Analysis Of the Kraft-Heinz Merger

Investment firms, 3G capital and Berkshire Hathaway, have teamed up to create a new company through the merger of H.J. Heinz Co. and The Kraft Foods Group (NASDAQ:KRFT). ^[1] The new company thus created will be called The Kraft Heinz Company. ^[2] In terms of annual sales, it is expected to be the fifth-largest food company in the world  and the third-largest in the U.S.. ^[3] In this article, we summarize the details of the deal and analyze how the fortunes of this new enterprise might evolve.

We currently have a $64 per share price estimate for Kraft Foods Group, which is significantly below its current market price.

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The Merger

According to the terms of the deal, the current shareholders of Heinz will hold a 51% stake in the newly formed company. These shareholders include 3G Capital and Berkshire Hathaway. The remainder will go to the current shareholders of Kraft. To sweeten the deal for Kraft’s shareholders, they have been provided a one-time cash dividend of $16.50 per share. The cost of this dividend, which amounts to $10 billion, will be borne by 3G Capital and Berkshire Hathaway. This will be paid out as soon as the deal is finalized. The amount of this dividend is more than a quarter of the closing share price of Kraft on March 24. ^[3] Each share of the Kraft Foods Group will entitle the shareholder to one share of the new entity. The shareholders will however have to be more patient to enjoy the full benefits of any improvement in operations of the combined entity, since the transaction is expected to be EPS accretive only by 2017. ^[4] The agreement to form a new company was unanimously approved by both the companies’ board of directors. ^[2] The deal has been valued at around $45 billion. The combined company will have annual sales revenue of approximately $28 billion. ^[3]

The new company will have at its helm leaders drawn from the two merging entities. The chairman of Heinz, Alex Behring, will assume chairmanship of the new company. The vice chairmanship will be reserved for Kraft’s current chairman and CEO, John Cahill. Bernardo Hees, the CEO of Heinz, will retain his title as the two companies merge into a single firm. ^[4]

Synergies Expected: International Growth and Economies Of Scale

There are various ways in which the management hopes to leverage the synergies that the combination of these two large food companies should provide. Heinz has a global footprint. It derives 60% of its sales from regions other than North America. Emerging economies contribute 25% of its sales. Kraft, on the other hand, derives 98% of its sales from North America. This provides scope for the combined entity to sell Kraft’s brands in international markets. However, that opportunity set would be limited by Kraft’s agreement with Mondelez International, which was spun off from Kraft’s namesake parent company in 2012 to focus on international growth. During the spin-off, Mondelez acquired the rights to sell many of their shared brands in international markets. Going by Kraft’s presentation on the deal, some iconic brands that don’t fall under this purview are A.1., Velveeta, Planters, MiO and Lunchables. ^[5] The sales of such brands outside North America could provide a boost to the new firm’s revenue growth.

The management of the two companies have also announced that they expect to realize $1.5 billion in annual cost savings by the end of 2017, as a result of this deal. ^[4] The cost synergies will mostly come from higher economies of scale in the North American market. Having larger volume of sales will help the company drive better bargains with clients such as large retail outlets and specialty food stores and restaurants. This will improve operating margins of the company and also give it an advantage in getting more shelf space in retail outlets. Some part of the cost savings will also come from the ability of the combined company to refinance Heinz’s high-yielding debt. Since Kraft has a much better credit rating, the combined entity will be able to replace such debt with low-yielding, investment-grade debt. Additionally, Heinz’s preferred stocks that become callable in June 2016 will also be replaced with such debt. This will help reduce the total cost of capital for the combined company. ^[5]

In addition, changes to the operations strategy can also contribute to cost savings. These could be targeted at reducing headcount, shutting down less efficient manufacturing facilities and implementing zero-based budgeting. Zero-based budgeting means that the managers have to explain every forecast expense for the year from scratch, without appealing to previous years’ trends. This helps the top management enforce a more stringent form of cost control and realize cost savings. Since the chairman-CEO team at the new company will be the same as that which implemented drastic cost cutting measures at Heinz, including a reduction in force of 4%, closing several factories and grounding corporate jets, there is reason to believe that the projected changes to the combined company’s operations strategy would be successfully implemented. ^[5]

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