Does a Colgate-Palmolive and Kraft Heinz Deal Make Sense?

Kraft Heinz Co (KHC 1.31%) has Colgate-Palmolive Company (CL 0.33%) on its shortlist of acquisition targets. But what is the rationale for merging a food and condiments revenue stream with a personal care business?

In this segment from Industry Focus: Consumer Goods, the cast peels back the layers of this potential blockbuster consumer goods combination.

A full transcript follows the video.

This video was recorded on May 30, 2017.

Vincent Shen: Rumors of another 3G-backed deal have been floating around since late last year, when the company began raising funding, about $10 billion worth for a consumer goods company, according to people who were close to the matter. You mentioned Colgate-Palmolive as the new potential candidate. The company, though, at least in relation to Kraft Heinz, has no food or beverage business that would mesh with Kraft, on top of its well-known toothpaste and personal care products, unless you count the dog and cat food business. So, why do you think Colgate-Palmolive is now in the crosshairs for 3G?

Asit Sharma: This is not just a great question for the podcast, Vince. This is a great philosophical question. Why on Earth would this company turn its attention to a totally different industry within consumer goods? I think the philosophical answer is that at some point, this particular business model that 3G employs, if you cannot improve revenue, you have to look somewhere, and I think they're out of options. There are only so many giant food conglomerates that are similar to Kraft Heinz that you can purchase. Mondelez International, which is, ironically, the old Kraft company, keeps coming up in conversation. That's a merger which may or may not occur in the future. There just aren't a lot of companies in the multi-billion market cap range that would make it worth their while. So, they have to look outside of their current wheelhouse. Colgate is an interesting option. You can't get deal synergies from complementary products, but you can diversify your revenue. So that's one optimistic way to look at this -- they're broadening out their product face and insulating themselves against possible future declines in their condiment and packaged foods business.

Shen: OK, that makes sense to me. I figured the diversifying aspect of it would be a key part of why Colgate-Palmolive is attractive. Another part that comes through is, they were recently rejected in that huge deal offer to Unilever, whereas with Colgate-Palmolive, they have a management team that seems quite happy to consider a sale of its company. I have a note here from CEO Ian Cook, who's reported to have stated his interest in selling the company at about $100 a share. That's a more than 30% premium to current trading levels. Ultimately, with a lot of the bigger names like you mentioned in these sectors, these huge portfolio companies are often dealing with stagnant or declining revenue. 3G Capital actually isn't the only company that's looking at Colgate-Palmolive, since there are reports that the company is considering a big move like selling itself. Unilever and Johnson & Johnson have also been named as potential suitors. To close us out, any final takeaways from you, Asit, in terms of the way that 3G Capital operates, but also what the deal might look like with Kraft Heinz and Colgate-Palmolive? Obviously, details right now are scarce. A lot of this is actually just breaking this morning and in the past day. Any final thoughts or takeaways?

Sharma: My final thoughts are, this company, Kraft Heinz, has extremely deep pockets, and they have financing on the side with Warren Buffett whenever they want it. So, they could pay the premium, and pay the $100 that Colgate-Palmolive wants. One not very fun aspect of the deal for Kraft Heinz is that they would like to find companies that have a much lower operating margin than they do and optimize that. Unilever would have been a great deal, because Unilever's operating margins are only around 14%, whereas Kraft Heinz's operating margin is about 23.5%. Looking at Colgate-Palmolive, their operating margin is already 25.5%, so there's not a lot of great work there to do in terms of the cost-cutting we talked about. However, final thought, and I've said this on the show many times, but I'm going to keep repeating it because it's a bit of a hard concept, when you are an acquiring company, you want to look for a target which has a lower enterprise value to EBITDA value to yours. That means the total value of the company divided by its earnings. If that multiple is lower than yours, there's some value creation that can happen afterwards. In this case, Kraft Heinz has a current EV to EBITDA value of just over 19. Colgate's EV to EBITDA is about 16.5. So, there's something in there for this very sharp management team at Kraft Heinz to work with. Like you said, they have the funds, we very well may see this deal go through, and this conglomerate only grow bigger in the near future.