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Friday Five: Heinz-Kraft Deal Makes for a Tasty Combo

Christine Benz
Jeremy Glaser

Christine Benz: Hi, I'm Christine Benz for Morningstar.com and welcome to the Friday Five. Joining me to share his insights on some of the top market news over the past week is Morningstar markets editor Jeremy Glaser.

Jeremy, thank you so much for being here.

Jeremy Glaser: You are welcome, Christine.

Benz: Jeremy, top corporate action this week is that Heinz and Kraft (KRFT) are getting together. Let's talk about your take and Morningstar's take on what this merger will mean.

Glaser: This really was the big piece of corporate news that came out this week. And Heinz is going to be purchasing; Kraft really is more of a merger. Heinz will own about 51% and Kraft will be 49% of the company. This will create the third-largest packaged-food company in North America behind PepsiCo (PEP) and Nestle (NESM). And I think we can look at this deal from a few different angles.

The first is really just strategic. And strategically, Erin Lash, our Kraft analyst, thinks that it does make a lot of sense. Heinz and their owner 3G Capital, the Brazilian private equity firm, really are known for being able to cut costs and to create very efficient enterprises. Kraft could probably use a little bit of that, and I think we could see a lot of more efficiency gains coming from there. Also, Heinz has much more of a global footprint, and that should help with the distribution of Kraft's products, maybe help kick-start growth a little bit into some markets that maybe are seeing a little bit of more growth in their packaged-goods space. That's something that that could be good for Kraft. So really, bringing these two together is something that makes sense from a strategic standpoint.

There is also the more financial angle, which is that Warren Buffett's Berkshire Hathaway (BRK.B) is going to be a big player here. They obviously went in with 3G Capital, and they had purchased Heinz. Buffett will own about a quarter of the combined Kraft-Heinz company, and he says that, as usual, his holding period is forever and that he really sees this as a long-term investment, a long-term use of Berkshire's capital, not something that he's going to make a quick buck on even though he has some very significant gains in it now.

I think that, for Buffett, this is a great use of his cash. Obviously, they are looking for ways to take that [roughly] $60 billion they have sitting around and get some higher returns on it. They don't need that much in order to continue to have that fortress balance sheet. This gives them the opportunity to do that, and it lets them work with 3G Capital--again, something Buffett says that he's been anxious to do, because he really sees them as very good operators, ones who can take businesses that maybe are underperforming a little bit and bring them back up to speed. This is the kind of deal that he really likes doing. I think it is a template for what we could see from Berkshire Hathaway; maybe even past Warren Buffett they will continue to work with these partners to get some of this capital to work.

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Benz: Elsewhere in the food industry, McCormick (MKC) came out with decent earnings. I guess the question is, Jeremy, is boring beautiful?

Glaser: I think, in the case of McCormick, it really is. And they had a good quarter. They beat expectations, and even though they are still struggling with the foreign-currency headwinds that all companies that have sales outside the U.S. are struggling with right now, they really were able to post some decent results. They saw a good mix toward some more of their premium products. They had pricing increases that they are able to push on to their customers. They had sale to consumers, sales to industry that looked pretty good. And even though they are facing some cost pressures like some of their raw ingredients increasing in price, they are able to actually wring out some efficiencies from some of their manufacturing processes in some of their plants in order to keep profitability from falling too much. Erin Lash, who also is a McCormick analyst, thinks that they will be able to move up their profitability and become more profitable over the next 10 years as these initiatives continue.

I think, as you mentioned, boring is kind of beautiful here. This is a wide-moat firm that has low uncertainty and is actually trading for a little bit below their fair value estimate--which in a market that looks pretty fully valued right now, that's rare to find with that kind of name right now. It's going to be kind of a slow-and-steady type of business, which might be what a lot of investors are looking for right now.

Benz: Historically, when you look at market history, some of these more stable companies are among the companies that perform pretty well in the late stage of a market uptick, right?

Glaser: That can happen. You are certainly giving up potentially some upside. When you don't have that economic sensitivity, when thing are getting better, people aren't rushing out and buying a lot more pepper. But when you have times when things are starting to slow down a little bit, it also means that they have maybe a little bit of downside protection as well. But certainly, it's still an equity; even if it's more conservative, it will sell off with the market--maybe just not quite as much.

Benz: Elsewhere in the tech/social-media space, Facebook (FB) had its developers' conference this week. Let's talk about some of the news items that came out of that event and also what we think the implications are for people who own that company.

