Thursday, March 26, 2015

Zero-based Budgeting Book

By the way, there is a lot of talk now again about zero-based budgeting because of the Kraft-Heinz merger.  Some view cost-cutters as people who just come in and blow-torch the place, take out short-term profits and destroy the business.  Maybe this was done in the 1980's.

But there is a lot more to it than that these days, especially when folks like 3G / Buffett are involved.  They want to create value in the long term.

Anyway, this book,  How to Double Your Profits in 6 Months or Less is apparently the 'bible' at 3G and is handed out to managers at their companies.  Zero-based budgeting is a lot older than this book, though, so the title of this post might be a little misleading.

It's an awful book title, like, How to Lose 50 pounds in Three Days! but it really is a good book.  It's a quick read too.

There are things that will make you cringe.  I don't agree with all of it.  Like not paying bills until you are billed for it twice and things like that.

But most of the other things are really sensible.

For employees, he doesn't advocate just firing everyone left and right and cutting salaries.  Fifer actually advocates paying productive employees more and paying less productive employees less (or getting rid of them).   He says that most companies pay based on seniority so the old guys are happy and the young, productive guys are unhappy.  You should do the opposite; make the young, productive guys happy and the old, unproductive guys unhappy.  This will lead to better results.

I've worked in a large, bloated, bureaucratic organization and saw this first hand.  Pay was based mostly on seniority and competence had nothing to do with anything.  So what happened?  The young, capable people left for higher paying jobs elsewhere (at companies that paid for performance), and the unskilled, unmotivated and not-so-competent stayed. And they got pay raises every year.  This continued for years until you had this huge, bloated middle of people getting paid a lot of money for doing nothing and an unhappy work force at the bottom who didn't stay long.

The funny thing about these companies is that since they don't like to fire people, and only one person can be CEO, the pyramid just keeps getting bigger and bigger.

I have seen first hand how someone gets old enough to become a head of a division, but all current divisions already have heads.  So what do they do?  They create another one.   And if more people reach a certain age and are eligible for a promotion to division or section head, they will just create another division or section.

And this goes on and on.

I imagine the big food companies like BUD, HNZ and KRFT are (or were) like this too; that's why it's so easy for outsiders to come in and boost margins by 8% in such a short period of time.   I bet the rest of the companies (KO etc.) are in the exact same position.

And it will usually take outsiders (I don't mean outsider in the Thorndike (Really Great Book) sense, but outsider in the sense of not being a lifer at the company).

Lifers and long-time employees can't do what 3G does.  If you work at a company for a long time, you know a lot of people.  You have mentors and mentees.  You've done favors and received favors from people in the company.  You've encouraged people to stay at the company.  Encouraged them to join.  Helped them start divisions and new businesses, supported new ideas which might have lead to creation of new sections/divisions etc.   You've been to weddings and bar mitzvahs.  You just know too many people.  So it will basically be impossible for a normal human being to make rational decisions.

Maybe someone can, but I think it's hard.

Anyway, it's a really good read.  Again, you won't agree with everything in there (but then again, when was the last time you read a book and agreed with everything in it?), but there are a lot of great ideas.  And you will see that what 3G is doing is not so one-dimensional and simple.  It's not just firing people for the sake of firing people.  It's not about cutting costs for the sake of cutting costs.  It's not either/or or a transfer of wealth from the middle class to the top 1% (which is the way the mainstream press likes to present these things).

Other Books I've Read Recently
I do read a lot but most of the time, I don't want to bother with 'reviewing' any book properly.  But I do mention books that I really like here.   If I had a lot to say about any particular book, they will be their own separate post, of course.  I've done that in the past.

But since this is sort of a book post, I thought I'd just mention some books I read recently:

Marissa Mayer and the Fight to Save Yahoo!
This was actually a lot better than I thought.  I only read it because of the current situation with Alibaba and Yahoo.  I've owned Yahoo for a long time (mostly as an Alibaba stub trade), but I wanted to get more of a sense of what's going on there in the Mayer era.

The book title is a little misleading as this book is almost a history of Yahoo and the internet itself.  It gives a really good, broad overview of the internet era.

There are a lot of interesting things about the previous CEO's too which to me were a little eye-opening.  Maybe not for some people who follow the industry closely.  But it was definitely interesting, with a lot of inside views too.  There is some detail on the interaction with Loeb and his involvement etc.

