Kraft Heinz: Latest Poster Child For CPGs' Conundrums

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Kraft Heinz – or more accurately, Brazilian buyout fund 3G Capital, which, with Warren Buffett’s Berkshire Hathaway, engineered the $49-billion merger of the two food giants in 2015 — has been hammered since the company dropped several bombshells on Feb. 21.

In reporting fourth-quarter/full-year results, the company announced a $15.4-billion write-down on the value of two of its largest brands, Kraft and Oscar Mayer; higher-than-expected costs; and (despite a 0.7% uptick in net sales), a resulting Q4 net loss of $12.6 billion ($10.34 per share), versus an $8 billion profit in the year-ago quarter. Revenue and earnings both fell far short of analysts’ expectations.

The company also disclosed that the Securities and Exchange Commission is investigating its procurement accounting practices and that, following an internal investigation, it was taking a $25-million charge in that area. While Kraft Heinz said that that charge wasn’t material to earnings, it topped off its list of bad news by cutting its quarterly dividend 36%, from 62.5 cents to 40 cents.

The company’s stock price, which had dropped by nearly 29% over the last year, but had perked up in January, dropped 27% the morning following its results, erasing more than $14 billion in market value. Shares are now down by more than 50% since the 2015 merger.

“It was a striking reversal for a company whose cost-management efforts and higher profit margins were seen as a packaged-food industry model,” pronounced The Wall Street Journal.

Yes, 3G has slashed $1.7 billion in annual costs at Kraft Heinz, thanks to chopping more than 5% of Kraft’s workforce and its originally much-vaunted zero-based budgeting method.

According to Fortune, between 2016 and 2017 alone, the combined costs of goods sold and general overhead, or SG&A (which includes marketing) dropped by $886 million, or 4.4%. Most of that was on SG&A, slashed by $514 million, or 15%. R&D spending was cut by $27 million, or 22.5%.

The hitch: Total revenues have fallen by about 1%, to $26.35 billion, compared to 2016, the first full year after the merger — “meaning that, adjusted for inflation, Heinz Kraft retreated by around 5 points over the past two years,” Fortune summed up. Total annual U.S. dollar sales declined 1.9% in 2016, 1.2% in 2017 and 1% last year, per IRI data.

“Critics have long contended that 3G’s cost-cutting went too far and came at the expense of growth,” wrote the Journal. “They were right. Starting in the first quarter of 2017, the company’s U.S. organic sales [which strip out portfolio changes and currency impacts] declined from a year earlier for six quarters in a row.”

“The pressure on revenues and margins forced a u-turn,” Fortune pointed out. In 2018, SG&A jumped by nearly $300 million or 10%. But the sudden spurt of investment produced no revenue gains. Cost-of-goods sold rose 2.1% and, combined with the revenue decline, sent operating leverage in reverse.”

“Kraft Heinz spent an additional $300 million on marketing its brands, developing new ones and renovating recipes to make them trendier,” elaborated CNBC. “The money also went into improvements in its supply chain and adding more salespeople to visit stores. The investments accelerated what would have been three years of spending into one year. [But] the budgeting process and cost controls didn’t generate enough savings to cover the cost of stoking sales.”

In short, Kraft Heinz has now lost the profit margins that were “the one thing that distinguished it” from similarly growth-challenged big-food cohorts General Mills and (Kraft spin-off) Mondelez, declared CNBC.

“Investors for years have asked if 3G’s extreme belt-tightening model ultimately would result in brand equity erosion,” JP Morgan analyst Ken Goldman wrote in a research note. “We think the answer arguably came… in the form of a $15-billion intangible asset write-down for the Kraft and Oscar Mayer brands.”

3G has also applied the strategy at Anheuser-Busch InBev — where shares are down nearly 30% over the past 12 months. To be fair, in the quite different arena of foodservice, the strategy seems to be paying off at Restaurant Brands International, formed in 2014 when 3G (with Buffett’s backing) added Tim Hortons to Burger King.

But what seems clearer than ever is that cost-slashing is not a sustainable strategy for large CPG food companies – or large CPG companies in general.

It’s hardly news that CPGs across categories have been struggling against a daunting, unprecedented array of challenges.

“Consumers, channels, and competition are all different than they were a decade ago, stymieing CPG manufacturers that had grown accustomed to the fairly stable growth brought about by rising consumer demand,” summed up a 2018 McKinsey report on CPG growth challenges. “And the next five years will almost certainly bring more change than did the previous five years.”

Since 2011, year-over-year organic-growth rates for CPG companies with material portions of their business in the United States have, on average, declined to “very low” single digits, the consultant/research firm reports. Further, CPG categories including personal products, household products, beverages, and food products “have fallen several rungs in industry rankings of economic-profit contribution, and shareholder returns have lagged the S&P 500.”

The food and beverage categories face even more challenges than most of the others, in the form of consumers’ shift toward fresh, “clean” foods and away from processed, packaged foods.

“Perhaps most alarmingly for large CPG manufacturers, American millennials are almost four times more likely than baby boomers to avoid buying products from ‘the big food companies.’” McKinsey stresses. “Size has become, to some extent, a liability. In addition, millennials are drawn to deals and discounts, in part because they don’t have that much money to begin with: millennials are poorer than previous cohorts.”

Although its critics rarely mention this, Kraft Heinz hasn’t been totally heedless of the need for innovation. A year ago, it created a brand-incubator unit called Springboard. In October, it followed the example of other big-food companies by forming a venture capital fund, Evolv Ventures, that will focus on ecommerce, direct-to-consumer (DTC) products, and supply chain technology.

It also launched the growing Devour frozen food brand in 2016, and as part of its recent marketing surge, it invested in a Super Bowl LIII ad for that brand, as well as one for Planters. Its traditionally bland advertising creative now at least tweaks parental foibles, and with male-targeted campaigns, even dares to be a bit risqué (e.g., Devour’s marketing, including the Big Game campaign -- sadly pushed to desperate extremes by running an ad on an actual porn site).

The company comes up with frequent social media-based stunts (like odd, “limited edition” branded products) that garner press and consumer engagement. During the recent government shutdown, it invested in creative goodwill generation with a pop-up store that gave free Kraft Heinz products to affected workers in the Washington, D.C. area. 

Still, 3G and even the legendary Buffett — who, following Kraft Heinz’s Q4 report, admitted straight up that he’d paid too much for that investment — clearly misjudged the velocity of the transformation of consumer demand, and the need for continued investment in traditional retail, as well as DTC channels.

In fact, until fairly recently, Kraft Heinz under 3G’s management had been raising prices to drive its margins — in the process alienating not only consumers, but their supermarket customers. Given that food retailers are listening to their own customers and shifting focus away from center-store packaged goods to the “fresh” store perimeter, those relationships need more nurturing than ever. Reducing the ranks of seasoned, well-networked salespeople at retail has not helped grease those wheels.

Large CPG marketers will need to succeed at mastering a virtual Rubik’s Cube of shifting challenges and opportunities now and in the years ahead. And as McKinsey points out, unprecedented agility will require transformational changes in structure and culture, not just tweaks.

While that’s a hell of a lot easier said than done, there’s certainly been some progress. With this new blog and newsletter for the CPG sector, we aim to explore some of the intriguing successes and failures, issues and opportunities.

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