Wednesday, March 25, 2015

Kraft is a Great Company For Heinz to Purchase

     Today’s blockbuster news event was the announcement the Heinz and Kraft would merge.  Bloomberg provides a good,overarching analysis of the deal:
The deal creates a stable of household names -- everything from Heinz ketchup to Jell-O -- with revenue of about $28 billion. It also could presage more consolidation in the U.S. food industry, which is struggling to reignite growth. Buffett and 3G, the private-equity firm founded by Brazilian billionaire Jorge Paulo Lemann, previously teamed up to buy Heinz in 2013 and they cut costs, a strategy they aim to repeat with Kraft.
It’s impossible to argue against the logic of this deal.  Heinz, which, like Kraft, owns numerous iconic American brands, was taken private a few years ago.  Now that private equity has cut costs and increased the company’s efficiency, the next logical business step is to go into acquisition mode to increase the company’s product offerings and market footprint.  Not only do Kraft’s product offerings complement Heinz’s, but the companies can potentially achieve a large amount of synergy and cost savings from their respective positions as market leaders in the consumer staples industry.  The deal illustrates why numerous investors still have tremendous admiration for Buffet’s investing acumen.
     Let’s take a look under Kraft’s financial hood starting with their balance sheet.  Asset structure has been remarkably consistent for the last four years, with total assets fluctuating between $21-$23 billion and the composition of those assets remaining near constant levels.  In 2012 the company added $9.9 billion in long-term debt.  But, using their highest interest expense and lowest EBITDA readings for the last five years, interest coverage is still a healthy 4.74.  The current ratio stands at one.  While this would normally create a bit of concern,   receivables and inventory levels are firmly under control, indicating the company is very well managed financially. Finally, with a large consumer staples company like Kraft, a tighter balance sheet should be expected.   
     Kraft’s income statement shows why this merger has tremendous opportunities.  Top line revenue has stalled between $18.2-$18.6 billion for the last four years.  Their biggest problem is the ease with which consumers can purchase substitute goods -- an especially prevalent activity when overall wages have stalled.  There have also been some short-term issues.  Last year the company had a huge, 10% drop in their gross margin, which was entirely attributable to a recalculation of pension liabilities.  Without this loss, EPS would have been 4.82.  But with the loss, EPS was $1.74.  While the company also had an increase in SGA expenses, the overall level rose to one more consistent with recent history.  Because Kraft and Heinz are in the same business, the merger should create tremendous cost savings and synergy, leading to margin expansion over the next 1-3 years.
     Finally, free cash flow to the firm has fluctuated between $1.4 and $2.5 billion for the last five years giving the company ample funds to self-fund all of their activities.  And their cash investing needs, which are solely derived from plant, property and equipment investment, have been very predictable for the last five years; they’ve fluctuated between $440 and $557 million.     
     Kraft was a great company before the merger.  It was the owner of numerous brands that are a staple of the US market.  The company managed its assets incredibly well and literally printed money.  Now with the addition of another major US consumer staple company, the combination can achieve major cost savings by eliminating duplicative operations and achieving even larger economies of scale.