It could soon become a classic Harvard Business School case study in how a new, highly-praised strategy for reviving slogging, slow-growing brands was exposed as disaster in a single earnings call.
Over the past several years, Brazilian investment firm 3G has deployed brutal cost-cutting to raise profits at Anheuser-Busch InBev, Burger King, and Kraft Heinz, using an approach called zero-based budgeting requiring that each expense be justified from scratch each year, as opposed to the traditional approach of adding a couple of percentage points to last year’s line items. The strong implication is that managers should strive to lower all costs from one period to the next, at all costs. A Harvard Business School article in 2016 warned that the technique is “not a wonder diet for companies.” That prophesy was confirmed by Thursday’s catastrophic announcement from Kraft Heinz.
The owner of Oscar Mayer, Jell-O, Kool-Aid, and of Kraft Mac and Cheese disclosed that it’s writing down $15.4 billion in goodwill and other intangible assets, meaning that management expects its portfolio of brands to generate future earnings that are about 25% lower than expected just a few months ago. The numbers Kraft Heinz has been posting since the completion of the food giants’ merger in 2015 demonstrate that it’s achieved all gains in profits exclusively from chopping costs, that starving the brands resulted in flat sales and rising debt, and that falling margins and zero growth forced the company to suddenly reverse course by swelling marketing costs. That move, in turn, hammered profits, and came too late. The damage to the brands, the announcement acknowledges, are permanent.
For more about the troubles at Kraft Heinz, read this
Let’s examine what how Heinz’e reported results chronicle its failed strategy:
Revenues went nowhere
In 2016, the first full year following the merger, Kraft Heinz reported revenues of $26.5 billion. On Wednesday, it announced 2018 sales of $26.35 billion, a decline of around 1%, meaning that adjusted for inflation, Heinz Kraft retreated by around 5 points over the past two years.
The juice was supposed to come from cost cutting, but it didn’t last
At first, the strategy of raising profits based on pounding down costs appeared to be working. From 2016 to 2017, the total of the two big expense lines––cost of goods sold and general overhead (or SG&A, which includes marketing) dropped by $886 million, or 4.4%, to $19.46 billion. Most of the improvement came from slashing SG&A by $514 million, a reduction of 15%. R&D expenditures shrank from $120 million in 2016 to $93 million in 2017, a sign that muscle was being eliminated along with the fat. But the pressure on revenues and margins forced a u-turn. This year, SG&A rose by almost $300 million––or almost 10%––and produced a zero gains in revenues. Cost-of-goods sold increased 2.1%, a result that combined with the decline in revenues sent operating leverage in reverse.
Profits excluding the writedowns looked extremely weak
Overhead and production weren’t the only costs that rose in 2018. Interest expense jumped by $50 million as Kraft Heinz piled on more debt. All told, operating income including interest costs decreased from $5.008 billion to $4.458 billion, a fall of 11%.
While profits have shrunk, Kraft Heinz has been adding lots of capital
The packaged good giant added $2.54 billion in long-term debt, bringing total borrowings to an extremely high $31 billion. Equity, excluding the writedowns, rose by $1.5 billion. So Heinz Kraft succeeded in generating substantially lower earnings while using $4 billion more capital.
What does the $15.4 billion writedown really mean
The gigantic downward adjustment lowered shareholder equity by around 23%. If Heinz Kraft’s cost-of-equity-capital is 8%, meaning that’s what investors expect to reap in investments that are no more or less risky, then a $15.4 billion writedown signals that profits will shrink by approximately $1.23 billion a year (that’s 8% x $15.4 billion). In 2017, excluding a big benefit from the new tax legislation, Kraft Heinz booked net profits of $5.5 billion. So erasing $15.4 billion in earning assets from its balance sheet in one stroke likely means that the company expects to earn around one-quarter less in the future than it was expecting.
What’s the market saying
On Friday, Kraft Heinz market cap dropped by $15.9 billion. So since its value fell by around one-quarter, investors are expecting future profits will be 75% of the level the markets were forecasting. That’s consistent with the annual loss of about $1.2 billion in net earnings.
Reviving a Jell-0 or Oscar Mayer or any old-line food brand challenged by healthy choices millennials savor is one the American businesses’ toughest jobs. The 3G folks were too tough on costs, when Kraft Heinz desperately needed trendy new products and offshoots that only targeted spending on R&D and marketing––and creative thinking––could bring. We’ll soon see if the Kraft Heinz bombshell on Feb. 21 will kill the once-powerful allure of the 3G model.