In February 2013, Berkshire Hathaway (BRK.A)(BRK.B) and 3G Capital announced a deal to acquire the 144-year old H.J. Heinz Co. for $23 billion. The firm I worked for at the time held the stock, so I remember that period pretty well. All-in, I remember thinking it was a win-win for both parties: Berkshire and 3G acquired a high-quality business with category leading brands (most notably the eponymous ketchup brand), while Heinz shareholders were fairly compensated as well.
Over the next two years, 3G initiated operational improvements that simplified the corporate structure at Heinz and rationalized the manufacturing footprint. Through these efforts, the company was able to improve operating margins by roughly 800 basis points. There was a Fortune article published in October 2013 that detailed some of these cost saving efforts:
“Every cost, no matter how minor, is attacked and reduced or eradicated … Heinz’s corporate planes are being sold, and the company’s two headquarters buildings are being combined into one. Individual offices are being done away with altogether. Instead, even top executives now work only inches from one another at white industrial tables … Execs who once rested up at Ritz-Carltons now stay at Holiday Inns when traveling, and they are expected to work even longer hours … Hees and his team adhere to the same spartan rules as everyone else.”
The next big development came in March 2015, when Kraft and Heinz merged to create the third largest food and beverage company in North America and the fifth largest in the world. As part of the deal, Kraft shareholders received a $10 billion special dividend ($16.50 per share) funded by Berkshire and 3G, which enabled the Heinz owners to collectively maintain majority ownership of the combined company (Berkshire owns 26.7% and 3G Capital owns 23.9%).
Kraft Heinz (KHC) holds a leading share in its primary markets, with a No. 1 or No. 2 position in 17 core categories that account for 80% of the company’s sales. In those areas (like Ketchup & Sauces and Cheese & Dairy), the company’s market share is roughly twice as large as its closest branded competitor. While there are threats to the business (which I'll discuss in a minute), I think it's fair to say that this is at least a solid starting position.
With the majority of the merger cost savings behind us (which have made their way through the profit and loss in the form of materially higher operating margins), the question is whether or not 3G can get this thing to grow. The strategy at Kraft Heinz has been built around three pillars: innovation through Big Bets, higher spending on effective marketing, and building go-to-market capabilities.
After three years, I think the jury is still out. While the company has had some success with its Big Bets (for example, stemming years of market share losses in the U.S. barbeque business with the introduction of Heinz BBQ sauce), it's also had a number of missteps. Management has been clear that there’s still plenty of work to do on this front.
After the merger closed in July 2015, there was a fair bit of optimism among investors. There was a belief that industry-leading margins, a return to organic sales growth and the optionality offered by another large merger or acquisition justified a large premium to the company’s peer group. In February 2017, the stock hit an all-time high of roughly $97 per share.
But then the balloon deflated. The company exceeded its initial synergy targets, but that was largely expected (3G has built a reputation for itself). In addition, the sales growth that investors expected in 2017 never happened. Finally, following the failed discussions with Unilever (UL) in early 2017, the timing of the next deal for Kraft Heinz (along with a suitable target) became increasingly unclear. It’s worth remembering that the news of a potential Unilever deal also led to a short-term bump in the company's stock price (pushing KHC up by 10% or so). As a result of these developments, the stock has fallen nearly 40% from its highs, and currently trades for $60 per share.
I think the stock got ahead of itself, trading at a forward P/E well north of 20x earnings. Expectations reached a point where any disappointment in the short-term would mean trouble for the stock price.
It looks very different today. Kraft Heinz should earn somewhere around $4 per share in 2018. The stock currently has a dividend yield of more than 4%, which I think has ample support at the current payout ratio (the remaining cash flows will largely be used to reduce the leverage ratio).
There’s no doubt that there are significant industry changes underway. The company is facing the dual threat of private label on the low end and niche brands on the high end. That threat is most acute from a retailer like Costco (COST), where the Kirkland brand offers consumers the best of both worlds (high-quality products at private label prices). That's also a great starting point for negotations with a supplier like Kraft Heinz. When you look at the numbers Costco puts up quarter after quarter, it's clear the company has earned the trust of its customers. I think we live in a world where the brand equity of a company like Costco or Amazon (AMZN) rivals the legacy consumer packaged goods (CPG) brands. If Kraft Heinz sticks to the status quo, I think this will be a failed investment.
Importantly, the pressures created by Costco, Aldi, Walmart (WMT) and Amazon are being felt across the industry (particularly for center of the store CPG companies). As management noted during a recent conference call, uncertainty may lead to restructuring: “As our industry is undergoing a period of change, this will increase the pressure for further consolidation.”
That comes to the crux of my thesis: I’m betting on management. I wrote an article last March about 3G that you should read if you want to understand my thought process. Here’s what Warren Buffett (Trades, Portfolio) said about the team at KHC during an appearance on CNBC:
“One thing I would emphasize about 3G: They are wonders at productivity, there's no question about it. But I've been on 20 boards: I have never seen anybody any better about marketing and product development and all that. I mean, that is what we talk about at board meetings. And it's hours and hours. And I've been on other consumer goods companies’ boards, and they're nothing like the intensity they bring. They don't just bring it to productivity, they bring it to new products. I learn about what's going on in the marketing world when I'm at the meetings of Kraft Heinz because it's their game. I was at the last meeting a month ago. We spent hours and hours [discussing different channels – online retailers versus brick-and-mortar]; they really understand their business. It's so much more of an informed discussion than I've heard at most board meetings in my life; it's night and day. Every aspect of management, they excel in.”
My bet is that 3G and Berkshire Hathaway will run Kraft Heinz to maximize long-term value for shareholders. This will likely include M&A (and possibly divestitures), but more importantly the day-to-day decision-making and strategic planning for the legacy businesses. At current levels, Mr. Market has given investors a chance to partner with the majority owners at a reasonable price.
For full disclosure, I have a cost basis of ~$70 per share (purchased over two transactions in February and March). I haven't bought more since then, but haven't ruled it out either.
Disclosure: Long BRK.B and KHC.