This is also a quick read and I found it definitely worth my time.

Setting the Table: The Transforming Power of Hospitality in Business
This is a book written by the Shake Shack founder Danny Meyer.  I am a sucker for books written by people who have done interesting things.   Think about it.  Most books are written by people who have never done what they write about.  That's not necessarily bad.  Journalists never do things they write about, but they write great books too.

Danny Meyer is someone who has created something really great, so it's great to hear what he has to say about his experience.   I enjoyed it.

Haunted Empire: Apple After Steve Jobs
This is a book that was widely panned.  I didn't have any interest in it either until, frankly, Tim Cook mentioned it.  That was when I decided I had to read it.  If a CEO is going to go out of his way to respond to a book, I figured, there must be something interesting in there.   If a book is really totally off and is nonsense, they are usually ignored.

The Amazon reviews, predictably, form a barbell shape.  They are either one star or five star.  If you love Apple, then you rate it one star.  If you don't like Apple it's five stars.

Some of the criticism is valid.  A lot of these stories are nothing new (labor practices in China), but there is plenty of other stuff in there that caught my interest.

My view on Apple hasn't really changed.  It's a great company with great products, but to me it's still a Steve Jobs company and Apple has been putting out iterations and updates to his creation.  I don't really have any faith that Apple will do anything as groundbreaking in any other area to the same degree.

This has nothing to do with my view of current management, which I think is as good as there is.  I wonder if even Steve Jobs can keep coming up with world-changing things.  At some point, no matter how innovative and earth-shattering, eventually you become the 'establishment'.  You become the target.

Apple will continue to innovate and make great products, I'm sure.  But what I don't have confidence in is that the next product will have the same sort of magnitude of growth for Apple that the others have had. If you look at how the iPod went to the iPhone, that's a huge leap.   The iPhone is a huge product.  The next thing has to be even bigger, or just as big just for Apple to stay in place.  This is the part I have a question about.

And sure, the iPhone upgrades may keep going for another cycle or two.  But at some point, as Clayton Christensen points out in the Innovator's Dilemma, the incremental improvement will exceed the needs of the consumer, at which point the product cycle will end (opening up an opportunity for alternatives).

But again, who the heck knows what will happen with Apple.

Netflixed: The Epic Battle for America's Eyeballs
This is also a great read on the story of Netflix, definitely a game-changing company.  Of course, one thing that sticks to me is how Blockbuster passed up an opportunity to buy Netflix early on for $40 million, I think it was.  Talk about an error of omission!

This is also a great read because it's not only about Netflix, but about business in general and how businesses can go wrong.   This book is almost as much about Blockbuster as it is about Netflix.  So it's almost a text book on "how to fail".

Blockbuster's mistakes are obviously being made today by many.  So it's good to learn about what went wrong there.


So 3G/BRK made their move and Kraft it is.   Buffett was on CNBC this morning and he said that BRK paid $4.25 billion for common stock in Heinz initially and will pay another $5.2 billion to get this deal done for a total common equity investment of around $9.5 billion.   After this deal closes, BRK will own around 320 million shares of the new Kraft-Heinz of a total 1.22 billion or so shares outstanding.   That puts BRK's cost per share at just under $30/share.    KRFT closed at $83.15/share yesterday.   Taking out the $16.50/share special dividend that will be paid out to the old KRFT shareholders (and BRK won't get), that puts the ex-dividend price of KRFT at $66.70/share, so that's roughly a double for BRK.  BRK also owns preferred shares and warrants.

$66.70/share and 320 million shares owned means that this stake is worth $21 billion, and this would be a listed stock holding.

This is great news for people who think BRK's equity portfolio is too financials-heavy.

As a refresher, check out BRK's equity portfolio at the end of 2014:

So this would be a gigantic position, second only to Wells Fargo.

What are They Paying for KRFT?
This is an unusual deal.  Usually, mergers/acquisitions are for cash, listed stock or some combination of them.  This one is a combination of cash and an unlisted stock.  So there is no fixed value (as in an all cash acquisition) or market value (price of acquirer's stock) to measure this deal against.

I wonder what merger arbs do in this case.  Usually, they buy the stock against a fixed price (in an all cash acquisition), or they buy the target and short the buyer against it (in a stock-for-stock merger).  Here, what do you do?

