Thesis 02/14/13
We've
long believed that Heinz is well positioned for the long term thanks to
its solid brand portfolio and expansive global sales and distribution
network, and it appears that others share our view, as the firm is now
set to be acquired by Berkshire Hathaway BRK.A BRK.B
and 3G Capital. The $28 billion deal values the packaged food firm
around 12 times our fiscal 2014 adjusted EBITDA estimate, which is
roughly in line with comparable multiples in the consumer product
category over the recent past. Despite intense competitive pressures and
rampant input cost inflation, Heinz has waded through the current
operating environment relatively unscathed, and we think its competitive
advantages should enable it to generate strong cash flows and returns
for shareholders over the longer term.
Above anything else, Heinz is known for its ketchup. However, its
products span several categories beyond the condiment aisle, including
sauces, soups, baked beans, baby food, and frozen foods. While the
namesake brand (which accounts for nearly 40% of the firm's annual
sales) possesses significant brand equity, the portfolio has another 15
brands that generate more than $100 million in sales annually. In our
view, Heinz is committed to enhancing its brand equity by continuing to
invest in marketing for core brands, which currently represent about
$300 million or nearly 2.5% of sales.
Although Heinz is the most globally diversified domestically based
packaged food firm (with total non-U.S. revenue accounting for 60% of
the consolidated total), management still believes there is room for
further expansion, and we agree. For instance, Heinz is squarely focused
on building out its distribution network by expanding in developing
markets. The firm has launched an infant formula product line in China, a
region ripe for growth, and recently announced acquisitions in China
and Brazil. We believe gaining entry into these regions by acquiring
local firms that are familiar with tastes and preferences in their home
markets is a wise investment, and from our perspective, these
initiatives won't saddle Heinz with additional debt, as ample cash
generation--free cash flow amounted to more than 9% of sales in fiscal
2012, which ended in April--will enable the firm to pursue more deals
around the world. Emerging markets account for about one fifth of
consolidated sales, and through a combination of internal growth (like
expanding the launch of infant formula) and additional acquisitions,
management is targeting that sales from these high-growth markets will
account for around 30% of total sales by fiscal 2016, which appears
achievable to us. In fact, under the ownership of 3G (which already
operates with a global portfolio of companies), more aggressive
expansion in emerging markets could now be in the cards, in our view.
Commodity cost inflation (particularly for resins, sweeteners, beans,
and meat) continues to plague packaged food firms, and Heinz is no
exception. The challenges don't end there, as prices throughout
the grocery store are trending higher, and we believe there is only so
much that today's fragile consumer is going to be able to
absorb--particularly in operating environments where unemployment levels
remain stubbornly high and austerity measures are constraining
discretionary spending. As a result, we think a focus on efficiency
improvements will be crucial. In light of these pressures, Heinz
announced that it intends to close an additional three factories
worldwide as part of its current restructuring efforts. This builds on a
plan announced in May to close five facilities around the world, trim
the workforce by 800-1,000 individuals (about 2%-3% of its global
employee base), and build a European supply chain hub. From our
perspective, these are worthwhile investments that stand to benefit
operations over the long term, despite the potential near-term hit to
profits.
Our
$72.50 fair value estimate for Heinz's shares reflects the all-cash
offer by Berkshire Hathaway and 3G Capital. We don't believe that
branded packaged food manufacturers or other financial investors will be
quick to cough up the funds necessary to make a sweetened bid for
Heinz, which management contends is the largest takeout deal in the
packaged food industry. As a result, we doubt competing bids will
surface. Further, we don't expect any roadblocks to prevent the deal
from going through.
We've long regarded Heinz--one of the most global of the U.S.-based
packaged food firms--as maintaining broad competitive advantages,
deriving from its expansive global scale and the brand strength inherent
in its refocused product portfolio, resulting in our narrow economic
moat rating. It appears that Warren Buffett shares our take. The Heinz
brand, which is on an array of products from ketchup to baked beans to
baby food, is a $4.5 billion global powerhouse, accounting for about 40%
of the firm's total revenue, and Heinz's top 15 brands (each of which
results in more than $100 million in annual sales) drive about 70% of
revenue every year. In addition, Heinz generates a boatload of
cash--free cash flow averaged nearly 10% of sales annually over the past
five years--and we bet that Berkshire found this to be quite
attractive.
With
about 40% of its total revenue resulting just from the Heinz brand, the
firm depends on the perception of its namesake brand among consumers.
Volume could remain under pressure as consumers remain cautious and
intense competitive pressures from other branded players and
private-label offerings persist. Finally, given that 60% of its sales
and more than half of its operating income are derived from
international markets, the firm is exposed to fluctuations in foreign
exchange rates.
Management & Stewardship
Overall,
we think Heinz's stewardship of shareholder capital is standard. The
firm's returns have exceeded our estimate of cost of capital over the
past 10 years, which is impressive. In addition, we are encouraged that
the firm has focused on returning excess cash to shareholders (through
dividends and share buybacks) while also pursuing strategic
acquisitions in order to build up its position in faster-growing
emerging and developing markets. Although Heinz has been reluctant to
disclose the price paid for most of these deals, we take some comfort
that it is being a prudent steward of capital, given that profitability
levels have not deteriorated. We expect that the firm will continue
looking to further expand in these regions through bolt-on deals, but we
caution that with several consumer product firms looking to developing
markets for expansion opportunities, valuation multiples could trend to
insanely high levels, making such deals less beneficial.
Berkshire Hathaway and 3G Capital's $28 billion buyout of Heinz
(which values the packaged food firm at around 12 times our adjusted
fiscal 2014 EBITDA estimate) strikes us as a great deal for
shareholders. William Johnson, 63, has been CEO since 1998 and chairman
since 2000. We believe Johnson brings extensive knowledge and experience
to the table, as he has spent more than 25 years at Heinz. Details
surrounding the management structure post-deal, though, have yet to be
determined.
Overview
Although
Heinz operates with a significant amount of leverage, we are comforted
by its cash generation. At the end of fiscal 2012, total debt stood at
0.6 of capital, but operating income covered interest expense around 5
times. Over the next five years, we forecast debt/capital to average 0.5
and earnings before interest and taxes to cover interest expense more
than 7 times on average. We are placing our A- issuer credit rating
under review, with the caveat that we expect to drop the rating once the
acquisition is completed as we do not rate Berkshire. We don't
anticipate any roadblocks to the deal's completion.
Profile:
Since
its founding more than 110 years ago, H.J. Heinz has grown into a
globally diversified manufacturer and marketer of packaged foods,
selling through grocery stores, convenience stores, and food-service
distributors. Its products include ketchup, condiments, sauces, frozen
food, soups, beans, pasta meals, infant nutrition, and others; its
namesake brand accounts for about 40% of annual sales. International
sales account for 60% of the firm's consolidated total.
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