By David Stockman, David Stockman’s Contra Corner:
Kraft shareholders woke up $12 billion richer this morning and for that they should thank their lucky stars—or at least send a case of Cristal to Janet and her merry band of money printers. Having passed-out free money to carry traders for 75 months running and after inserting a liquidity and verbal “put” under every market dip since March 2009, the money printers had generated downright giddiness (as of Monday night!) in the Wall Street casino.
And when it came to the shares of Kraft, the casino was indeed giddy even before the deal was announced. A few months ago when it was trading about $55/share, the company was already valued at 31X its $1.75 per share of net income for the year then ending.
So now those fast money traders who somehow “got wind” of the deal early are just plain tickled pink. At $83 per share they are up 50% on their cash position and several hundred percent on their call options. That’s quite the pay-day, amounting to about 47X last year’s earnings on Jell-O, Kool-Aid, Lunchables, Maxwell House, Oscar Mayer, Philadelphia cream cheese, Planters peanuts and Velveeta spreads.
Setting aside the Kool-Aid, you might wonder how hot dogs, peanuts and sliced cheese are really worth such a snappy valuation multiple. Actually, however, that’s not the complete wonder of it. In the year just ended, Kraft posted a hardly impressive $2.9 billion of adjusted EBITDA less CapEx. Yet the casino is now pegging its total enterprise value (TEV) at $58 billion—including about $9 billion of net debt.
Can you say 20X free cash flow? Well, Warren Buffet can. Gushing away in a statement accompanying the deal, the Oracle of Omaha said:
“I am delighted to play a part in bringing these two winning companies and their iconic brands together. This is my kind of transaction, uniting two world-class organizations and delivering shareholder value. I’m excited by the opportunities for what this new combined organization will achieve.”
We will get to Jorge (Jorge Paulo Lemann of 3G Capital) next, but here’s where the Fed and its casino come in. Kraft is a dead in the water financial engineering plaything of Wall Street. It was spun-off from its parent company in 2012 purportedly to unlock hidden value, but the only thing it has unlocked is a torrent of cash payments to its shareholders.
That started with a $7.2 billion going away dividend gifted to its parent company (Mondelez International) in conjunction with the spin-off. Including dividends and share repurchases since then, Kraft has distributed a total of $10.4 billion in cash to shareholders over its brief three-year life.
And where did it get the $10 billion? Not surprisingly, it wasn’t out of free cash flow from operations—which amounted to $3 billion during the period. Thank you, Janet, the $7 billion difference was borrowed, including a sale leaseback of the corporate headquarters. All in, Kraft’s $10 billion of debt costs just 3.0% on an after-tax basis.
Needless to say, while its executives and Wall Street advisors were furiously stripping the cash and loading its balance sheet with cheap debt, Kraft’s tired, over-priced grocery store brands were not going anywhere—notwithstanding all the promises that the spin-off would catalyze a new era of growth.
To wit, net sales of $18.2 billion in 2014 were just a tad above the $17.8 billion recorded in 2010, meaning that its four-year growth rate amounted to, well, 0.5%. Likewise, operating income last year of $3.0 billion was actually identical to the figure back in 2010. In short, not the stuff of a 47X PE multiple.
To be sure, the Wall Street hucksters claim the deal multiple is much more reasonable because 2014 results were marred by large “non-recurring” pension charge. Yes, and the year before that the company’s results were pumped higher by the same accounting shenanigans. So in the analysis above we just took Kraft’s three-year average of operating free cash (EBITDA less CapEx) adjusted for its footballing of pension charges.
As indicated, the average number for this flat-lining collection of long-in-the-tooth brands is $2.9 billion. In short, the “lumpy” accounting doesn’t matter: the casino is valuing a zero-growth enterprise at 20X operating free cash flow.
