From an owner’s perspective, the advantage of having 3G operate your business is that a higher percentage of revenues become net profits that can be paid out to shareholders as dividends free and clear. The downside is that you cannot cut your way to prosperity, and eventually, you have to come up with growth initiatives.
Let’s look at what 3G did to Anheuser Busch since taking over. Even though the ADR of Anheuser-Busch began trading on July 1st, 2009, I am going to compare 2010 to 2015 because the 2009 recession distorts the picture of what 3G management does because the demand was unusually low for Anheuser-Busch products that year.
In 2010, Anheuser-Busch sold $36 billion in beer. It made $4.0 billion in profits. About 11% of revenues went to the bottom line as net profits. This is essentially a snapshot of what Anheuser-Busch looked like when it was run by St. Louis management because net profits as a percentage of revenue amounted to between 8% and 12% during the 1990s and early 2000s.
Fast forward to 2015, and the cost cuts and heavy investments into Brazil and Latin America have taken place. The debt load is quite high—Anheuser Busch Inbev has $51 billion in debt on its balance sheet—but Anheuser Busch is on pace to sell $47 billion worth of beer this year and generate $8.8 billion in net profits. That is the effect of 3G management—now almost 18% of beer sales will count towards the bottom line as net profits. This blows away anything that was done when the brewery was in Midwestern hands. Looking back at Anheuser-Busch’s records dating to 1984, I can only find three years where 13% of revenues went to shareholders as profits.
This is why Warren Buffett is enthusiastic about doing deals with 3G. That five percentage point gap between what 3G is doing right now and what Anheuser-Busch did during its most efficient year explains why Buffett likes the thought of turning slow-growth consumer products into dividend machines that send him fat checks. If Anheuser-Busch were still operated in St. Louis, the best you could hope for with $47 billion in sales would be $6.1 billion in profits. Realistically, based on what Anheuser-Busch was doing before the takeover, Anheuser-Busch would be earning $5.2 billion in profits right now. But because 3G is in charge, the profit figure is $8.8 billion. Over a five-year measuring period, that is the difference between 3G and the status quo.
Now, let us take a look at Kraft today. Kraft generates $18.3 billion in revenue, and creates $2.0 billion in net profit. In other words, 11% of revenues count as profits. This is very similar to the situation at Anheuser-Busch before 3G imposed its cost-cutting measures. Based on existing revenues, if 3G repeated its formula and increased the net profits to 18% of overall revenues, the profits at Kraft would grow to $3.3 billion. If it were valued at 18x earnings, it would be a $59 billion company by the time the cost cuts took full effect (and this assumption does not take into account any revenue growth from Kraft.)
The company is currently valued at $50 billion, and plus, you need to account for the $16.50 per share dividend that Buffett and 3G will be paying to KRFT shareholders to provide the necessary equilibrium so that the new enterprise Kraft-Heinz can be 51% owned by Heinz’s current owners and 49% owned by the current Kraft shareholders.
How it will work is this. Someone who owns 100 shares of Kraft right now will receive a one-time payment of $16.50, or $1,650. If you choose to reinvest it into the new Kraft-Heinz enterprise, the valuation should be around $68.50 per share after the $16.50 cash dividend gets paid. So $1,650 reinvested at $68.50 would get you 24 shares of the new enterprise.
Obviously, market prices can fluctuate, but the current status quo indicates that a buy-and-hold Kraft investor with 100 shares of KRFT right now will end up with around 124 shares of The Kraft-Heinz Company as the merged company begins its corporate life (assuming reinvestment of the one-time dividend payment).
What makes the 3G deal for Kraft more attractive than the Anheuser-Busch deal is that Heinz possesses 26% of the global ketchup (and has over half of the Ketchup market in the United States). Kraft does not have that kind of international platform. About 85% of the company’s revenues occur in the United States, and Kraft gave away the distribution rights to some of its brands when it split off from Mondelez. The attractive theory is that Kraft brands like A1 steak sauce, which Kraft has the right to distribute internationally but has not really begun doing yet, will benefit from the Heinz platform because 3G will be able to grow revenues by making A1 steak sauce at its international ketchup factories and selling Kraft products alongside it. The devil may be in the execution, but there is a clear path for revenue growth for Kraft brands using the Heinz international distribution network that was not readily available during the Anheuser-Busch acquisition.
The cynical view of this transaction is that 3G operates in a way that causes elite talent to flee and is heavily associated with wringing the maximum amount of profit out of existing products rather than coming up with new developments on its own (for instance, the Anheuser-Busch revenue growth between 2010 and 2015 was the result of price increases and Brazilian beer acquisitions paid for with debt, rather than the organic development of in-house beer products.)
Warren Buffett did not talk about this at the most recent shareholder meeting, but there is a difference between what Berkshire Hathaway attracts and what 3G attracts. Buffett has spoken repeatedly about Berkshire’s benefit in acquiring private businesses without any bidding competition because of his genteel leeway with operations. He doesn’t gut out businesses, and if that’s your life work, the continuation of the culture status quo is something you care about enough that you might sell your business at a moderate discount if you believe your life’s work will remain generally intact. This is especially true if you want to sell your business, collect a million-dollar payday, and continue working as CEO. People flock to Berkshire because it permits long-term capital investments and the preservation of cultural status quos.
That is not true at 3G. I have never heard of any businessman or businesswoman talk about wanting to be subject to the authority of 3G. If you are plainly brilliant and have a net worth of $25 million, you don’t want to ask for permission to use the copy machine. Online forums are filled with Anheuser-Busch employees plotting exit strategies and looking for work elsewhere. Prior to 3G, the demand for such an online forum to develop would have been non-existent. The effects of this kind of thing are hard to measure, and that is why people tend to ignore it and favor the discussion of numbers, but it is logically unsound to claim that these things don’t matter just because they can’t cleanly be measured.
In this regard, 3G reminds me of Nabisco after Adolphus Green left. You can cut costs and raise the dividend for ten to fifteen years, and this keeps shareholders happy in the interim, but it lacks the structural stability of something like Hershey where revenues naturally grow at 7% annually and you get your 10.5% earnings per share growth without having to be especially creative. It is entirely possible that the Kraft-Heinz deal happened because 3G ran out of ways to cut costs at Heinz, and figured it could buy ten to fifteen years of time by slashing costs at Kraft and achieve revenue growth by augmenting Kraft products to the Heinz international distribution platform.
Originally posted 2015-05-27 20:47:53.