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Wednesday, February 20, 2013

FINANCIALTIMES: Buffett brand has more beans than Heinz


February 18, 2013 7:42 pm

The investor has won every advantage in the deal, writes Alice Schroeder
By now the “Buffett deal” has become familiar: an investment by Berkshire Hathaway that includes high-yield preferred stock and very little risk. Berkshire’s purchase last week of Heinz fits the classic pattern. Before yawning, “he’s pulled off another one”, let us pause to consider some new shading that Heinz brings to the portrait of Warren Buffett as dealmaker and capitalist. Also worth noting are subtle signals that suggest where the US economy is heading. Mr Buffett has a history of being right about such things, so let us pay attention.
Through the deal, Berkshire and its partner 3G Capital, the Brazilian private equity firm, will each take half of Heinz in exchange for $4bn of equity. For another $8bn, Berkshire acquires redeemable preferred stock yielding 9 per cent and warrants(options that give investors the right to buy shares at an agreed price at some point in the future). The $72.50 per share cash transaction includes $12bn of new and assumed debt, valuing Heinz at $28bn.
What do these details tell us about Mr Buffett as a dealmaker? The most notable point concerns his tolerance for leverage. Heinz will sport $6 of debt for every dollar of equity – a ratio that has made bondholders and rating agencies uneasy. Mr Buffett bristles at applying the term “leveraged buyout” to the deal on the grounds that he does not intend to flip the company in a sale. That is a fair point. On the other hand, the deal does bark like an LBO – otherwise, the numbers would not work for the sellers. It may seem puzzling that Mr Buffett, who has criticised LBOs for decades, signed up to such a deal, but here is the twist. The leverage – which is very real for all the other parties – is largely illusory for Berkshire.

Even if Heinz loses money, Mr Buffett’s holding company is paid its preferred dividend. Only in the unlikely event of bankruptcy is Berkshire at risk. Should that happen, Berkshire would be in a position to wipe out other creditors. Its power to snag a cheaply restructured Heinz essentially eliminates Berkshire’s risk. No wonder bondholders are nervous.

These facts make it understandable that Mr Buffett would react to the term LBO as if it did not apply to him – because it does not. In effect, he has pulled off a leveraged buyout that leverages everyone but himself. While he has a well-established pattern of using other people’s money for Berkshire’s benefit, this sets a new bar. Generations of financiers to come will be studying his unparalleled creativity in finding low-risk ways to leverage.

Then there are the nuances the deal brings to our picture of Buffett the capitalist. However warm and grandfatherly he may be, the way he squeezed out every advantage in this deal underlines the fact he is as red in tooth and claw as any Wall Street predator. He is also exquisitely attuned to incentives, and worked out long ago there are many forms of currency. Here, he canonised his Brazilian partner, Jorge Lemann, who will be running the highly leveraged Heinz, as a hugely admirable businessman and “human being”. Mr Lemann, if he is smart, will use his reputational currency in other deals to extract actual money.

Mr Lemann and 3G did not secure the same terms as Berkshire, just as any future transactions involving Heinz are unlikely to be as attractive. Thus, there is no particular reason why – contrary to some forecasts – this deal signals a turn in the economy that should spark a wave of mergers and acquisitions. That said, Mr Buffett has reminded us that, when money is cheap, takeovers follow. In that sense, leveraged deals could be seen as central bankers’ gift to acquirers.

Even with the leverage that supported it, the lofty valuation that Heinz commanded raised questions about whether investors are chasing growth. A chorus of response quickly pointed out Heinz’s valuable brands as justification.

There is little doubt that people will be enjoying the famous ketchup, Lea & Perrins and other sauces 50 years from now. Yet the pace of brand erosion in all industries is accelerating. Mr Buffett is well aware of this. So too are supermarkets, which are pushing harder than ever to close the gap between Heinz and other brands’ prices. The justifiable premium for brands is declining. This deal actually strikes a cautious note about the decades-old philosophy of investing in great brand businesses at premium prices. When Mr Buffett made investments such as in Coca-Cola in the 1980s, he was happy to make unprotected bets on growth. Berkshire never bit on Heinz until now, when a deal arrived with terms that guarantee it a 6 per cent return.

In a world of near-zero interest rates, that 6 per cent looks pretty attractive. Mr Buffett, evidently, does not expect rates to rise sharply any time soon. A decade ago, he demanded a first-day return of 13 per cent before he would bother to consider a deal. Now the Oracle takes 6 per cent for his money. We should pay attention. There could hardly be a stronger signal that the investing tide has changed.

The writer is author of ‘The Snowball: Warren Buffett and the Business of Life’


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