3G acquiring Heinz, Kraft, Anheuser Busch, SAB Miller: the common denominator

What attracts Brazilian takeover specialist 3G to mature companies in low/no growth industries?

Three features are right out of a finance or marketing textbook:

–the target firms are priced at modest multiples of earnings in the stock market, that reflect the consensus assumption that earnings growth will be hard to come by.  So there’s money to be made if 3G knows that assumption is too pessimistic.

–in an industry that has two giant competitors with, say, 25% of the total market each, and then a bunch of firms with no more than 5% each, the two leaders will continually knock heads with one another.  Both have large absolute market shares but no relative market share advantage against one another.  If 3G already owns one (as is the case with Kraft and SAB Miller) and the two combine, even if they are forced to divest assets to avoid antitrust objections , the post-merger industry structure will be something like one 40% giant and a (possibly larger) bunch of 5% midgets.  The one giant will have 8x the market share of its nearest rival–a huge competitive advantage.

–in mergers like Kraft/Heinz and AB InBev/SABMiller, there’s lots of duplication in SG&A that can be eliminated


There’s a fourth reason that doesn’t get talked about much, but which I think is much more important than the other three–

–at the end of WWII, victorious troops returned to the US and began fashioning the “modern” American corporation, the structure that most mature publicly traded enterprises still maintain.  A basic building block was the idea of span of control, or the maximum number of people who any manager could effectively supervise directly.  That number was seven.  So if a firm had 7,000 workers performing essential company tasks, they would need 1,000 first-line supervisors.  Those would, in turn, require 70 second-line supervisors, who would be controlled by 10 third-line managers…

Of course, that was in combat.  And that was before copiers, fax machines, television, cheap landlines, personal computers, cellphones or the internet   …and when most workers had far less training/education than today.

In addition, in the army, a lieutenant would be in charge of 30 people, a captain 150, a lieutenant colonel a thousand.  So it was an easy conceptual step to associate importance in the company hierarchy with the number of people under a manager’s purview.  But this means that if a manager opts to run a department more efficiently with fewer people he risks losing status in the firm.  So no one does this.  Instead, managers want to have more subordinates, even if they’re underutilized.

So these companies tend to be bloated with non-productive labor.


To address again the question of what 3G does

…it looks for companies that still cling to a seventy five-year old business model that internal bureaucracy keeps in place, and modernizes it.  It looks for the 15% – 20% extra people the target firm employs and lays them off.  It also sells the corporate art collection or the polo club a former chairman persuaded the board to allow him to buy.  It installs zero-based budgeting, meaning managers are required to justify all expenses each year, not just new ones.  By this time, it doubtless has a good idea going in of where to look for fat.

To my mind, the surprising thing is that this pre-technology corporate structure has lasted so long past its sell-by date.  3G is willing to be a catalyst for change because it sees the immense profits that can be made by doing so.


oil? ebola? the dollar?–why stock prices have been falling

In many ways, stock market commentators have an unenviable task.  At any given moment they have to come up with new and interesting reasons why stocks are rising or falling.   The media gurus’ difficulties are compounded by the fact that most are story presenters who have little understanding of investing and are therefore reliant on sources whose statements are many times influenced by their own private agendas.

After peaking in mid-September, US stocks have fallen by about 7% through yesterday/  This has erased most of their year-to-date price gains, although with dividends factored in the S&P is still up about 4% since New Year’s Day.

Among the current “explanations’ for the fall are:

–a falling oil price.  I don’t think this makes sense.  It would be one thing if world GDP were turning negative and demand were sagging as a result.  The current issue, however, is oversupply, being caused by the rise of shale oil/gas production in the US.

Yes, 10% of the S&P 500 consists of oil-related stocks, many of which are hurt by lower prices.  But, to simplify a bit, the other 90% of the index is a beneficiary.  Lower prices are bad for oil-producing nations in the Middle East, for Russia and for the rest of OPEC.  But they’re great for consumers.

Another point:  today’s production contracts with national oil companies provide that virtually all revenue from oil price increases above a certain level goes to the host country, not to the international oil firm that is developing the petroleum deposits.  Although this has been true for decades, my sense is that many investors still don’t get this.  The dynamic is much more consumers gain/emerging countries lose than the consensus thinks.

–ebola.  More about this tomorrow.  Ebola is scary.  The only model we have for what happens to stocks once investors become aware of pandemic possibilities is SARS.  On the other hand, Doctors Without Borders has been handling ebola patients for many years without a single infection of their own.  In my view, stocks would be way lower than they are today if investors viewed ebola a real threat.

