On March 25, 2015 H.J. Heinz Company and Kraft Foods Group, Inc. (NASDAQ: KRFT) announced they have entered into a definite merger agreement to create The Kraft Heinz Company. Existing Heinz shareholders will have a 51% ownership stake in the combined company, whereas existing Kraft shareholders will have a 49% ownership stake.

Drivers of the deal

Without any doubt, the billionaire Brazilians behind 3G Capital and Warren Buffett like working together. The two giant investment firms have already marked their presence in the consumer sector with their acquisitions of Burger King in 2010, Heinz in 2013 and Tim Hortons in late 2014. The addition of Kraft Food seems like a logical continuation of this strategy. The announced merger has already received positive feedback in the market as it is expected to benefit both Kraft Foods and Heinz. The 3G Capital team has a proven track record of achieving operational excellence and making businesses leaner and more efficient. In just two years, they managed to increase the EBITDA margin of Heinz from 18% to 26%. Kraft’s margin is 20% and 3G sees an opportunity to realise at least $1.5bn in savings. This number looks particularly hefty considering that Kraft’s last year EBITDA was only $3.7 bn.

As far as Heinz is concerned, the company is said to benefit from Kraft’s relatively low financial leverage. Because the deal doesn’t add any new debt, the combined company’s leverage will fall to 5x net debt-to-EBITDA from the current Heinz’s level of 8x. What is more, Heinz’s management anticipates to refinance $17bn of predominantly high yield obligations including a piece of Buffett-owned preferred stock with a 9% coupon. This is expected to bring $1bn worth of saved interest payments.

The Heinz Kraft merger will create the 3rd largest food and beverage company in North America and the 5th largest in the world. The new company will have a substantial brand portfolio with eight $1+ billion brands and five brands between $500 million-$1 billion. According to the Heinz’s management, the complementary nature of the two portfolios presents substantial opportunity for operational synergies. Market analysts explain one of the motives of Kraft Foods as a strategic move to boost flat sales amid U.S. consumers’ growing demand for healthier, non-processed food. Indeed, Kraft hopes to leverage on the Heinz’s established international platform (Kraft at the moment generates only 13% of revenues outside US while Heinz around 60%).

Looking at the two companies and potential synergies the deal seems to be the right move. However, the big question is whether The Kraft Heinz Company will manage to tap into changing appetite of costumers around the world and to confront the revolution in consumers’ taste and health trends in the US.

Transaction terms and structure

Carried out at an amazingly fast speed, in just 10 weeks, starting in mid-January, the merger of H.J. Heinz and Kraft Foods Group Inc. characterized itself as one of the largest takeover of the year. It will create the third largest food and beverage company in North America behind only PepsiCo Inc. and Nestle SA.

The distinctive trait of this deal is that Heinz is private and will publicly list its shares in connection with this transaction. For this reason, there is a question related to the proper valuation of the merger and Mr. Buffett and 3G are the only ones to have a complete knowledge on Heinz’s value. It is estimated that The Kraft Heinz Company, the newly created entity, will have an enterprise value around $100bn and Kraft market capitalization, prior the transaction being announced, was $36.64bn ($61.33 per share), which corresponded to an enterprise value of approximately $46bn, given the low leverage of the company. After the announcement, on March 25, Kraft share price jumped to $83.17 (+35.6%) and it is currently trading around this level, which corresponds to a market capitalization of $50.27bn.

According to the terms of the transaction, Kraft shareholders will own a 49% stake in the combined company, and Heinz shareholders will own 51%. Kraft shareholders will receive stock in the combined company and a special cash dividend of $16.50 per share. The dividend amounts to more than a quarter of the closing share price of Kraft on March 24 ($61.33). The total value of this special dividend payment is approximately $10 billion and it will be fully funded by an equity contribution by Berkshire Hathaway and 3G Capital. Nevertheless, Kraft’s shareholders will wait to actually enjoy all benefits from the merger since the transaction is expected to be EPS accretive only by 2017.

Another distinctive trait of this transaction is that a single advisor has represented each side: Lazard Ltd. (Heinz) and Centerview Partners (Kraft). For this reason, the transaction has been deemed as “the megadeal without megabanks”.

The combined business, Kraft Heinz Co., will have headquarters in Pittsburgh and the Chicago area. After the closing of the deal (second half of 2015), the Board of Directors will consist of five members appointed by the current Kraft Board and six members nominated by the current Heinz Board. Heinz CEO Bernardo Hees will be CEO of the merged entity. Alex Behring da Costa, former Chairman of Heinz and the Managing Partner at 3G Capital, will become Chairman of the combined entity. John Cahill, Kraft Chairman and CEO, will become Vice Chairman and Chair of a newly established Operations and Strategy Committee of the BoD.

Industry Overview

The high level of M&A activity in the North America packaged food industry is mainly driven by a sluggish US consumer demand, slow organic growth and the need to modify product portfolios, following a shift in consumer preferences away from highly processed foods. Conversely, the gluten-free and healthy products are the rising stars.

It is important to note that large US consumer goods producers, including Kraft, have identified “millennials” as a key demographic group. The estimated 87 million US citizens born between 1980 and 2000, often referred to as millennials, account for about 27% of US population. The group’s preferences, more tilted towards extreme flavours, have prompted packaged food companies to modify their brands. Raised with Internet access and mobile devices, this group is also more aware of the benefits associated with food with simpler and healthier ingredients.

Moreover, millennials are shaping packaged food companies marketing and selling initiatives: young consumers take about 23% fewer shopping trips on average than other shoppers, reflecting their preference for online shopping.

Another fact is that US food companies are seeking growth in emerging markets, where annual growth in spending is significantly increasing. In conclusion, in the food industry it seems there is more to eat.

To contact the authors:

Costantino Brizzi                         costantino.brizzi@studbocconi.it

Fabrizio Colloca                           fabrizio.colloca@studbocconi.it

Isabella Diplotti                           isabella.diplotti@studbocconi.it

Michał Ozimski                            michal.ozimski@studbocconi.it