When you hear the word ketchup you likely think “Heinz” and when you think of macaroni and cheese you’ve probably got Kraft Dinner in your mind and flashbacks to childhood. Thanks to Warren Buffett, of Berkshire Hathaway fame, and 3G (the sometimes unloved “efficiency-oriented” managers) have put these two companies together. The idea was simple – Step 1) Buy Heinz in 2013, Step 2) make it more efficient through scaling input purchases and consolidating plants, and turn it into an acquisition vehicle, 3) buy more brands to get more scale, lower cost more, and take bought brands to new places, 4) rinse and repeat.
Things seem to be ticking along OK, especially with the acquisition of Kraft in 2015. Although the synergies and such seem reasonable, it has left it with an awkward structure with two head offices. When WB and 3G bought Heinz in 2013 for $23 billion they promised they would keep the head office in Pittsburgh, the Company’s hometown. Then they bought Kraft for $46 billion or so, a much larger Company based in Chicago, and here we are today. But that’s a sidenote. The real challenge is that the Mr. Market is just not happy with how things are going. Although initially the stock continued to climb it has recently dropped from ~$94 to $54.11, with a recent recovery to the $63ish range.
What's going on with the stock?
· One issue is that it is just simply extremely hard to grow consumer staples brands and immediate growth hasn't materialized so they are now out of favour. There is a lot of pressure from competitors, a push by large chains to move towards private labels, and other issues leading to the moat not quite being as good as it used to be.
·Concern that the 3G aggressive relationship will hurt their ability to buy the next KD. 3G has had a bit of trouble with negative press to put it lightly. Their hostile takeover attempt of Unilever did not help – Here is a good article about it: https://www.reuters.com/article/us-unilever-m-a-kraft-3g/3g-capitals-austere-empire-building-weighs-on-krafts-unilever-bid-idUSKBN15X01T
·Noise – lot’s of it. The Company has gone through a massive restructuring over the past few years, they are trimming/”renovating brands”, and sprinkle in things like significant tax changes, and you have quite the murky picture.
The table below shows how noisy things have been.
Here’s the cost breakdown of the restructuring they have gone through as well as the impact of the U.S. tax code changes.
As a side note – It’s interesting to see how the recent tax reforms have impacted the Company. The table below is from their 2017 annual report.
The reasons why we are looking at Kraft Heinz in the first place:
1) Capacity to take pain as Thomas Russo says (see our article about his 2017 Value Investing talk) and capital diligence. Being backed by 3G and Berkshire Hathaway and most of the management team being from 3G will allow the Company to take short-term pain for long-term gain. This is evidenced by a $2.1 billion dollar restructuring reorganization of the combined company (which led to 4,900 redundancies for those keeping count), brand adjustments and wind downs. Currently Berkshire owns 26.7% while 3G owns 23.8%, making them the two largest shareholders with effective control. The third largest shareholder is 3.7%.
2) Strong brands and significant economies of scale combined with 3G’s management. Their efforts seem to be showing some fruit with improved EBITDA margins in both the U.S. (70% of sales) and Canada. It will be worth watching closely how they continue to adjust their brands and those strategies in Europe and the Rest of the World.
3) Brand Strategy
Although 3G is known for cost cutting, in this case it is not just about costs. They are focusing on Renovating Brands and White Space initiatives.
An example of a Renovation is what they recently did with KD:
“Our renovation of Kraft Mac & Cheese is a great example of evolving an iconic brand to meet consumer preferences for cleaner ingredient lines. We did that in 2016, replacing artificial colors, flavors and preservatives. We launched the renovation with an unexpected twist: we didn't tell anyone. That's right. We changed the product without telling mom while successfully preserving all the qualities the consumer loves, the cheesy, multi-goodness. Driving not only consumer reappraisal but also making Kraft Mac & Cheese part of the cultural dialogue with over 1 billion impressions. It led to 2016 being the first year-over-year growth in Kraft Mac & Cheese in 5 years. And together with other innovations like Cracker Barrel Mac & Cheese in deluxe cups, drove category growth in both 2016 and 2017.”
White space initiatives are a bit different. A product example is their recent launch of Heinz Seriously Good Mayo, where the strategy is to leverage the Heinz ketchup brand. #2 The second type of white space opportunity is “entering a new category in a market where the brand hasn't previously had a presence. An example of that is our launch of Planters into China. China's net market is at $4.2 billion in annual sales, growing 11.5% annually, so a significant opportunity for the Planters brand to travel abroad.”
They summarize their sales growth strategy quite concisely:
“Beginning with our strategic plan work in 2016, we identified 3 global brands, 5 global platforms and foodservice as our biggest opportunities. Currently, these 3 brands and 5 platforms represent about 2/3 of our retail sales.
The opportunities to expand the global brands and platforms we've identified is tremendous. To put the opportunity in context, in 2016, only 10% of the countries that we served had 2 or more of our global priority brands. And over the next 3 to 5 years, we expect to have 2 or more of our global brands into markets representing 80% of the countries we serve. So we have big plans to move quickly. We also have a big need to smartly prioritize. So how do we prioritize at a local level? In each market and in each region, we prioritize our big bets through clear portfolio roles, with the goal of strengthening and expanding our core categories and brands. We organize our categories by portfolio role based on share, profitability and category attractiveness in order to guide investment decisions in our portfolio.”
It's essential to read the Company’s February 2018 Business Update - http://ir.kraftheinzcompany.com/static-files/67db0f7b-755c-44a4-8f9e-7455d2781aa6
What does cash flow look like anyway?
We put together the following simplified summary table outlining how cash flow looks over the last few years.
The Base Case cash flow really is a “base” scenario, in that per share cash flow has a few tail winds behind it, namely 1) settling in of restructuring (like a factory hitting its stride once it’s worked out the kinks of the line), 2) the Company’s continued brand initiatives providing fruit, 3) continued share repurchases (303,048 in Q1), and 4) incremental value through further mergers (in Q1 they bought Cerebos Pacific Limited of Australia/New Zealand in Q1 for $238M).
It's an interesting company at an interesting time and we will continue to look at it. It can’t be ignored though that this business is getting harder, not easier, over time.
Heinz Buyout Article – 2013 - https://www.reuters.com/article/us-berkshire-heinz/buffett-brazils-3g-team-up-for-23-billion-heinz-buyout-idUSBRE91D0PY20130214
February 2018 Company “Post-Integration Business Update” - http://ir.kraftheinzcompany.com/static-files/67db0f7b-755c-44a4-8f9e-7455d2781aa6