I guess you can view the $16.50/share special dividend as sort of the premium on the deal.  KRFT's pre-announcement price was around $62/share so this premium is around 27%.  KRFT shareholders receive $16.50/share in cash and one share of the new Kraft-Heinz for each KRFT share.

But let's say yesterday's closing price, $83.15/share is the acquisition price.   What is the valuation at this level?

P/E ratio
KRFT's EPS in 2014 and the estimates for 2015 and 2016 were:

                  EPS            P/E
2014a        $3.15          26.4x
2015e        $3.24          25.7x
2016e        $3.47          24.0x

So the current price implies an acquisition price of 26.4x P/E, pretty high.

EBITDA in 2014 was $3.6 billion (both the above EPS and EBITDA exclude a non-cash charge for post-retirement benefit expense), and EV is around $56 billion so that comes to 15.6x EV/EBITDA.

Price After Synergies
That seems high.  But they said there is $1.5 billion in synergies to be expected.   If we adjust the above figures, we can get $5.1 billion in EBITDA; that would bring the deal price down to 11x EV/EBITDA post-synergy.  For EPS, we can add $1.5 billion after, say, 30% tax and using 588 million shares.  That would add close to $1.80/share in after-tax earnings per share.  Add that to the $3.15/share and we get $5.00/share post-synergy EPS.  That brings the acquisition price down to around 17x P/E.    11x EV/EBITDA and 17x P/E is very reasonable.

What is the New KRFT Worth?
Well, this is the key issue.  The above acquisition price is sort of circular.  The more we think the post merger entity is worth, the higher the old KRFT price will go up, and the higher the acquisition price will look.  Even if the current KRFT stock price went up a lot, the cost to HNZ to acquire KRFT will not increase at all as the cash portion is fixed, and the stock portion will not increase. Regardless of how high the old KRFT goes, shareholders will still only receive one new share of the new KRFT.

Anyway, let's take a look at the post-merger valuation of KRFT.  First of all, we have to adjust the current price for the $16.50/share special dividend that will be paid once to the old KRFT shareholders.

Ex-dividend, the new KRFT would be trading at around $67/share.    There will be 1.22 billion shares outstanding, and net debt will be $28 billion.  This includes repaying the preferreds to BRK and replacing it with debt.   Therefore, post-merger, the EV would be around $110 billion.

Adjusted EBITDA at HNZ in 2014 was $2.8 billion, and the old KRFT had EBITDA of $3.6 billion (again, this excludes the post-retirement benefit adjustment so will differ from what you may see elsewhere).   That gives us total EBITDA of $6.4 billion.

On this basis, the new KRFT is already trading at 17.2x EV/EBITDA.

That seems a bit on the high side.  But wait.  There will be $1.5 billion in synergies, so we might have to put that in.  We can just add $1.5 billion to the $6.4 billion combined EBITDA and then we get a pro-forma combined EBITDA of $7.9 billion.   That gets us to EV/EBITDA of 13.9x EV/EBITDA.

We'll start with the combined $6.4 billion EBITDA.   Take out D&A for both of $961 for an EBIT of $5.4 billion.   Take out $1.2 billion of interest expense and we get $4.2 billion in pretax income.   But this interest expense actually doesn't include $8 billion of preferreds, which will be refinanced with investment grade debt.   They say current HNZ debt and this preferred stock will be refinanced by investment grade debt, but let's just use 5% for now.   That's another $400 million of interest expense (for the preferreds that get refinanced at 5%).  So pretax income is actually $3.8 billion.   (It's a little complicated, but I think the preferreds don't show up in the Heinz 10-K because they are at the parent company level.  The 10-K only includes financials of the subsidiary and not the parent (that's why you don't see preferred stock on the balance sheet or preferred dividends in the income statement)).

Using a 30% tax rate (I used 24% for HNZ and 33% for the old KRFT for a 40/60 blended rate), that's net income of around $2.7 billion.   That's $2.20/share in EPS for a 30x P/E for the new combined entity at $67/share.    That's kind of expensive.

But then again, let's include the synergies.  Then we get $6.4 billion + $1.5 billion = $7.9 billion in EBITDA, take out D&A of $961 million for EBIT of $6.9 billion.  Take out $1.6 billion in interest expense (which includes preferreds converted into debt at 5%) for pretax income of $5.3 billion.  After tax, that comes to $3.7 billion in net income or $3.00/share in EPS.   That brings down the P/E to 22.3x. 

