Should You Pass on the Kraft Heinz Merger?

Kraft-LogoHindsight being what it is, I would have liked to have owned Kraft Foods Group (NASDAQ: KRFT) shares on March 24. Come March 25, I’d have woken up to a 33% gain that has since swelled to 45%.
But of course I didn’t own Kraft, and for what I thought were sound reasons: I didn’t want to own a no-growth company trading at 35 times 2014 EPS of $1.74.
Admittedly, 2014 EPS was blemished by a large “non-recurring” pension charge. EPS for the previous two years were $4.51 and $2.73, respectively. But weren’t they overstated for the same reason 2014 earning were understated – pension charges were improperly apportioned?  Oh well, “normalized” EPS for 2015 would be closer to $3.50.
Still, I remained on the sidelines. I also had no interest in owning an array of hidebound food brands whose heyday was the 1970s: Kraft Macaroni & Cheese, Jell-O, Cool Whip, Jet-Puffed Marshmallows, Oscar Mayer, Kool-Aid, Cheez Whiz. That a block of cheese-like product – Velveeta – can sit indefinitely at room temperature should give reason to pause.
More consumers are pausing. Kraft’s annual sales were $18.21 billion last year. In 2011, they were $18.66 billion.
So much for sound reasoning. Little did I realize alchemists were waiting in the wings. What’s more, they were waiting with promises of efficiency, cheap financing, and a $16.50 dividend.
I refer to 3G Capital and Berkshire Hathaway (NYSE: BRK-B). The combination might ring familiar. 3G Capital (lead by Jorge Paolo Lemann) and Berkshire (lead by Warren Buffett) hooked up a couple years ago for the leveraged buyout of H.J. Heinz. They’ve hooked up again. Heinz will take over Kraft.
The mechanics of the deal call for Heinz to offer one share of its stock for each Kraft share. There is one minor inconvenience. Heinz is private and will have to publicly list its shares in connection with the transaction. Asymmetrical knowledge should, therefore, raise an eyebrow (though it apparently doesn’t). Buffett and Lehmann have the best knowledge, if not only knowledge, of Heinz’s value.
But what about the $16.50 per share dividend?
3G Capital and Berkshire aren’t being magnanimous. If Heinz had offered all stock, 3G’s and Berkshire’s ownership of the combined enterprise would have dropped below 50%. Therefore, 3G and Berkshire are tossing in a $10 billion ($16.50 per share) dividend. This keeps 3G’s and Berkshire’s combined ownership of the new enterprise at 51%.
If you were to buy Kraft shares today, you can be sure of receiving a $16.50 per share dividend, and a likely equal haircut in share value. This isn’t to say Kraft shares (or the new Kraft Heinz) won’t rise. 3G Capital has a storied history of taking stagnating brands and milking them for all they are worth.
For instance, 3G Capital orchestrated the merger of brewery giants Anheuser-Busch and InBev in 2008.  Since then, gross margins of the combined entity have improved nearly 800 basis points. I hear 3G has worked similar magic on Heinz.
Like with Anheuser-Busch and Heinz, growth is non-existent at Kraft. The value proposition centers on deft handling of the scalpel. The new Kraft Heinz is expected to find savings of $1.7 billion annually by the end of 2017.
It won’t be easy. Virtually all of Kraft’s sales are generated in North America. By contrast, 62% of Heinz’s $11 billion sales are generated outside North America. It’s safe to assume that Heinz is running close to maximum efficiency, so it’s Kraft’s hide that will account for most of the savings. I’m skeptical that Kraft has that much hide to lose.
What’s more, I’m unconvinced more inefficiencies aren’t in the waiting. Offering diverse products across highly diverse consumer economies, Kraft and Heinz could as likely generate diseconomies of scale as synergy savings. This isn’t a company with a single-product offering, like beer.
Yes, I could be wrong again, but I’ll chance it. I’m taking a pass on this $16.50 dividend.

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