Pop quiz: what is the result when you combine two iconic American consumer product companies with 150 years of history, let hot-shot private equity guys do their soft-shoe jazz hands bit with the imprimatur of no less than Warren Buffett, load it with debt, “create synergies and eliminate waste,” and then briefly make it the darling of investors everywhere?
Answer: The Kraft Heinz Company
It’s hard to believe the merger of Kraft and HJ Heinz, which was orchestrated by 3G Capital and Berkshire Hathaway, happened 4 years ago now. The 3G playbook was well known by then:
- Implement zero-based budgeting to cut costs;
- Lay off anyone who isn’t necessary and restructure the business to streamline it; and
- Roll up smaller companies into larger companies to create economies of scale.
3G had seen significant success with the above approach with AB InBev and Burger King right before they combined Kraft with HJ Heinz in a merger worth $50B. As soon as the merger closed they started implementing their normal playbook: they laid of ~5 percent of the workforce, started slashing costs, and brought in their own management. Three months later, they laid off another 5 percent of the workforce. While the workers who were laid off didn’t appreciate 3G’s playbook, investors certainly did as they bid up the combined company’s stock price until it reached its peak in February 2017.
Unfortunately for investors, there’s only so much you can do with cost-cutting and acquisitions before you run out of meaningful targets and the core business has to perform on its own. Investors started to realize that by the end of the summer of 2017 as the stock price started to slide lower and lower with each quarterly report that came out. The issue was the Company’s inability to align its product portfolio with changing consumer tastes, such as the shift to more organic and “natural” food. While toddlers and college students still had a strong preference for Kraft Mac n Cheese, and Heinz Ketchup still enjoyed a 70 percent market share, Kraft Heinz’s other brands were losing the industry dominance they had enjoyed for years.
As the chart above shows, the stock price of Kraft Heinz continued its slide through the latter half of 2017 and all of 2018. When the fourth quarter 2018 earnings were released at the end of February, the stock plunged around 30 percent on the announcement that Kraft Heinz was taking a $15.4B writedown. More hits kept coming when the Company announced in May that it would be forced to make a nine-figure adjustment to its financial results of 2016, 2017, and the first nine months of 2018 due to an SEC investigation into its procurement practices.
Given the breadth of these accounting irregularities, perhaps the PE guys’ notion of hiring a 29 year old to be the CFO wasn’t the best idea. Regardless, the 29 year old was fired. I’m not sure if they were able to use the euphemism that he wanted to spend more time with his family given his age, but they brought back the previous CFO to replace him.
The Company also replaced the 3G guy who had stepped into the CEO role since the merger and replaced him with Miguel Patricio, who was the Global Chief Marketing Officer at AB InBev from 2012 to 2018.
Kraft Heinz: Fallen Angel? Stub Stock? Opportunity?
With Kraft Heinz trading around $33 per share it’s worth looking at as it’s incredibly rare to be able to buy an iconic consumer staples company at a sub-15x normalized P/E multiple (or sub-10x normalized EBIT multiple if you want to continue the Buffett references).
Given the drop in revenue and earnings from the change in consumer preferences, what is management planning on doing to turn things around? From their February 2019 earnings presentation:
1. Sell more product (duh)
2. Sell non-core assets
3. Reduce the risk of going bankrupt
Standard Turnaround Playbook
Honestly, the above three slides are your standard turnaround playbook if you’ve already cut costs and you’re over-leveraged at 5x debt to EBITDA. The easiest way to de-leverage your business is to grow earnings. The second easiest way is to sell non-core brands or business units that don’t contribute a lot to earnings but that someone else will pay dearly for.
The interesting takeaway from their presentation is that they aren’t planning for consistent top and bottom line growth until 2020. I like how they assumed it would only take one year to reinvigorate sales through new products and revamped marketing. Nevertheless, an investor must weigh whether the marketing department at Kraft Heinz can keep up with consumer preferences and ensure that those products are delivered in the channels their target customers shop in.
At the end of the day, this is the defining question that will dictate whether Kraft Heinz can turn itself around or whether it will end up a shrinking cash cow that’s slowly sold off in pieces and parts.
Which brings us to 3rd quarter results…
When the Company reported third-quarter results earlier this week, they showed an overall sales decline but only barely. The Company was able to increase prices on products sold by one percent but its volume/mix declined by 2.1 percent, which caused the overall sales decline. While the result was still negative, the price increase does illustrate continued pricing power, and overall they’re showing some stabilization in revenue.
What caught the market’s eye were the savings from cost-cutting efforts. Since the merger was announced, the Company has promised cost-saving synergies without delivering. Now it looks like they actually made some progress in the third quarter. As a result of the cost savings, the Company exceeded the market’s estimated adjusted earnings per share by 15 cents, which caused the stock to pop ~8 percent after the announcement.
To Pull the Trigger or Not to Pull the Trigger?
Say what you want about private equity, through their over-leveraging of companies, they do periodically create opportunities in the marketplace. What you generally want to see in a turnaround before you dip your toe in the water:
- Two quarters of sequential sales and earnings growth with a positive outlook; and
- Reversal of the current negative stock price momentum.
If you wait for both things you risk losing out on buying at fire-sale prices, but if you don’t wait, you’re always at risk of buying a falling knife. While Kraft Heinz’s third-quarter results didn’t show sequential sales and earnings growth, the report was good enough to reverse the negative price momentum.