This doesn't take into account the refinancing of current HNZ high yield debt into investment grade debt.

By the way, even though they won't give us long term guidance on growth, one of the major factors in this deal is growth.  Most of KRFT's sales are in the U.S. while HNZ has 60% of sales outside the U.S.  The idea, like in the Burger King/Horton deal, is to use HNZ's global distribution platform to increase sales of KRFT products around the world.   This is probably too aggressive, but just imagine if KRFT's sales breakdown evolved to something simliar to HNZ's; a double in sales?

By the way, the old KRFT had these margins:

EBITDA margin:      17.6%
Operating margin:     20.0%

After 'synergies', their margins would be:

EBITDA margin:       28.0%
Operating margin:      25.8%

For the new entity, the margins would be:

EBITDA margin:       22.0%
Operating margin:      18.6%

After synergies, this would be:

EBITDA margin:        27.2%
Operating margin:       25.2%

For reference, here are some comps; their current valuations and margins:


*For K, I used "comparable" figures, which exclude charges.

With the best margins out there (and similar to KO), there shouldn't be a problem with the new KRFT trading at 22x P/E and 14x EV/EBITDA.   Yes, we are assuming the $1.5 billion in synergies get realized, but when you look at what 3G has done in the past, I don't have any doubt it will be realized.

For reference, here are some figures from the HNZ merger proxy back in 2013:

This is what the comps were trading at back in 2013.  Maybe this is not so useful but it's good to look at everything so...

    Enterprise Value/EBITDA  P/E
Company  LTM  CY 2013E  LTM  CY 2013E
Campbell Soup Company
    9.7x    9.8x  14.9x  14.7x
ConAgra Foods, Inc.
    9.9x    9.8x  13.8x  13.9x
General Mills, Inc.
  10.1x  10.0x  15.6x  15.3x
The Hershey Company
  13.4x  12.5x  24.9x  22.2x
The Kellogg Company
  11.6x  10.9x  17.3x  15.4x
Kraft Foods Group, Inc.
  10.8x  10.4x  not meaningful  16.2x
Groupe Danone S.A
  10.3x    9.7x  16.9x  16.1x
Mondelēz International, Inc.
  13.9x  12.5x  not meaningful  17.6x
Nestlé S.A.
  12.2x  11.1x  19.3x  17.7x
PepsiCo, Inc.
  10.6x  10.2x  17.3x  16.4x
Unilever PLC
  10.9x  10.2x  18.6x  17.1x
The results of the analysis were as follows:

  Enterprise Value/EBITDAP/E
  LTM  CY 2013ELTM  CY 2013E
11.2x  10.6x17.6x  16.6x
10.8x  10.2x17.3x  16.2x
11.9x  11.2x17.3x  16.4x

And here is the precedent transactions of comps:

Selected Precedent Transactions Analysis
Centerview analyzed certain information relating to selected transactions since 2000 in the food industry with transaction values over $3.5 billion that Centerview, based on its experience and judgment as a financial advisor, deemed relevant to consider in relation to Heinz and the merger. These transactions were:

Date of Transaction
  Target  Acquiror  Transaction
Value /
Value /
November 2012
  Ralcorp Holdings Inc.  ConAgra Foods, Inc.

