The failure of Kraft Heinz
Radical cost-cutting is out, and investments in brands is in
The Kraft Heinz experiment in radical cost-cutting has failed. For the broader food industry, investments in innovation and brand-building are coming back into style. Investors and companies must now adjust accordingly.
The food giant backed by Brazilian private-equity firm 3G Capital and Warren Buffett’s Berkshire Hathaway announced an avalanche of bad news Thursday, sending shares down 27% in Friday trading. The company missed earnings estimates, issued weak guidance for 2019, slashed its dividend, took a $15 billion writedown on the value of some of its most famous brands and told investors that the Securities and Exchange Commission is investigating its accounting practices.
Critics have long contended that 3G’s cost-cutting went too far and came at the expense of growth. They were right. Starting in the first quarter of 2017, the company’s U.S. organic sales declined from a year earlier for six quarters in a row; organic sales strip out portfolio changes and currency impacts.
The company’s disastrous results this week further validate the criticism. Shares are now down by more than half since the merger of Kraft and Heinz in 2015.
On a conference call, JPMorgan analyst Kenneth Goldman argued the write-down of the Kraft and Oscar Mayer trademarks could be seen as a de facto admission that the company’s cost-cutting strategy has damaged its brands. In a note, Mr. Goldman pointed out that the company’s guidance for adjusted earnings before interest, tax depreciation and amortization next year is no higher than Heinz and Kraft’s combined Ebitda in 2014, suggesting the merger has created no value.
The humiliation of Kraft Heinz will come as a relief to the harried of bosses of rival food companies, particularly Europe’s lumbering giants Unilever, Danone and Nestlé. It was Kraft Heinz’s botched bid for Unilever in early 2017 that triggered a wave of cost cuts at Europe’s big-name consumer brands, which have traditionally been run less efficiently than their U.S. counterparts.
Unilever, which makes Dove soap and Lipton tea, and dairy company Danone promised to take a combined $8 billion in costs out of their businesses. Nestlé, under siege by Third Point activist Daniel Loeb, succumbed to pressure and set an operating-margin target for the first time in the company’s recent history.
Activist investors will now have a tougher time. Consumer companies were the thirdmost-targeted of all sectors in 2018, according to Lazard data, and are probably still vulnerable—but hedge funds will have to bring fresh ideas to the table. Elliott Advisors, for example, needs to do more than push for simple cost cuts to push up margins at Jameson whiskey owner Pernod Ricard to the level of Guinness parent Diageo.
On Wall Street today, investors are looking for growth from food companies. That requires spending on innovation to keep up with rapidly changing consumer tastes, as well investments in marketing. Tellingly, when Third Point mounted an activist challenge to Campbell Soup last year, the main criticism was that the company wasn’t investing enough to update its aging soups. For their part, both Unilever and Danone expect sales growth to be at the low end of their targets in 2019 and could do with some breathing room to focus on their top-lines.
One of the best success stories in food recently has been Conagra Brands, which presented itself as something of an antiKraft Heinz, preaching the importance of investing in and nurturing brands. Conagra successfully turned around aging frozen-food brands Healthy Choice and Marie Callender’s by incorporating fashionable ingredients like kale. Conagra’s success will be tested with Pinnacle Foods, which it acquired for $8.2 billion, only to be hit shortly afterward by a sudden downturn in Pinnacle’s sales.
Another popular Wall Street strategy that now looks defunct is the practice of buying into companies that seem likely to be 3G’s next target. This explains why Campbell Soup and J.M. Smucker, two companies that in the past have been rumored to be in Kraft Heinz’s sights, fell 9% and 7%, respectively, in Friday trading.
Kraft Heinz managers themselves seem not to have gotten the memo yet that they are less welcome. On Thursday’s conference call, Kraft Heinz chief executive and 3G partner Bernardo Hees depicted the company’s dividend cut as part of an effort to strengthen the balance sheet for future acquisitions. That seems fanciful. Food companies around the world have new ammunition to argue that a merger with Kraft Heinz would only destroy value.
This doesn’t mean food companies can relax. They have an urgent task to find ways to appeal to modern consumer tastes. That can be much harder than cost-cutting.