest in the history of the food packaging industry. Why would Warren Buffett pay a +20% premium over the current stock price for a company that, at least according to traditional valuation metrics, was already richly valued? Heinz’ stock was just off all-time highs. How does Heinz fit the “reasonable margin of safety” requirement?

Value investors should keep in mind that Warren Buffet isn’t exclusively interested in strictly value-oriented propositions; rather, Buffett seeks out growth at a reasonable price from strong businesses with relatively low debt and solid cash flows.

Buffett's take

So what does The Oracle receive in return for his massive investment in Heinz? $720 million (pre-tax) a year on his $8 billion worth of preferred shares with a 9% yield, and zero management on Berkshire’s end. Interest on the $7.1 billion in new debt will run $200 million a year after tax. The remainder will be divided equally between 3G and Berkshire, roughly $40 million each per annum.

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