  $6.8    1.5x    11.9x  
November 2010
  Del Monte Foods Co.  Funds affiliated with Kohlberg Kravis Roberts & Co. L.P.,
Vestar Capital Partners and Centerview Partners
  $5.3    1.4x    8.8x  
January 2010
  Kraft Foods’ North America frozen pizza business  Nestlé S.A.  $3.7    1.8x    12.5x  
July 2007
  Group Danone S.A.’s biscuits division  Kraft Foods Group, Inc.  $7.2    2.6x    13.2x  
December 2000
  Quaker Oats Co.  PepsiCo, Inc.  $14.0    2.8x    15.6x  
October 2000
  The Keebler Company  The Kellogg Company  $4.4    1.6x    11.1x  
July 2000
  Pillsbury  General Mills, Inc.  $10.5    1.7x    11.0x  
June 2000
  Nabisco Holdings Corp.  Philip Morris Companies Inc.  $18.9    2.1x    13.2x  
June 2000
  Bestfoods  Unilever PLC  $24.3    2.6x    13.9x  
No company or transaction used in this analysis is identical or directly comparable to Heinz or the merger. The companies included in the selected transactions are companies with certain characteristics that, for the purposes of this analysis, may be considered similar to certain of Heinz’s results, business mix or product profile. Accordingly, an evaluation of the results of this analysis is not entirely mathematical. Rather, this analysis involves complex considerations and judgments concerning differences in financial and operating characteristics and other factors that could affect the public trading or other values of the companies to which Heinz was compared.
For each of the selected transactions, based on information it obtained from SEC filings, FactSet, Wall Street research and Capital IQ, Centerview calculated and compared transaction value as a multiple of LTM sales and LTM EBITDA, with LTM EBITDA excluding one-time expenses and non-recurring charges. This analysis indicated the following multiples:

Implied Enterprise Value
as a Multiple of:
  2.0x    12.4x  
  1.8x    12.5x  


Company  EV  EV/EBITDA  
    ($ in millions)  2013E  P/E 2013E
Nestlé S.A.
  $233,969    11.3x    17.6x  
PepsiCo, Inc.
  135,550    10.3x    16.5x  
Unilever plc
  123,112    10.5x    17.8x  
Mondelēz International, Inc.
  75,436    12.6x    17.6x  
Groupe Danone S.A.
  50,478    10.0x    16.0x  
Kraft Foods Group, Inc.
  37,387    11.1x    17.4x  
General Mills, Inc.
  37,561    10.4x    15.2x  
Kellogg Company
  29,064    10.8x    15.4x  
The Hershey Company
  19,605    12.5x    22.1x  
ConAgra Foods, Inc.1
  24,429    9.5x    12.8x  
Campbell Soup Company
  16,281    9.9x    14.6x  
The J.M. Smucker Company
  11,639    9.3x    16.2x  
McCormick & Company, Incorporated
  9,614    13.0x    19.6x  
Hormel Foods Corporation
  8,990    9.9x    18.0x  
1Financial data were pro forma for the Ralcorp acquisition.
This analysis indicated the following mean and median multiples for the selected companies and for Heinz:

Selected Public Companies
Heinz –

Heinz – Street

    Mean  Median  
  2013E  10.8x  10.5x  11.1x11.2x
  2013E  16.9x  16.9x  16.4x16.4x
Moelis then used its professional judgment and experience to apply ranges of selected multiples derived from the selected companies of (i) 9.5x to 11.5x, in the case of the EV/EBITDA multiple for calendar year 2013, and (ii) 16.0x to 18.0x, in the case of the P/E multiple for calendar year 2013

Selected Precedent Transactions Analysis. Moelis reviewed financial information of those transactions announced between 2000 and 2012 involving large target companies with significant food businesses that Moelis deemed generally comparable to Heinz in product mix and geographic scope. Moelis reviewed, among other things, transaction values of the selected transactions and the merger as a multiple of EBITDA for the most recently completed twelve-month period (“LTM”) for which financial information had been made public at the time of the announcement of each transaction, unless otherwise noted. Financial data for the selected transactions were based on publicly available information at the time of announcement of the relevant transaction. The list of selected transactions and the related multiples are set forth below:

  Target  Acquiror  EV
($ in thousands)
Dec. 2012
  Morningstar Foods, LLC  Saputo Inc.  $1,450    9.3x  
Nov. 2012
  Ralcorp Holdings, Inc.  ConAgra Foods, Inc.  6,775    12.1x  
Feb. 2012
  Pringles Business of Procter & Gamble Company  Kellogg Company  2,695    11.1x1 
June. 2010
  American Italian Pasta Co.  Ralcorp Holdings, Inc.  1,256    8.3x  
Jan. 2010
  North American Frozen Pizza Business of Kraft Food Global, Inc.  Nestlé S.A.  3,700    12.5x  
Nov. 2009
  Birds Eye Foods, Inc.  Pinnacle Foods Group, Inc.  1,371    9.5x  
Sept. 2009
  Cadbury plc  Kraft Foods Inc.  21,395    13.3x  
June 2008
  The Folgers Coffee Company  The J.M. Smucker Company  3,398    8.8x  
Apr. 2008
  Wm. Wrigley Jr. Company  Mars, Incorporated  23,017    18.4x  
Nov. 2007
  Post Foods  Ralcorp Holdings, Inc.  2,642    11.3x1 
July 2007
  Global Biscuit Business of Groupe Danone S.A.  Kraft Foods Global, Inc.  7,174    13.6x1 
Feb. 2007
  Pinnacle Foods Group, Inc.  The Blackstone Group, L.P.  2,142    8.9x  
Aug. 2006
  European Frozen Foods Division of Unilever plc  Permira Advisors Ltd.  2,199    9.9x1 
Aug. 2006
  Chef America, Inc.  Nestlé S.A.  2,600    14.5x  
Dec. 2002
  Adams Confectionary Business of Pfizer Inc.  Cadbury Schweppes plc  3,750    12.8x1 
Oct. 2001
  The Pillsbury Company  General Mills, Inc.  10,396    10.1x2 
Dec. 2000
  The Quaker Oats Company  PepsiCo, Inc.  14,010    15.6x  
Oct. 2000
  Keebler Foods Company  Kellogg Company  4,469    10.7x  
June 2000
  Nabisco Holdings Corp.  Philip Morris Companies Inc.  19,017    13.7x  
June 2000
  International Home Foods  ConAgra Foods, Inc.  2,909    8.5x  
May 2000
  Bestfoods  Unilever plc  23,503    14.5x  
1 Financial data were based on latest available fiscal year end information; not latest quarter-end information.
2 Financial data reflected revised deal terms pursuant to a second amended merger agreement.

This analysis indicated the following mean and median multiples for the selected transactions and the merger were as follows:

Selected Transactions

The Merger

      Mean  Median
    11.8x  11.3x13.7x
since 2009)
    10.9x  11.1x13.7x
Moelis then used its professional judgment and experience to apply a range of selected multiples derived from the selected transactions of 11.0x to 14.0x LTM EBITDA to Heinz’s LTM EBITDA as of the announcement date of the merger. This analysis indicated the following implied per share reference range for Heinz (rounded to the nearest $0.25), as compared to the per share merger consideration:

Moelis determined that a fair value range for HNZ, based on previous food company deals, was 11.0x - 14.0x LTM EBITDA.

So according to this, KRFT is currently trading within range.  Keep in mind that the new KRFT is going to have tremendous margins and some real growth opportunities.

So this deal looks really interesting.  Some people are skeptical of these cost-cutting deals but I think the 3G guys are really good.  Sales is not growing at HNZ currently because they were rationalizing their SKU line-up, cutting unprofitable lines etc.

The right way to look at this is that the special dividend itself is the acquisition premium.  Something around 30% is typical in takeovers.

Other than the special dividend, old KRFT shareholders end up with one new Kraft-Heinz share.  What does that mean?  At the pre-deal price of $62/share, old KRFT shareholders owned a company trading at around 20x ttm P/E and 12.4x EV/EBITDA.   This company had an operating margin of 18% and EBITDA margin of 20%.

Post deal, before an increase in the stock price (other than the amount of the special dividend), on a pro-forma basis at $62/share, the old KRFT shareholder would own the new Kraft-Heinz that trades, on a pro-forma basis at 21x P/E and 13x  EV/EBITDA, a pretty similar valuation.  But the pro-forma operating margin would be 27% and EBITDA margin would be 25%.

That sounds like a good deal to me.  You get a nice premium, and you end up with a better stock than you owned previously.  You were stuck with sort of a no-growth situation and suddenly there is hope.

The new Kraft-Heinz (synergies are already priced into the above metrics) would not only have better margins, but also a much more interesting and promising growth profile than the current KRFT.

The post-announcement rally in the stock price has pushed up the valuation of KRFT to $67/share on an ex-dividend basis, so the current pro-forma valuation is more like 22x P/E and 14x EV/EBITDA. This is at the high end of food companies, but they will also have margins at the high end and greater growth prospects.

This is a first pass look at this deal, sort of a back-of-the-napkin look so I am probably missing a few things here and there.  There are a lot of moving parts here and others will make different adjustments than I made so may come up with different figures.

And there are things that we don't know yet.  The merger proxy should be very enlightening in that sense.

Anyway, this is kind of an exciting deal; it will be fun to follow.