Kraft Heinz Offer for Unilever Could Be Where the Party Ends

 | Feb 17, 2017 | 1:00 PM EST
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In the midst of any raging bull market -- and the current market, in the throes of the Trump Jump, is no different -- there is always one moment when sober heads say, "This is it." The catalyst for such reflective statements is almost always an M&A transaction. A company with an overvalued stock price makes an audacious -- and expensive -- bid for a competitor, and traders and analysts ping each other with messages stating, "This is a top-of-the-market deal." 

I believe today's offer for Unilever (UN) from Kraft Heinz (KHC) is such a deal. (Kraft Heinz is part of TheStreet's Action Alerts PLUS portfolio.) 

Details of the offer are scant as of this writing, but as reported the deal would offer Unilever shareholders $30.23 per share in cash and 0.22 shares of the combined company. Based on Unilever's share count of 2.84 billion as of year-end, that would imply a cash component of the deal of $86 billion. KHC's offer of $50 a share values UN at 23x the consensus EPS estimate for 2017. 

Kraft Heinz shares have risen this morning on news of the offer, and KHC's market cap is now about $112 billion. So for a company with $112 billion of equity value to offer to fund an $86 billion cash payout, that would imply the addition of a huge amount of leverage. 

Where would Kraft find the $86 billion? Presumably from sponsors Berkshire Hathaway (BRK.B) and 3G Capital, who together control 50.6% of KHC shares. Yes, Berkshire has a huge cash hoard; this is not news. 

So, we have a situation in which shares of both the potential acquirer and the target company are rising sharply on the announcement of a takeover offer. Normally, shares of the target company would rise to a level at which an "arb spread" imputed the likelihood of a deal, taking into account Unilever's immediate rejection of KHC's initial offer. That is what is happening with UN shares today, but the jump in KHC shares is much more difficult to explain. 

The packaged-foods industry may or may not be ripe for consolidation, but the Kraft Heinz merger is not necessarily a blueprint for success. As a leveraged buyout, it worked very well for 3G and Berkshire, through participation in both KHC shares and an $8 billion preferred that was redeemed in May. 

But has merging Kraft and Heinz really created value at the operating level; i.e., excluding all benefits of financial engineering? It's very difficult to tell from KHC's results. Sales fell 3.7% in the fourth quarter, with each geographic region producing a decline. Yes, KHC's results were impacted by currency and an extra week in the fourth quarter of 2015, but that shouldn't hide the fact that packaged foods is not a growth segment. KHC's gross margin did improve year on year in the fourth quarter, a hallmark of merger savings, but the bulk of KHC's 45% year-on-year growth in net income in the fourth quarter of 2016 was driven by a wild swing in G&A costs and a much lower tax rate. So it's hard to determine from the financials if Kraft Heinz is really "working." 

Also, remember that Unilever is not just a food/refreshments company. In fact, those two segments only contributed 40% of sales for UN in 2016, with personal care and home care contributing the balance. I'm just not sure there is any synergy between Dove and Velveeta, but I don't consume either product, so I could be missing the connection. 

So, mark it down. Bookmark this column. On Feb. 16, 2017 (Kraft's offer to Unilever was announced after market hours), the S&P 500 closed at 2,347 and the DJIA closed at 20,620. Only time will tell if Kraft and Unilever can agree on a deal, and how such a deal would work out. But froth, leverage and deal mania are measurable in real time, and when I see them represented in a straight-from-1987 LBO deal (at its core that's what Kraft's offer to Unilever represents) I get nervous about the markets as a whole. Very nervous.

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