my take on Kraft Heinz Co (KHC)

Late last week, KHC reported 2Q18 earnings.  The figures were disappointing.  More importantly, the company announced it is:

–cutting the $.625/quarter dividend to $.40,

–writing down the value of its intangible assets by $15.4 billion (about 28% of the total) and

–involved in an SEC inquiry into the company’s accounting practices for determining cost of goods sold.  Apparently prompted by this, KHC boosted CoG for full-year 2018 by $25 million in 4Q18.

The stock declined by 27% on this news.

 

What’s going on?

broadly speaking…

KHC is controlled by famed investor Warren Buffett’s Berkshire Hathaway and by 3G, a group of investment bankers behind the consolidation success of beer maker Anheuser-Busch Inbev.

As I see it, Buffett’s principal investing idea continues to be that markets systematically undervalue “intangible assets,” accounted for as expenses, not assets–namely, successful firms’ brand-building through advertising/marketing and superior products/services.  This explains his preference for packaged goods companies and his odd tech choices like IBM and, only after all these many years of success, Apple.  All have well-known brand names cemented into public consciousness by decades of marketing expenditure.

3G believes, I think, that in most WWII-era companies a quarter to a third of employees do no useful work.  Therefore, acquiring them and trimming the outrageous levels of fat will pay large dividends.  Remaining workers, arguably, will figure out that performing well trumps office politics as a way of climbing the corporate ladder, so operations will continue to chug along after the initial cull.

These beliefs account for the partners’ interest in KHC.

 

My take here is that the investing world has long since incorporated Mr. Buffett’s once groundbreaking thinking into its operating procedures, so that appreciating the power of intangibles no longer gives much of an investing edge.  (Actually, KHC suggests reliance on the fact of intangibles may make one too complacent.)  As to G3, it’s hard for me to figure how companies fare after the dead wood is eliminated.

the quarter

The most startling, and worrying, thing to me about the quarter is the writedown of intangibles.  My (admittedly quick) look at the KHC balance sheet shows that total liabilities and tangible assets–working capital and plant/equipment–pretty much net each other out.  This means that shareholders equity (book value) pretty much consists solely in the intangibles that drive customers to buy KHC’s ketchup and processed cheese foods.  That number is now 28% lower than the last time the company looked at these factors.  Did all that decline happen in 2018?  Is this the last writedown, or are more in the offing?

The fall in the stock price seems to me to correspond closely to the writedown.  I’d expect the same to hold the in the future.  And it’s why I think the risk of further writedowns is a shareholder’s biggest worry.

 

–A dividend reduction is always a red flag, especially so in a case like this where the payout has been rising.  It suggests strongly that something has come out of the blue for the board of directors.  However, KHC appears to be indicating that cash cows are being divested and that loss of associated cash flow is behind the dividend cut.  I don’t know the company well enough to decide how cogent this explanation is, but it’s enough to put the dividend cut into second place on my list.

–an SEC inquiry is never a good sign.  In this case, though, it seems that only small amounts of money are at issue.  But, if nothing else, it points to weaknesses in management controls, supposedly 3G’s forte.

 

Final thoughts:

–Experience tells me the whole story isn’t out yet.  I’d want to know whether KHC is taking these actions on its own, or are the company’s lenders, its auditors or the SEC playing an important role?

–This case argues that the intangible economic “moats” that value investors often talk about have less protective value in the Internet/Millennial era than in earlier, slower-changing times.

 

 

 

 

Warren Buffett’s bid for Unilever (ULVR)

(Note:  ULVR is an Anglo-Dutch conglomerate with what is for Americans a very unusual corporate structure.  I’m using the London ticker.)

Late last week word leaked of a takeover offer Kraft Heinz (KHZ)–controlled by Warren Buffett and private equity investor 3G Capital–made for Unilever.  Within a day, KHZ withdrew its offer, supposedly because of a frosty reception from the UK government.  Not much further information is available.  In fact, when I checked on Monday evening as I was writing this, there’s no mention of the offer or its retraction among the investor releases on the KHZ website.  Press reports don’t even seem to acknowledge that Unilever is one set of assets controlled by two publicly traded companies.

In any event, two aspects of this situation seem clear to me:

–Buffett’s initial foray with 3G was Heinz, where the Brazilian private equity group quickly established that something like one out of every four people on the Heinz payroll did absolutely no productive work.  Profits rose enormously as the workforce was trimmed to fit the actual needs of the company.

