Harvesters target Unilever

The merger of Kraft and Heinz was the combination of two processed foods groups that were nearing the end of the road in terms of organic revenue growth and cost savings.  In a world of sub-normal carrying costs for debt and over $1.5bn of additional cost synergies from merging the groups, their PE owners were able to keep the carry trade party going for a few more years while vaguely promising some downstream revenue synergies from being able to utilise Heinz’s more developed international sales operation outside the US.  Unsurprisingly, international palettes are proving resistant to Kraft’s American culinary delights and organic sales for the enlarged group are as uninspiring as for the separate entities. Time for a rinse and repeat, so it perhaps ought not to come as a surprise to see KHC move on to harvest their next victim, where costs can be squeezed, while spinning out some of the ‘non-core’ operations to maintain the illusion of value creation and keep the advisers well fed.  In this instance, non-core could be the 60% of Unilever’s business in personal care, with Kraft Heinz consolidating the remaining 40% represented by its food activities.

Like a shark, this model only works as long as it can keep swimming forwards and consuming ever larger prey, otherwise they sink as the lack of real underlying growth is revealed and that this is no more than a gigantic carry trade. Buy a business, which with cost synergies can deliver an initial ROIC substantially ahead of funding costs (which today isn’t hard) and you’ll grow earnings. Do it enough and like the 1980’s conglomorates such as BTR, BET, Hanson etc who where playing the same game and you can generate some pretty impressive EPS growth, which you can use to convince some gullible analysts deserve a premium PE ratio.  If the underlying business is still flat-lining with no growth, then the OpFCF yield should still reflect this.

The real question is about opportunity value and whether a management is adding real value for shareholders or just short term EPS accretion from a asymmetric carry trade.  Adding value will be when post cost synergies, the implied growth being priced into the acquired asset is less that the organic growth being generated from it. Adding to EPS growth meanwhile just needs the initial EBITA yield to exceed the cost of capital, which if debt funded may be less than 5%.  For example, if I bought a group with zero growth, then it’s OpFCF yield should be the same as the equity cost of capital, which for ease of explanation let’s make 10%. For such a company making post synergy OpFCF of say £10m, that would suggest a justifiable purchase EV of approx £125m (10%/£10m plus the tax shield, assuming interest  tax relief remains in place, with corporation tax at 20%).  As the OpFCF of £10m is also post tax, this might suggest a pre-tax profit on this business of £12.5m.  From an earnings perspective, if one funded this with debt at say 5%, then this would be interest expense of -£6.25m, which would halve the PBT to £6.25m, which after a 20% tax provision would be accretive to your earnings to the tune of +£5m.  The reason why you can pursue an acquisition strategy that is earning accretive, but value neutral (or even negative) is because the interest funding cost fails to reflect the full forecasting risk of debt (see Modigliani & Miller), which is why exploiting this asymmetric risk proposition can deliver fictional value. But hey, when there is a whole industry out there pushing stock recommendation on a PE basis, there are investors to be harvested!