We remain In-Line for 2017, with optimism on tax reform and consolidation offsetting yield headwinds and the challenge of delivering on an increasingly ambitious margin outlook. We continue to prefer advantaged margin + consolidation stories, and see the greatest upside at KHC, MDLZ, CAG, and APFH.
KHC and the Near-Term Consolidation Outlook
We expect Kraft Heinz (KHC) to reaffirm its position as the lead consolidator in the
fragmented US Food industry in 2017, with smaller players such as ConAgra (CAG)
likely to play important secondary roles. Despite a wave of large-scale consolidation in
recent years, the US Food industry remains fragmented relative to similarly mature
industries such as beverages and tobacco. In recent years Kraft Heinz has taken
advantage of this opportunity, leveraging its proven integration and cost reduction
capabilities and peer-leading access to capital, emerging as the industry’s logical
consolidator. Since acquiring Heinz in June 2013 and Kraft in July 2015, 3G has achieved a
combined ~$2.3 Bn in cost savings, representing ~9% of combined net sales, and – as
with its multi-year involvement in the beer industry – appears to be only in the earlymiddle
innings of a longer-term consolidation strategy.
As outlined below, we believe the phase of large-scale industry consolidation could
occur as early as 1H17. However, in the near term we would expect the market to remain
focused on a wide range of potential outcomes, providing at least temporary downside
support for valuations across the group. In addition, looking beyond the KHC nexus, we
expect CAG to leverage its balance sheet flexibility (~1.5x net debt / EBITDA), with an
initial focus on transformative and highly synergistic transactions which could enhance
the company’s growth and earnings. We have no knowledge of any pending
transactions, and to our knowledge the companies have not commented.
Potential policy changes under the Trump administration could also contribute to nearterm
M&A dynamics. As detailed elsewhere in this note, we see a high likelihood of
material changes to US corporate tax code, which could include measures such as (i)
lowering the corporate tax rate from 35% to 20-25%; (ii) Eliminating interest deductions;
(iii) Allowing a cash repatriation holiday; (iv) The potential for border tax adjustments
which could favor domestic manufacturing of goods (although we view this as a
measure less likely to be implemented) and (iv) Higher interest rates (due to higher
inflation from fiscal stimulus). We see these potential changes as somewhat mixed from
an M&A standpoint, as potential changes in corporate tax rates or interest withholding
(if only prospective) could incentivize the pursuit of near-term M&A, as could
expectations of further rate increases. However, we also view the uncertainty around
this issue as a potential hurdle in M&A negotiations, which could be augmented by a
lack of clarity on interest deduction.
Near term, KHC has already completed the primary integration milestones, and should
fall below 3.5x leverage in early 2017. In addition to having already completed the key
integration milestones for Kraft Heinz (SAP harmonization and organizational
restructuring), we estimate the balance sheet should fall below 3.5x leverage in early
2017, positioning the company for another transformative transaction. Our current
understanding of debt markets suggest KHC could maintain its investment grade rating
at 5.0x leverage in an acquisition scenario, consistent with the 5.0x+ leverage of ABI
followings the SAB acquisition.
Utilizing capital contributions from 3G/Berkshire, we believe Kraft Heinz will be in the
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position to perform a transformative transaction while maintaining its existing majority
ownership. We would also expect 3G/Berkshire to structure any potential transaction so
that the cooperative maintains majority voting, the same practice utilized in the beer
industry. We believe this can be accomplished across all of the potential acquisitions
discussed in press reports, assuming an outside capital contribution from the
cooperative. Recall Reuters reported that 3G was said to have begun raising up to $10
Bn for a new fund in mid-November (3G Capital Raising Up to $10 Billion for Takeover,
Blog Says), just as it did prior to the Kraft Foods acquisition (Brazilian Billionaire Trio
Reportedly Sets Up new Fund, Possibly To Acquire All-American Brand Cocal-Cola). It is
also worth mentioning there is nothing that precludes 3G/Berkshire from diverging from
either company's current proportionate ownership, meaning Berkshire could
theoretically contribute capital in excess of the $10 Bn raised by 3G (or less, of course).
A variety of acquisition candidates have been actively discussed in the media, most of
which have been part of the debate since the 2012 Heinz acquisition. The Kraft
acquisition in July 2015 did little to alter the debate around the next potential
acquisition, which have consistently included Campbell, General Mills, and Kellogg
(Forbes, Bloomberg, Bloomberg), while MDLZ is a more recent addition as reported in
the media. Based on discussions with the company, we believe KHC's acquisition
guideposts include brands with dominant category positioning, potential for
international expansion, and attractive post-synergy valuation. We believe each of the
companies mentioned in the media provide these guideposts in varying degrees, and use
these criteria to guide our own interpretation of KHC's most likely next target. We
reiterate that we have no knowledge of any pending transactions, and have looked at
all of the hypothetical combinations below based only on widely disseminated media
reports.