Kraft – Heinz and the Buffett Return

We looked carefully at the Kraft and Heinz merger deal and we were blown away by the numbers. Let us look at it two separate ways to see whether it holds water:

Berkshire and 3G bought Heinz by investing $4.25B of equity each and Buffett topped it with $8B of preferred stock in Heinz. Berkshire has already received $1,440M of dividends from the preferred stock in two years. Chances are by the time the stock gets called, he would have received another $720M of the dividends.

Berkshire and 3G are adding $5B each to pay the $10B dividend @ $16.5/share. At today’s closing price of $88.95/share, ex-dividend, the share is worth $72.45/share. Buffett on CNBC said that post the $5B investment, he would own 320 million shares of the combined company. That is worth $28.3B. $5B of that is yet to be invested, so, $4.25B turned into $23.45B in 2 years. This is a mind-boggling return of 450% in 2 years. What an elephant he has bagged on such a big investment…..

To top it all, Berkshire will also get $8B back next year that he has to deploy elsewhere from the calling of the preferred stock. In addition, 3G has indicated that they will maintain the current 3% dividend, that is $2.2/share dividend on 320 million shares, about $700M/year will flow into Omaha starting this year.

The other way to calculate it is, Kraft’s market cap today is $52B; Kraft’s shareholders will get $10B dividends; 49% of the combined company that Kraft’s current shareholders will own, will be worth $42B; 51% of the rest will be worth $43B; initial equity investment was $8.5B equally by 3G and Berkshire; Implied value for the original $8.5B is $43B; (not taken into account the $10B dividend as it will flow from Berkshire and 3G in the future to Kraft’s shareholders)

Either way, Warren Buffett’s elephant gun has fired a salvo that will bring cheers to his shareholders as a new equity position that will be his largest or second largest position once the transaction is closed depending on the stock price on any given day.

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The contrarian insurance play — Fairfax Financials 2014 Letter

Fairfax Financials, run by the contrarian CEO, Prem Watsa, continues to be bearish on the prospects for the world economy and Fairfax is backing his conviction with a very big bet on CPI linked contracts. While the world continues to be riveted on the statements of the Fed and is expecting a rate hike in the near future, Fairfax bets seem to question the sustainability of the hikes. Recent comments from Bridgewater chief, Ray Dalio, seems to the only other prominent voice echoing similar sentiments.

Fairfax had a good 2014, as is the case with most insurers, primarily driven by lack of catastrophes. Book value increased 16% to $395.  Combined ratio was 90.8% and the company ended with $11.7B of float. Unrealized gains from bonds held in the investment portfolio contributed $1.1B of gains and drove the net earnings number higher in 2014. A closer look at the performance of the investment portfolio shows a mixed picture. The equity hedges has cost the company a pretty penny and almost all of the gains have come from the bonds portfolio.

Performance

Fairfax’s bet on bonds has spectacularly paid off while its equities have severely underperformed the market primarily driven by hedging. Prem Watsa and his team seem to be very confident about the market unravelling due to the grand disconnect between fundamentals and stock prices. It is worth noting that ten years ago, Prem Watsa had placed a similar bet on the housing market and suffered through initial years of losses before spectacularly reversing the losses during 2007 and 2008 as seen below. Only time can tell whether Fairfax will gain spectacularly on these CPI linked hedges.

20032006

If one digs a little deeper into this, the cost of these contracts seem to be only 7% of equity. On the surface, it looks like a bet where the payoff is huge with minimal downside risk. Currently, they have a string of loses to show for the bet between the CPI linked contracts and the equity hedges. Cumulatively, it has cost Fairfax Shareholders close to $4B to keep this bet on.

Hedges

Furthermore, Fairfax is increasing the size of the CPI linked bet on deflation. The notional amount is now $111B. CPI seems close to the strike price and for the first time, the bets looks like having any chance of making money for shareholders.

CPI1

So far so good. However, if inflation does occur like the rest of the investment community believes in, Fairfax stands to suffer from a triple whammy. Firstly, the loss from the CPI indexed contract. Secondly, the gain on equity will be minimal due to the hedges involved if the market does not unravel. Thirdly and most importantly, the bond portfolio might come under attack. Fairfax would still retain the option on holding the bonds to maturity and redeeming them but will have to announce mark to market losses in the meantime.

In net, Fairfax seems to be riding the wave of good underwriting profit along with most of the good insurers. The future seems to be hinged on the great disconnect in the stock markets. Only time will tell whether there the grand strategy will pay off or will it result in a lost decade for the insurer.

Disclosure: Long Fairfax

Markel 2014 Year End Letter

Markel Corp. is arguably one of the world’s leading insurance operator. It has one of the best track records in the insurance business with a very conservative management, accounting practices and a business model that is evolving to the size the Markel is growing to. We purchased Markel on the days after the acquisition of Alterra, when for a brief few days, the shares traded at book value. Since then, we have been sitting on it.

As seen below, Markel has had a stupendous year, with both book value and the 5-year CAGR both doing pretty well. The 5 year book value CAGR is a good indicator for long term value creation for balance sheet driven companies. By and large, the letter is all good news.

Results

There is one painful section of the letter that I had a tough time comprehending — Markel Ventures. Markel has been on the tested path of Berkshire Hathaway, to own operating companies as an alternative capital allocation vehicle to investments. By and large, it has been fairly successful. Compared to ten years ago, the revenue has growth from $60M to $800+M. However, it was the discussion about EBITDA that caught my attention. Markel Ventures is measured based on adjusted EBITDA. EBITDA as a metric is bad enough but the metric goes even further and excludes goodwill impairment charges. The letter then goes through a painful section on how the goodwill impairment charges could have been avoided if the business had been lumped under a bigger business. I think since the entity was not bought as part of a bigger company, the goodwill must be evaluated at the entity level balance sheet. When one pause and thinks about it, it does not put Markel’s management in very good light. It will very important to keep track of Markel Ventures as it becomes a bigger piece of Markel. More disclosure in Markel ventures would be a welcome change in the future.

EBITDA

Impairment1

Beyond that, the letter provided a good insight into the state of affairs at Markel. With Alterra being more conservatively reserved than before, the integration happening well, the insurance business performing robustly and the investment business roaring, Markel’s management no doubt deserves the trust of shareholders. The record that they have generated speaks volumes for the way the management runs the business. This is one no brainer compounding machine over the long run if bought at the right prices. At March 20th closing price of $778.5 and book value of 1.4, good performance is fairly baked in the price. It is no longer the bargain it was post the Alterra acquisition but definitely one worth holding in the books if one already has it.

Disclosure: Own shares of Markel.