Glaser: This was interesting. Facebook had their developers' conference, and Rick Summer, our Facebook analyst thinks that the most important thing they launched was, in their native Messenger app, a way for you to interact with businesses--either do customer support or find ways to interact with brands. We don't know if this will take off or not, but it's a sign that Facebook really has invested a lot in continuing to be a platform to bring brands and customers and their consumers together. They really want to be in the middle there, and they are going to keep investing heavily in order to do this and to show people that they are more than just the news feed--they are more than just people sharing photos of their dogs. It's really going to be a true platform that is going to help businesses make money, and Facebook wants to take a little bit of that, of course, along the way through advertising or through other fees. And Rick Summer really thinks that this is part of their wide moat. This is how they continue to keep their wide moat going, by investing in these types of platforms. They do seem focused on that long-term growth and not just kind of on the short-term issues.

And because of their focus on the long term, it does mean that you could see quarters, you could see times where Facebook is going to underperform. They're willing to put this money to work and not worry that, "oh, this is going to make this quarter look bad, or these expenses are going to be too high. And because they're willing to make those investments, it means you could see times when their shares could sell off, could become unpopular because of this. We've seen this a few times already, and then the market sentiment seems to change pretty quickly.

So right now, the shares aren't trading at a particularly attractive valuation; but I think, given these investments, it's likely that investors will get another shot, that they will become unloved at some point. Facebook is one of those ideas that you might want to just keep in the back of your mind.

Benz: You probably want to share management's long-term mindset if you're looking at the company, though.

Glaser: Yes, definitely.

Benz: Another thing I know you've been keeping your eye on is the rate of inflation. CPI actually ticked up a little bit in February after being pretty benign over these previous couple of months. Let's talk about the latest CPI number and what you think the implications are potentially for Fed policy.

Glaser: CPI was up 0.2% in February from the previous month, and that's about flat, year over year, now. But if you exclude food and energy prices--and obviously energy has been huge drag on inflation recently--you are up about 1.7%, year over year, which is really getting relatively close to that 2% target that the Fed is looking for in terms of inflation.

I think that looking at inflation through the Fed's lens is probably important now, given how concerned people are getting--maybe overly concerned, in my opinion--about exactly when the Fed is going to raise rates and then after they raise rates. So, after the first time, how quickly will those subsequent raises come? And if you think about the Fed's dual mandate, they are concerned about having full employment--and we're doing better on the jobs front and people have been very focused on that jobs number--but they also want us to be at 2% core inflation, which is something that we've been much farther away from. This is kind of a sign that we're getting a little bit closer, but still we don't see a lot of inflationary pressures.

I think if inflation remains very, very benign, you could see the Fed decide to maybe be not so aggressive in raising rates after that first rise and kind of let the economy grow maybe a little bit faster in order to get that inflation number back up to their targets and kind of stave off any worries about deflation. So, I think, if you're thinking about what the long-term trajectory is of Fed increases to the short-term interest rates, you should really spent some time about where inflation is going.

Benz: All market participants experienced some volatility this past week. Let's talk about your take on what was driving some of that rockiness. And also, is it here to stay, in your view?

Glaser: We did have some more volatility this week than we've seen recently. And really, the last couple of weeks have been more volatile as people seem laser-focused on what's happening with the Federal Reserve and also focused on what's happening in Europe and China and elsewhere. This week, there were some growth concerns--things like the durable-goods order report didn't look particularly strong. There are some other reports that looked a little bit better. So, it's hard to say exactly what drives any short-term move, but we did see some selling, particularly among small caps and biotechs. Some areas that have been really highfliers recently kind of pulled back and came back to earth a little bit.

I think we shouldn't be shocked that volatility is here, given how far we are into this bull market--over six years now of very strong returns. That's left us with some valuations that are very full, so if things don't look like they are going to work out exactly as people have expected, [it's likely the result of how far along the bull market is now]. There is not a margin of error there. There is no margin of safety; you could see those pull back a little bit. And there are a lot of genuine uncertainties about what's happening with growth, what's happening with monetary policy, and what's happening abroad. So, I think that's why you're seeing a lot of this volatility, and you could expect it to be here for some time.

Now, what to do about it is probably the important question here. As we've said before, you can overreact to this; you have to give yourself maybe a little bit of a personal stress test and make sure that assets that you need anytime in the near future are not in stock so that you're not worried about that volatility and that you're able to the potentially ride it out. If you have been sitting on some cash, maybe it's time to think about what you would buy if there were to be a correction, if you were to see a further decline that would give you that opportunity to buy some things.

That being said, sitting on the sidelines forever--waiting for a big correction--you could be waiting for some time. Matt Coffina, the editor our Morningstar StockInvestor, has done a lot of work in looking at, given current valuations, what does that say about short-term returns? Really, there is not a lot of correlation there. From where we are today, we could see continued increases in prices; it could be flat; it could be down. It's very difficult to predict short-term market movements, and maybe a dollar-cost-averaging strategy or something like that would make more sense. But certainly, volatility is something that's going to be, I think, top of mind, potentially, for the rest of the year.

Benz: Jeremy, it's always great to hear your insights. Thank you so much for being here.

Glaser: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.