KraftHeinz last week stunned the financial world with its announcement that earnings fell and the company was cutting its dividend. The company also wrote-down the value of some of its brands.
The news was a big surprise. The stock price fell more than 25% on Friday and is continuing to fall. Investment managers are now dumping the stock. In February, 2017, KraftHeinz stock was trading over $90 per share. It is now down more than 60%.
A deeper look, however, suggests that the decline was entirely predictable and there may be better days ahead.
Over the past five years, the most powerful force is the packaged good industry has been 3G Capital. This huge Brazilian investment firm is best known for its simple investment model: buy established businesses and transform them through a relentless focus on cost-cutting and efficiency. The idea of Zero Based Budgeting (ZBB) is at the core of the model: cut everything and then only add back what is absolutely essential.
The model seemed to work very well, especially at AB InBev, another 3G company. Warren Buffet and many others thought the approach would work similarly well at other firms such as KraftHeinz.
The problem, of course, is that the 3G – ZBB model is fundamentally flawed. Cutting expenses and firing people only drives profit growth as long as there are things to cut. Once the easy savings are realized, profit growth stops. Along the way, the drive for efficiency also reduces innovation, customer focus and brand building, which is a problem in an intensely competitive industry flooded with new entrants.
The executives at 3G are well aware of the limits of ZBB; they are smart people and the issue isn’t complicated.
They are working very hard to drive growth, not just cut costs. At KraftHeinz, for example, the company is now emphasizing innovation and marketing. In 2018, KraftHeinz increased marketing spending by $300 million. Just weeks ago, the company was a major player on the Super Bowl, running ads for Planters and frozen-food brand Devour (both of which did well in the Kellogg Super Bowl Ad Review rankings).
All of this makes the recent results from KraftHeinz entirely predictable, at least with hindsight. When you invest in innovation and marketing, profits will suffer, and that is what is happening. Innovation is difficult and expensive. Brand building is great but it doesn’t produce quick financial returns.
Building a business is a bit like beginning a new fitness regime. At the start, you don’t feel good, and you don’t look any better. It takes time to see the results.
When you think about KraftHeinz, the only big surprise is that people were surprised.
If KraftHeinz is going to thrive, the company has to accept smaller margins. Profits should not improve anytime soon.
The reality is that there is a limit on how far you can push margins on categories like BBQ sauce and natural cheese. Private label players work with tight margins, so it is impossible to maintain share as you push your margins to the moon. I spent eleven years at Kraft managing different businesses so I’m familiar with the challenge.
I’m optimistic. If things go well, KraftHeinz will now find a balance between growth and profitability. Profits will slowly rebound. The lower stock price sets the company up for longer term success. CEO Bernardo Hees said in a New York Times interview, “The important piece is to recognize and learn fast. New mistakes are welcome.”
If you believe KraftHeinz will learn from its stumbles, support a balanced growth model and retreat from its relentless focus on ZBB, this is a great time to buy the stock. Just be patient.