Why Buffett’s Consumer Staples Gamble Should Pay Off

When you combine the world’s most recognized investor with one of the largest mergers in the consumer staples universe, you’re going to garner some attention. And when you add in a hyped earnings report, you have a true story on your hands.

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With Kraft Foods Group (NASDAQ: KRFT) reporting its first earnings since it entered into a merger agreement with Heinz Foods backed by Warren Buffett’s Berkshire Hathaway (NYSE: BRK-B) and the Brazil-based 3G Capital, that’s what we have this week.

The full story started more than a month ago, however, when Kraft – the fourth-largest food company in North America – announced a huge deal to combine with the recently private Heinz Foods. Heinz was taken private by a large investment group called 3G Capital in June 2013. Kraft, on the other hand, broke up its business the year earlier into two companies, Kraft Foods Group and Mondelez International. So both are coming from strange places in their long corporate histories.

This deal will create the third-largest North American food company and the fifth-largest in the world. But more importantly is the timing of this deal. Kraft is much larger in the United States. But Heinz is an enormous international food business. The Mondelez breakup left Kraft with restrictions on when and where it can sell products. Those restrictions are expiring. And by latching onto Heinz’s already-dominate international platform, there’s big money to be made overseas.

The problem is, Kraft doesn’t have a great track record with acquisitions or mergers. Its 2010 Cadbury acquisition did help boost revenue for Kraft, but the company couldn’t control its spending. Earnings plummeted 24% in the first quarter after the deal was finalized. Since then, it has been under fire for factory closings and employment layoffs it didn’t foresee prior to the agreement – which was itself a long and disastrous journey for Kraft shareholders.

That’s why all eyes are on its earnings. With Heinz still private, Kraft is taking the brunt of the attacks and praise of this deal. Buffett’s Berkshire and his new partner, 3G, will own 51% of the new Kraft Heinz Co. when it is finalized. So you can bet the world’s most prominent value investor has his gaze fixed on these numbers, which were released Tuesday after the bell.

Fortunately for the mac ‘n cheese giant, all was well . . . so far. Earnings beat estimates by more than 6%. And revenue grew a hair to $4.4 billion. More importantly, free cash flow climbed 11.4% year over year. And for new investors, not to mention creditors, worried about how the company will pay for this merger, there’s no sweeter sign than large cash flows.

Buffett has been quiet so far on this earnings announcement. But then again, he does play the long game when he invests. And that’s going to have to be the right course for this deal.

As of now, it’s too early to tell if Kraft is a better buy now or after the merger is finalized – estimated to happen later this year. But for those willing to jump in now, here’s what you can expect.

The new company will have a combined $28 billion in annual revenues. On the earnings side, with the two working together, managements are estimated to save approximately $1.5 billion in costs. The problem, however, lies in the shareholder value side of this deal. While the new company expects to eventually increase its dividend, for the meantime it is going to come out of the gate with flat shareholder distributions. And it won’t even be looking at share buybacks for more than two years after it combines.

There is a huge positive here, however. Kraft’s management – which performed poorly after its Cadbury acquisition – is not going to be taking the lead in the new company. The team from Heinz’s 3G Capital, or at least its leader CEO Bernardo Hees, will take over the top spots. And his success record is much, much better.

In just the two years since Heinz went private, Hees has overseen rapid margin expansion, from an EBITDA margin of just 18% in June 2013 to 26% today. That kind of efficiency could make this combination much easier to swallow than the Kraft-Cadbury combination a few years ago.

Right now, Kraft’s stock has already priced in the one-time dividend that shareholders will receive from this deal. Adjusting for that, it is properly valued compared to competitors like PepsiCo  (NYSE: PEP), Kellogg (NYSE: K) and General Mills (NYSE: GIS).

If you have a spot open in your long-term retirement account, you might want to sock away a small investment in Kraft now, before the deal is done and the Mondelez restrictions expire. Kraft may not be perfect. But as Buffett predicts, I believe Heinz is the right group to transform the company into a long-term success story. It’s not always smart to follow him into an investment. But this time, it looks like a smart bet to join up with the “Oracle of Omaha.”

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Published by Wyatt Investment Research at