by Erin Lash, CFA
Authors can be reached at Analyst FeedbackMorningstar's Editorial PoliciesThesis 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.
Valuation
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.
Risk
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
Financial Health:
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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