–the dollar.  This is an issue, although almost no one is talking about it. The US dollar has risen against the euro by almost 10% since early May.  In back-of-the-envelope terms, 25% of the earnings of the S&P 500 is sourced in euro.  A 10% fall in the dollar value of the euro means that overall S&P earnings–without factoring in current Euroland economic weakness–will be 2.5% lower than previously thought.  Discounting this outcome would explain about half the recent market decline.

my take:

–technicals.  At the peak a few weeks ago, stocks had already discounted all the S&P earnings growth that’s likely for 2014.  In addition, the market had already also factored into prices, let’s say, a third of the expected earnings growth for the index next year. This is normal market behavior, granted, though, that we haven’t seen “normal” for the better part of a decade.

By September, potential short-term buyers couldn’t justify paying higher prices for stocks.  In addition, euro weakness + a lot of other miscellaneous stuff had put 2015 profits under threat.

We’re now in the process of determining how low prices have to go to bring buyers back.

Looking at past levels where lots of buying and selling has taken place ends up being a surprisingly effective tool for figuring out where buying will emerge again.  Don’t ask me why.  If this rule of thumb holds true, as I read the charts the key levels are 1840-80 (i.e., where we are as I’m writing this) and 1800.

restaurants vs. supermarkets: reversal of form?

trend reversals

The government shutdown means that all the government databases are unavailable.  That’s good news for me   …and bad.  It means I can’t get precise data.  On the other hand, I feel justified in winging it.

I’ve been thinking a lot lately about Millennials vs. Baby Boomers, probably because I’m one and my kids are the other.  I’ve also been thinking about trend reversals, mostly because I believe we’re in a time when a lot of this is happening.  There are always to make money from recognizing trend reversals early.

restaurants vs. supermarkets

I remember seeing a piece of truly excellent sell-side research about ten years ago that documented the changes in American eating habits over a 30-40-year period.  The essence was that through good times and bad Americans were spending an ever-increasing proportion of their food budgets on meals away from home (eating in restaurants + take out).  Not only that, but the extra expense of restaurant meals vs. home cooking had been on a steady decline from, say, a 40% premium over cooking at home two decades earlier to 20% at the time of the report.

The conclusion:  a MEGATREND favoring restaurants over supermarkets (which were having competitive problems with Wal-Mart, anyway).  At that time, home cooking represented just over half of what consumers were spending on food.  The restaurant share was inching up by 0.5% – 1.0% annually.  NO END IN SIGHT!

Well, the Great Recession has changed that.  Over the past few years, eating out has been falling as a percentage of consumer spending on food.


–everyone outside the top 20% by income has cut back on restaurants a lot in order to save money– and by enough to derail the long-lasting pro-restaurant trend

–Millennials have not only cut back, but they’ve aggressively traded down to less expensive eateries

–seventy-somethings have changed their behavior the least

I think there are two related reasons for the cutback:

–what economists call a substitution effect, as consumers rejigger their spending to maintain, or enhance, their lifestyles in a world without pay increases and where interest rates are ultra-low, and

–workers realize they can’t get sick if they want to retain their jobs, so they’re eating healthier.

I’m not sure how much of this is already baked in the stock price cake, as it were.  But I think it’s worth taking a look at eat-at-home beneficiaries to check.

thinking about Consumer Staples stocks

Consumer Staples

I had lunch yesterday on eastern Long Island with my friend Richard, who is an astute investor despite being handicapped by being a physician.  Among other things, we talked about Consumer Staples.  He’s a big fan.  …me, not so much.  Anyway, I decided to write about this sector today.

starting with the nuts and bolts:

–the S&P 500 Consumer Staples sector makes up 10.3% of the total capitalization of the S&P 500 index.  That puts it about in the middle as far as size goes.  (IT, at an 18.1% weighting, is the biggest sector;  Telecom, at 2.5%, is the smallest.)

–the Consumer Staples sector has 40 constituents.  Procter and Gamble, Coca-Cola and Philip Morris are the biggest three.  Of them, only P&G cracks the top ten for the S&P as a whole.

–as the sector name suggests, members provide everyday necessities, like groceries, whose purchase isn’t easy to postpone.  It contrasts with Consumer Discretionary, which deals in items like entertainment or restaurant meals, that people can go without for a while.

steady growth → defensive industry

True, every sector has some sensitivity to economic conditions, even Utilities and Staples.  But in these two cases, the sensitivity is small.

In bad times, people may buy one bar of soap instead of a three-pack, or a store brand rather than a deluxe offering.  But they continue to buy something.  That’s not the case with big-ticket items, like refrigerators, autos, houses, industrial machinery, hotels…

As a result, earnings for Staples companies hold up better than for most other sectors in recession.   Knowing this, investors flock to the sector in bad times–and away from it toward more cyclically-sensitive areas when recovery is underway.

a global, but mature, industry…

…except for in emerging markets.  Staples companies tend to grow by taking market share away from their rivals, rather than by finding new customers who have, say, never used shampoo before.  Yes, these firms can raise prices under most conditions (not so much currently) but generally by no more than overall inflation.  So eye-popping profit growth is rare.

sensitive to currency and to input costs

That’s because they can’t raise prices quickly.

a play on the €?