But wait. When you combine Kraft with some stuff that is even more yesteryear—Heinz’s ketchup, sauces, soups, beans, pasta and Ore-Ida potatoes—there comes an explosion of synergies. Why, the companies said so themselves:
… they estimated they could find savings of $1.7 billion annually by the end of 2017 through cost reductions and efficiencies of scale.
Right. Both Kraft and Heinz have been harvesting merger synergies and announcing cost-cutting campaigns for the last 30 years—billions and billions worth. So only in today’s Wall Street casino can it plausibly be claimed that another $1.7 billion of earnings will be plucked out of the same cost wells. No Sweat.
As a practical matter, virtually all of Kraft’s $3 billion of operating free cash flow is generated by its US and Canada operations. By contrast, 62% of Heinz’s $11 billion sales are generated outside of the North America. Indeed, Heinz has only $2.9 billion of cash costs in all of North America. So good luck with eliminating two-thirds of those dollars in a brutally competitive, drastically over-supplied industry of flagging mid-market grocery brands. To make that work will take more than Kool-Aid—even the kind dispensed from the Eccles Building.
For the moment, however, the latter kind is just what Warren Buffet and Jorge Paulo Lemann are so thrilled about. The combined operation is claimed to be worth $70 billion today and going up from there:
Kraft will hold a nearly 50 percent stake in a company worth more than $70 billion. Because Heinz is private, its equity value is not publicly known, but people briefed on the matter said the combined company is expected to be worth as much as $100 billion by 2017.
Let’s see. Heinz’s 2014 net income was $650 million and that was down from about $1 billion prior to what amounted to an LBO sponsored by Berkshire-Hathaway and 3G Capital. Even after adjusting for the pension “one-timer,” Kraft’s net income was barely $1.9 billion. So call it $2.5 billion of net income on a post-merger basis.
Needless to say, at the hoped for $100 billion of equity value—that’s a 40X multiple or one humongous pile of synergies. Indeed, the combined company’s entire worldwide payroll is only 46,000, which computes out to a total compensation expense of $3.5 billion, at best. Maybe Warren and Jorge plan to eliminate the whole thing.
In fact, the merger makes no business sense. Spread all over struggling but highly diverse consumer economies in Brazil, Europe and North America, there are likely to be as many diseconomies of scale as there are synergy savings. Besides, there is nothing special about putting Heinz ketchup on Kraft Macaroni & Cheese, and certainly not 40X type of special.
But at the end of the day, Warren and Jorge are not counting on synergies and savings. They are counting on Janet and Mario to keep the cheap debt flowing and the casino smoking.
That’s been working for them for years. Thus, 3G Capital did not roll-up the Anheuser-Busch InBev global beer behemoth by scraping together nickels and dimes of new equity. In fact, in the process of buying up beer brands on three continents, the company’s debt grew from $5 billion in 2005 to $50 billion at present. Nor has St. Warren been loath to borrow against Berkshires trove of assets, either. During the last decade its debt has risen from $14 billion to $80 billion.
And why not. Thanks to the 12 money printers domiciled in the Eccles Building, whom Buffet never stops praising for bailing out Wall Street and Berkshire’s enormous mountain of derivatives in 2008, the after-tax cost of capital is close to free.
Once upon a time that kind of blatant central bank distortion of capital markets would have been viewed as beyond the pale. Indeed, Jay Gould, Andrew Carnegie and JP Morgan were no saints, but they didn’t have a free-money central bank financing their empire building, either.
Nor did their riches grow from strip-mining the cash out of already long-in-the-tooth/no-growth empires of beer, cheese, nuts and burgers. They actually built companies and invested massively in new technologies and new productive assets.
So what has transpired is another day and another play in the casino. This ketchup and mac merger could not be more emblematic of how the Fed’s destruction of honest financial markets has fatally deformed American capitalism.
Warren and Jorge are understandably singing Janet’s praise. Everyone else should be getting out the torches and pitchforks. By David Stockman, David Stockman’s Contra Corner
But at some point, realty intrudes. Read… The Great Immoderation: How The Fed Is Sowing The Next Recession