Seriously, Why Did Buffett Pay So Much for H.J. Heinz Company (HNZ)?

It’s a perfectly logical question. And it’s a question you absolutely want a good answer to if you’re a Berkshire Hathaway Inc. (NYSE:BRK.A).

As my Foolish colleague Alex Dumortier put it: Did Buffett Overpay for H.J. Heinz Company (NYSE:HNZ)?

H.J. Heinz Company (NYSE:HNZ)There’s a strong feeling in the media that the answer to that question is a pretty glaring “yes.” The Financial Times went as far as to say that, with regards to Warren Buffett’s reputation as a savvy value investor, “That is not a ketchup stain on your reputation, Mr Buffett. It looks more like blood.”

Ouch.

Indeed, as Alex pointed out, the deal does look pricey at 21 times estimated forward earnings.

But there are a few things that investors want to be sure to consider when chewing on that price. First, the $23 billion that Berkshire and partner 3G Capital are paying for Heinz’s equity is being financed in part by $7 billion-ish in new debt from financing partners JPMorgan Chase & Co. (NYSE:JPM) and Wells Fargo & Company (NYSE:WFC). The finance wonks out there will say that this lowers the cost of capital — we’ll just say that it provides better returns for the remaining equity. Heinz doesn’t have a stellar credit rating, but with corporate borrowing rates extremely low, and Berkshire at its back, I would expect to see some pretty decent borrowing terms.

We also don’t want to overlook the importance of the preferred shares Berkshire reportedly got — and their fat 9% yield. The FT notes that, “It is one thing to extract a good preferred dividend from a company in which you own a slice … When you own a company outright, you are paying yourself.” Fair, but Berkshire isn’t the only owner here. The preferred puts Berkshire’s equity ownership ahead of 3G’s and sends much of the profit to Berkshire’s coffers.

And with the sheer size of Berkshire’s cash position, where else could it have looked to buy something of that size, in Buffett’s strike zone, and cheaper? Campbell Soup Company (NYSE:CPB) is cheaper, but its bottom line has also been moving in the right direction. The same could be said of Kellogg Company (NYSE:K). Kraft Foods Group Inc (NASDAQ:KRFT) could have been interesting, but would have been just as expensive valuation-wise. And The Hershey Company (NYSE:HSY) is just plain more expensive. And comparing any of these suggests that they could be bought out for a similar 20% premium. Management and/or shareholders of these companies might have demanded an even richer bump to sell.

Taking into account the new debt plus the preferred equity, I assume Berkshire will see an annual return in the high 6% to low 7% range right out of the box. In a world of sub-1% five-year Treasury yields, getting that kind of return on $12 billion in a stable, high quality company like Heinz is nothing to sneeze at. On balance, I see this as a positive for Berkshire shareholders — of which I’m one.

Now, as far as the returns that 3G Capital will be looking at … I’m admittedly scratching my head.

The article Seriously, Why Did Buffett Pay So Much for Heinz? originally appeared on Fool.com and is written by Matt Koppenheffer.

Matt Koppenheffer owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway, H.J. Heinz Company, and Wells Fargo. The Motley Fool owns shares of Berkshire Hathaway, JPMorgan Chase, and Wells Fargo.

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