Buffett subsequently joined with 3G in the same rationalization process with Kraft.

For some time, achieving stock market outperformance through portfolio investing has proved difficult for Berkshire Hathaway.  Tech companies are basically excluded from the investment universe; everyone nowadays understands the value of intangibles, the area where Buffett made his reputation.

The bid for ULVR shows, I think, the Sage of Omaha’s new strategy–acquire and rationalize long-established, now-bloated firms in the food and consumer products industries.

Expect a lot more of this, with any needed extra financing likely coming from Berkshire Hathaway.

–the sitting pro-Brexit UK government is showing itself to be extremely sensitive to evidence that contradicts its (questionable) narrative that Brexit is good for the UK.  That seems to me to not be true in the case of UVLR.

Sterling has fallen by 15% or so since the Brexit vote, creating problems for firms, like UVLR, which have revenues in sterling + euros but costs in dollars.  Since the Brexit vote, and before the revelation of the bid, UVLR ADRs in the US had underperformed the S&P 500 since last June by about 20 percentage points.  Yes, UVLR has been a serial laggard, but most of the recent stock price decline can be attributed, I think, to the currency decline brought about by Brexit.

The idea that a venerable British firm would fall into American hands, with layoffs following close behind, appears to have been more than #10 Downing Street could tolerate.

That attitude is probably also going to remain, meaning that weak management teams in the UK need not fear being replaced–and that Buffett will likely have to look elsewhere for his next conquest.

 

 

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.

 

Berkshire Hathaway and Kraft

A little less than a month ago, Warren Buffett’s Berkshire Hathaway and Heinz (controlled by Brazilian investment firm 3G) jointly announced a takeover offer for Kraft.  The Associated Press quoted Mr. Buffett as asserting “This is my kind of transaction.”  I looked for the press release containing the quote on the Berkshire website before starting to write this, but found nothing.   The News Releases link on the home page was last updated two weeks before the Kraft announcement.  Given the kindergarten look of the website, I’m not so surprised   …and I’m willing to believe the quote is genuine.  If not, there goes the intro to my post.

 

As to the “my kind” idea, it is and it isn’t.

On the one hand, Buffett has routinely been willing to be a lender to what he considers high-quality franchises, notably financial companies, in need of large amounts of money quickly–often during times of financial and economic turmoil.  The price of a Berkshire Hathaway loan typically includes at least a contingent equity component.  The Kraft case, a large-size private equity deal, is a simple extension of this past activity.

On the other, this is not the kind of equity transaction that made Mr. Buffett’s reputation–that is, buying a large position in a temporarily underperforming firm with a strong brand name and distribution network, perhaps making a few tweaks to corporate management, but basically leaving the company alone and waiting for the ship to right itself.  In the case of 3G’s latest packaged goods success, Heinz, profitability did skyrocket–but only after a liberal dose of financial leverage and the slash-and-burn laying off of a quarter of the workforce!  This is certainly not vintage Buffett.

Why should the tiger be changing its stripes?

Two reasons:

the opportunity.

I think many mature companies are wildly overstaffed, even today.

Their architects patterned their creation on the hierarchical structure they learned in the armed forces during the World War II era.  A basic principle was that a manager could effectively control at most seven subordinates, necessitating cascading levels of middle managers between the CEO and ordinary workers.  A corollary was that you could gauge a person’s importance by the number of people who, directly or indirectly, reported to him.

Sounds crazy, but at the time this design was being implemented, there was no internet, no cellphones, no personal computers, no fax machines, no copiers.  The ballpoint pen had still not been perfected.  Yes, there were electric lights and paper clips.  So personal contact was the key transmission mechanism for corporate communication.

Old habits die hard.  It’s difficult to conceive of making radical changes if you’ve been brought up in a certain system–especially if the company in question is steadily profitable.  And, of course, the manager who decided to cut headcount risked a loss of status.

Hence, 3G’s success.

plan A isn’t working  

One of the first, and most important, marketing lessons I have learned is that you don’t introduce strawberry as a flavor until sales of vanilla have stopped growing.  Why complicate your life?

Buffett’s direct equity participation in Kraft is a substantial departure from the type of investing that made him famous.  I’ve been arguing for some time that traditional value investing no longer works in the internet era.  That’s because the internet has quickly broken down traditional barriers to entry in very many industries.  It seems to me that Buffet’s move shows he thinks so too.