Kraft Heinz backer 3G Capital faces reality: Brutal cost-cutting isn’t enough

Protestors outside 3G Capital’s office, angry about its performance |
Lauren Hirsch | CNBC

It’s been nearly four years since Kraft and Heinz merged — a deal applauded by some on Wall Street as the chance for private equity firm 3G Capital to exercise its reputation for cost-cutting and dealmaking.

The results have been disappointing and raise the question of whether 3G’s model really works. The firm, which has roots in Brazil and made much of its initial money in railroads, has had to run a packaged food company just as the industry turned on its side.

Kraft Heinz late Thursday handed investors a raft of bad news that only added to the string of disappointments from the ketchup maker. It delivered earnings and revenue that were sharply lower than estimates, slashed its dividend by 36 percent and took a $15 billion write-down on two of its biggest brands, Kraft and Oscar Mayer. The company also revealed it received a subpoena from the Securities and Exchange Commission in October related to its accounting policies and internal controls. On Friday, shares cratered more than 28 percent to a 52-week-low, lopping off more than $16 billion in market value from the stock.

“We believe these impairments validate fears that Kraft Heinz may have been more focused on costs than building brand equity, and even if management now has ‘seen the light’, we are now concerned that its brands lack the equity to drive pricing power needed to compete and drive growth in a sustainable way,” said Piper Jaffray analyst Michael Lavery.

Kraft Heinz attributed its miss to operational challenges. The company said it stands by its famed zero-based budgeting approach to cost-cutting, in which managers need to justify all costs. It faced pressure from supplier negotiations, delayed manufacturing projects and rising costs. Those setbacks came amid tastes that have changed away from packaged food like Oscar Mayer deli meat and Capri Sun drink pouches toward upstart brands with healthier images created by smaller companies like Kind Bar.

“We are overly optimistic on delivering savings that did not materialize by year-end,” said CEO Bernardo Hees, a 3G Capital partner. “For that, we take full responsibility.”

But analysts and investors have wondered whether there is a deeper problem with 3G’s approach. Its model, in large part, depends on dealmaking: 3G buys a slow-growing company like Kraft, slashes excess costs and then moves on to another acquisition. It’s the same approach that 3G has applied to the beer industry with Anheuser Busch Inbev. But Kraft Heinz hasn’t done a deal in years, far longer than most investors expected. So now it needs to navigate the challenging prospect of managing a big food company just as tastes are moving markedly away from them.

Kraft Heinz was publicly and embarrassingly rebuffed by Unilever in 2017 — a rejection that some say emboldened other food companies, which once feared Kraft Heinz, to realize they too could say no to the company and its 3G backers. As Kraft Heinz’s shares since have fallen more roughly 60 percent, a potential deal has become even more challenging, particularly because one of its biggest backers, Warren Buffett, is opposed to hostile takeovers

Those challenges may have led Kraft Heinz to pass on the chance to acquire Pinnacle Foods, as CNBC previously reported, a deal they might have otherwise had previously pursued. When Campbell Soupunder activist pressure was forced to evaluate a sale last year, Kraft Heinz did not step up with any meaningful premium to buy the soup company, which would only have offered it more slow growth and off-trend brands.

Kraft Heinz leadership has over the past two years sought to change the narrative, speaking often to analysts and the media about the company’s focus on growth and assuring investors they do not need to a big deal to be successful. They have taken actions to back up some of that rhetoric: launching a food incubator program and acquiring a small paleo mayo and dressing company.

But creating growth for any big food company is hard, with small upstarts rising daily. Big Food is left with machinery and big brands that are only cost-effective if they are feeding America by the boatload. It is even harder for Kraft Heinz, which cut more than 5 percent of its workforce after the merger closed, according to media reports at the time. Along with those cuts, the company lost valuable knowledge of how to run a food company, say people familiar with the company’s dynamics.

Hees has a track record that includes 3G-backed Burger King and the railroad industry. Its chief financial officer, David Knopf, joined Kraft Heinz in 2015, after having previously worked for 3G Capital and Goldman Sachs.

That background brings with it an expertise in numbers, but not necessarily managing relations with suppliers and grocers or anticipating challenges in building out a new facility with the foresight that comes with experience.

Kraft Heinz also disclosed Thursday the SEC probe into its accounting practices in its procurement business. It said it’s in the “process of implementing certain improvements to its internal controls to mitigate the likelihood of this occurring in the future.” Some have said those processes should have already been in place.

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