A few weeks ago, I wrote an article as a direct rebuttal to an argument Warren Buffett made, essentially contesting the idea that Kraft Heinz (KHC) is a wonderful business. Towards the end of the article, I issued a fair value estimate for the enterprise of $54.6 billion, even under what I considered to be a very optimistic assessment of future business performance. When reflecting on this price target, I realized that I had over-simplified the differences between debt and equity, and I would like take a deeper dive into the capital structure of the company, and refine my fair value estimate further.

Debt is Cheap, but Risky

As of the end of 2018, Kraft Heinz carried almost $31 billion in long term debt, an increase of $2.5 billion from the prior year, and paid about $1.3 billion in interest on it, a rate of about 4%. As of writing, the company has a market cap of about $40 billion, meaning debt is now making up almost as large a piece of the pie as equity. In my article explaining my valuation methodology, I require a minimum return of 10% on any equity I'm interested in purchasing, which makes debt at 4% quite a lot cheaper. However, this also means that repaying the debt is an expensive affair, as any cash spent in this way carries only a 4% return on investment. In contrast with retained earnings being reinvested into the core business at 71%, or even in contrast with shareholder returns, at an earnings yield of 8.6%, paying down debt offers poor returns.

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