Are Buffett and Heinz overpaying for Kraft?

March 26, 2015, 10:00 AM UTC

Warren Buffett may eat like a six-year-old, but more and more he is throwing his wallet around like a wealthy old uncle.

On Wednesday morning, ketchup maker H.J. Heinz said it would buy mac-and-cheese giant Kraft Food. Buffett’s Berkshire Hathaway (BRKA) is playing a big role in the blockbuster deal, which will create a food company with more than $28 billion in sales.

Two years ago, Berkshire bought Heinz in partnership with Brazilian investment firm 3G Capital. So Berkshire will own a big chunk of the combined Kraft Heinz.

Part of the Buffett mystique, and his down home charm, is that at heart he is a cheapskate. He’s always looking for a good bargain. People have a lot of other reasons for why Buffett is a success (I made a chart of them once.) But value investor always ranks high.

Nonetheless, as Buffett’s acquisitions have gotten bigger and bigger over the years, he has been willing to pay more and more for them. His latest deals have raised questions about his bargain hunter image. The original Heinz deal certainly tested his reputations as a value hunter. Is he getting a bargain this time with Kraft (KRFT)? It doesn’t seem so.

With Heinz, Berkshire and 3G paid $72.50 per share, or a 20% premium to their price before the deal. And that was on top of the 27% gain in the stock’s price over the two years prior to the deal. The only conclusion to draw is that Heinz was far from a beaten down value stock. All told, the deal valued Heinz at 20 times earnings. That seems high for a company with profits that had been growing 6% annually. And it was more than the 18 times earnings Buffett had paid a few years earlier for railroad company Burlington Northern Santa Fe.

But in the Heinz deal, Buffett received, along with this regular common stock, special preferred shares that paid out a dividend of 9%. Two years ago, I calculated that the special dividend Buffett gets from the preferred shares reduced Buffett’s effective price in the deal to nine times earnings. And indeed those preferreds proved pricey for Heinz. Last year, Heinz paid $720 million in dividends to Berkshire, eating up all of the ketchup company’s profits and then some.

This time, with Kraft Heinz, there are no preferred shares. What’s more, the new Kraft Heinz said it would buy out Buffett’s pre-existing preferred shares as soon as it can, in 2016. So that 9% dividend will go away.

What is Buffett paying in the Kraft deal? When the acquisition is done, Berkshire will own roughly a quarter of the combined Kraft Heinz. As part of the deal, Berkshire and 3G will each pay half of a special dividend of $10 billion to Kraft shareholders. On top of that, Berkshire is contributing its stake in Heinz to the new company. As of the end of the year, according to its financial statements, Berkshire valued that stake at $11.7 billion. Add that to the Berkshire’s $5 billion portion of the special dividend and Buffett’s insurance conglomerate is putting in $16.7 billion for its roughly 25% in Kraft Heinz.

What’s he getting? Kraft Heinz looks likely, at least by my math, to earn around $2.7 billion this year, before one-time merger costs. Buffett, remember, gets a quarter of that, or $675 million. So Buffett is paying $16.7 billion for $675 million in expected profits. On a price to earnings multiple basis, that’s nearly 25 times this years expected earnings.

Is that a lot? It is compared to where Buffett has done past deals. And it’s a lot compared to Kraft’s earnings growth, which before the deal was expected to be 8% in 2015. Shares of other food companies like Campbell Soup and General Mills, trade for 18 and 21 times expected earnings. What’s more, 10 of the 15 analysts who covered Kraft thought the company’s shares were fully priced before the deal. Presumably, if Berkshire and 3G paid any premium for Kraft they would think it was too much.

Part of this is a function of the market, which has been hot. On CNBC on the morning of the deal Buffett said that he got the best deal he could. And my Kraft Heinz earnings estimate is before 3G’s famed cost cutting, which should boost the company’s bottom line and effectively make the deal cheaper. Kraft Heinz has already said that the company will be able to cut $1.5 billion in costs. Buffett, who says he plans to be a long-term share holder, is betting that over the long haul all that cuts cutting and the strength of Kraft and Heinz’s brands will make the deal pay off despite the seemingly high price now. So many of Buffett’s long-term bets have worked out, it’s hard to bet against him.

But here’s another way to look at the deal, and what Berkshire and 3G are paying for Kraft: Start with the $10 billion dividend to Kraft shareholders to gain 51% of the new company. That seems like a bargain. Kraft was trading at $36 billion before the deal was announced. Half of $36 billion is $18 billion, which is more than $10 billion. But Kraft shareholders are also getting 49% of the new company, which will also include Heinz. That means, along with the dividend, Berkshire and 3G are handing over half of Heinz. So whether you think Kraft is getting a deal depends on what you think Heinz is worth. Two years ago, Berkshire and 3G paid $28 billion for the company.

By this method, what Berkshire and 3G are paying for Kraft is $10 billion (the dividend) plus $18 billion (half of Kraft) plus $14 billion (half of Heinz), or $42 billion.

On Wednesday, Kraft’s shares rose 36% following the announcement of the deal. That gives the company a current market cap of $50.6 billion. Take out the special $10 billion dividend, which is currently factored into the price but will eventually be paid out and not a long-term part of the company’s value, and that’s $40.6 billion, or $1.4 billion less than what Berkshire are 3G is paying. That means either the value of Heinz has dropped, and Buffett has said it hasn’t, or the market thinks Kraft is getting a really good deal.

Even for Buffett finding a bargain these days is really hard to do.

More Fortune coverage of the Heinz-Kraft deal and Warren Buffett:

Kraft + Heinz = Growth?

Kraft is one big mess. Here’s how Heinz could help.

Will betting on junk food be a winning strategy for Kraft Heinz?

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