The sector tends to have large EU exposure.

And that’s a potential reason to be interested in the sector today.  If the € beings to rise against the $, which I think is likely, EU-oriented Staples companies should start to show surprisingly strong earnings gains.  That will come both from better unit volume growth as the EU recovers from recession and–more importantly–from the higher value in $ of their € profits.

I haven’t acted on this though yet.  But I’m considering it.

Is there a “lost generation” of marketers?

The Unilever marketing story:  the “lost generation”

The Financial Times of a couple of days ago had a report of its interview with Simon Clift, who is retiring as head of marketing for Unilever, one of the largest personal care products companies–as well as one of the largest advertisers–in the world, with a marketing budget of $7.2 billion.

In it, Mr. Clift makes a number of, to me, surprising observations, among them that:

–the people Unilever has running its global brands, aged 25-45, have very little knowledge of, or experience with the internet.  They don’t know how the consumers of Unilever’s products gather information or share views online.  As to social networking, they are “a lost generation.”  Armed with a lifetime of television advertising expertise, they continue to cling to the idea that a good commercial solves all problems.

Their subordinates aged under 25 know better because they have grown up using today’s communications media.  Their bosses do too, since they see how their kids behave.  But the guys actually steering the ship “built our business on brilliant use of television.  You can’t immediately change your competence.”  This seems kind of like saying you can lead a horse to water, but…  Is this good enough if you’re the boss and know better?

–Unilever’s brand managers’ counterparts at advertising agencies are apparently in the same bad shape.

–in contrast, public relations agencies “get” the internet and are leaders in effective use of social networking sites.

Can this be right?

For at least the past decade studies have shown that consumers who have grown up with traditional advertising know it well, but consider it distortive and don’t trust it. This might have been news at the end of the last century, but not today.

Again, for at least the past ten years, large advertising agencies have been buying public relations shops as fast as they can, both for the superior earnings growth profile of pr, as well as for the greater persuasiveness of public relations campaigns.  I presume that every ad agency Unilever works with has plenty of pr talent just itching to enter the fray on Unilever’s behalf.  But it seems the ad agencies haven’t offered and Unilever’s brand managers, despite their boss’s insistence, haven’t asked.

The head of marketing at Unilever says that he understands the company’s main communications problem and what the solution is, but that his subordinates are either incapable of doing what he wants, or have refused to do what he has told them.  If true, this really says something, not only about the boss, but about the corporate culture at Unilever as well.

maybe so

…speaking of which…When I entered the stock market in the late Seventies, I had an acquaintance who got his PhD in history just as the Baby Boom finished college and the bottom fell market for young professors.  So he got a job at a consulting firm, writing corporate histories.  The idea was by so doing to help client firms recapture the vigor that they once had.

For him, the pattern for successful companies was clear:

the founders were swashbuckling entrepreneurs.   Succeeding generations of managers became more concerned with preserving gains already made and the company would gradually ossify.  The current set would typically be bureaucrats, punching in at nine, out at five and doing little in between other than seeing to it that the status quo is not disturbed.

So I guess it’s possible that the FT article accurately portrays what’s going on in the consumer products industry.

investment implications

1.  The “lost generation” idea implies that, ten years in, there’s still a lot of scope for growth in internet advertising and for disappointment in traditional media, especially television.

2.  Bureaucratic inertia is a more difficult problem to handle than most investors realize.  GM, which turned a 40% share of the US car market into a bankruptcy filing in about thirty years, is the classic case in point.  The way I see it, successive managements decided they didn’t want to be the ones to be responsible for the down profit years (and consequent lower bonuses) that change would have implied.  And had they opted for change, they may well have been sabotaged by their own employees, who wouldn’t/couldn’t learn new skills.

To me, the case of a large, established company is the most difficult one to be persuaded by the value investor’s argument to buy, in the belief that assets are undervalued and that either management will change or the company will be taken over.

3.  Some investors argue that in an industry that’s behind the times, as the FT asserts the personal care products firms as a whole is, it’s okay to buy a competitor that may not be a great company but is at least better than its peers.  This is a variation on the argument that if your group is being chased by a hungry bear, you don’t need to be able to outrun it.  You just need to be able to run faster than one other group member.

My experience is that a situation like this always ends in tears.  I think that great companies routinely surprise on the upside; weak companies always find new and inventive ways to underperform.  And an industry with five weak competitors is a more attractive target for new entrants than one with only a few.  But then, I’m a growth stock investor.  A value investor would probably write the opposite.