Apple, and Why Buffett Really Bought Heinz
Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
No doubt you’ve heard of Hedge Fund Titan David Einhorn. He has been plastered all over the news lately. Einhorn was pestering Apple (NASDAQ: AAPL) to pay out cash to shareholders. The interesting part is that Einhorn wasn’t pushing for a simple dividend increase on common stock.
Instead, Einhorn wanted Apple to create a special preferred equity instrument whose payouts were tied to Apple’s secure stream of earnings. Its seniority would rank below the bondholders but above the equity holders. Thus, a 4% – 5% annual return at par wouldn’t be unreasonable.
The interesting part is that Einhorn was playing a game of interest rates. Who are the likely buyers of such a preferred security? Fixed-income investors starved for yield. So while Einhorn would sit on a security paying a secure 4 – 5%, the equity prices would see extreme appreciation from institutional buying. (For more information, I covered this in my post “Apple Fiasco Proves That Interest Rates Could Blow Up.”)
Basically, Einhorn tried to seek a sturdy return in an environment where seemingly none can be found. Einhorn isn’t alone. Warren Buffett just did the same thing.
It almost makes perfect sense why Buffett’s Berkshire Hathaway (NYSE: BRK-B) bought Heinz (NYSE: HNZ). Almost. A look at Buffett’s 1978 letter to shareholders walks you right through what I call his “Buffett Framework.” According to the letter, Buffett looks for businesses with four characteristics. Here is how Heinz fits in.
1. “We find businesses we can understand”
2. “With Favorable long-term prospects”
Heinz has 30 consecutive quarters – 7.5 years – of revenue growth. In addition, Heinz continues to expand into emerging markets at a time when two-thirds of the company’s sales already come from outside the United States.
Also, Heinz sells 650 million bottles of ketchup at a price premium as high as 50% above competitors. Surprisingly, the ketchup market is one that is stubbornly difficult for competitors to break into. As Mary Buffett puts it, “It’s a love affair that has gone on for a century,” and she explains that “ketchup sets the table for all the other flavors found under a hamburger bun.”
All this to say that Heinz ketchup is not commoditized, and it likely won’t become commoditized in the future.
Add to Heinz’s strong market position its strong balance sheet and the fact that a private company can focus on the long-term without having to please short-term “quarterly-minded” shareholders, and we have a winner. (As an aside, this point about favorable long-term prospects is likely why Buffett is known to avoid tech companies, because in tech it is notoriously hard to look out 10 or 15 years.)
3. “Operated by honest and competent people” –
Heinz is run by sharp, civic-minded executives. Buffett puts it best:
Heinz has strong, sustainable growth potential based on high quality standards, continuous innovation, excellent management and great tasting products. Their global success is a testament to the power of investing behind strong brand equities and the strength of their management team and processes.
And if the management team were to leave, certainly 3G Capital could assemble a “competent” team.
4. “And priced very attractively” –
Price is where the investing world keeps getting hung up. Why did Buffett pay a 20% premium – 19% above Heinz’s all-time high? Especially when, in that same 1978 shareholder letter, Buffett explains that he likes buying slices of public equity because buying entire firms is so ridiculously expensive?
Interest rates. Buffett cautioned that Berkshire isn’t likely to continue producing 20%+ returns like it used to. Especially when rates are so low (after all, the supposed “riskless” return on the 10-year Treasury hovers at or below 2% before taxes).
That’s why I think Buffett views this deal from the lens of fixed-income, looking for a growing “equity-bond” that will increase payouts over time.
To Buffett, returns come from two places – appreciation of book value (often through reinvestment of earnings) and dividend payouts.
1. Book Value Appreciation
Buffett does a great job aligning himself with businesses that naturally expand. For example, Heinz sells ketchup to people. Over time, the world tends to have more people. Heinz sells its product throughout the entire world and is even growing its presence in emerging markets. Thus, Heinz should logically be able to continue its growth trajectory without too much additional capital investment.
However, right now I think that Buffett is really after the payout.
Buffett structured his deal so that he paid $12.12 billion – $8 billion for preferred stock that yields 9%, and the rest for common stock. A 9% return is good in most market conditions, especially when that return is backed by a stable business that grew revenue for 7.5 years, straight through a recession. But – a 9% return is coveted right now.
And with the 10-Year Treasury so low, who wouldn’t turn down a stable 9% yield from Heinz?
As for Buffett’s common stock, Heinz pays out a 2.84% dividend, according to institutional research firm ETFG.com. And that dividend has increased for eight years running.
So, for simplicity sake, assume that Heinz’s dividend payout ratio stays constant. I would assume that down the road Heinz’s growth in book value (through earnings) will kick into gear and its dividend increases will flourish as a result.
Thus, Buffett’s common stock investment could begin to rival the 9% fixed rate about the time that he starts eyeing returns above 9%. Looks like a smart hedge to me.
Heinz or Junk?
For comparison sake, take a look at Barclays Junk Bond ETF (NYSEMKT: JNK). According to ETFG, the ETF yielded just 6.265% per Wednesday’s close of $41.02. That’s a miserly return for “junk.” Here’s a list of its top 5 holdings:
For another example, look at Commercial Mortgage Backed Securities. According to real estate newsletter Sheets Sheets, “The average YTM for January 2013 high-yield paper fell to 5.0% for BB-rated issues versus 8.5% in October 2011.”
The conclusion? Across asset classes, investors are chasing yield.
Conclusion: The Price Is Attractive
From a fixed-income viewpoint, Buffett’s price is “very attractive,” satisfying his fourth criteria. Because I must ask: What other asset can return a durable 9%?
Now consider that Berkshire had $42.36 billion in cash and equivalents sitting on its balance sheet at YE 2012 that it could put to work. So, considering just the $8 billion investment in preferred shares, Berkshire earns a cool $720 million annually.
In short, the world is dumping money into junk bonds hoping to earn above 6%. But Buffett just got a leading consumer staple to pay him 9% on $8 billion cash. To most, an attractive price is one that allows for quick capital appreciation. But for Buffett, an attractive price is one that has a sturdy, stable return that will only increase with time.
And the interesting part is that Buffett got himself a deal that is perhaps enough to make even David Einhorn jealous.
Chris Marasco has no positions in any of the securities mentioned.