Kraft Heinz Facing the Painful Downside

Kraft Heinz, born of the $49 billion merger of Kraft Foods and Heinz in 2015, had a disastrous fourth quarter, posting a net loss of $12.6 billion on Thursday, leading to a plunge of 27 percent in the share price on Friday.

A scathing article in the Wall Street Journal called that proof that the company’s “experiment in radical cost-cutting has failed.” “The company’s management has few good options,” it said.

Controlled by the Swiss-Brazilian billionaire Jorge Paulo Lemann, via the investment firm 3G Capital, and American billionaire Warren Buffett, who holds 25 percent of the company’s capital, Kraft Heinz has relied on its famed zero-based budgeting approach to cost-cutting.

Basically, that system requires every expense to be justified in each period, pushing managers to drastically reduce spending. But that philosophy can lead to the elimination of investments needed to drive profit and sales growth, and it can be undermined by a market downturn. The food industry has for several months faced a rise in logistic costs and ingredients and materials. Kraft’s strategy worked for two years, allowing it to generate profit margins that were the envy of its rivals.

Kraft Heinz has more than $30 billion of debt after its 2015 merger. Its bonds are plunging toward record lows after its highly-disappointing earnings, likely making it more expensive for the company to borrow in the future. https://t.co/cJBxrDjDqZ pic.twitter.com/Hv4doK1QVz

— Lisa Abramowicz (@lisaabramowicz1) February 22, 2019

But growth in sales stalled in the first quarter of 2017, and six consecutive quarters of poor performance led to an asset write-down of $15.4 billion on two of its flagship brands, Kraft and the Oscar Mayer meat products.  JPMorgan analyst Kenneth Goldman warned that “the intense cost-saving efforts will, over the long run, sort of erode brands … if the belt-tightening strategy goes too far.”

Kraft has built its reputation on products such as ready-to-eat macaroni and cheese, while Oscar Mayer is known for deli meats and hot dogs and Heinz for its ketchup and other condiments. But consumer tastes have been changing, with rising concerns about health issues and a growing shift from processed foods to fresh produce.  “All they have done is lower costs as competing companies like Danone and Nestle invest in products that are more in line with current public demand,” said Gregory Volokhine at Meerschaert Capital Markets.

Many companies in the food industry have responded to the changing trends: McDonald’s, the world leader in fast food, in 2016 stopped selling chicken treated with antibiotics, and now offers hamburgers made with fresh beef.  Volokhine said Kraft Heinz seems to have “applied recipes that worked for a time, but the problem was no longer in the expenses but in products that became obsolete,” like Jell-O desserts.

To make up for its shortfall, Kraft Heinz rapidly deployed $300 million last year to beef up brand marketing, recruit salespeople, improve its supply chain and modernize its recipes. “We were overly optimistic on delivering savings that did not materialize,” CEO Bernardo Vieira Hees acknowledged.

But as he added in a call Thursday with analysts, “We still believe strongly that our model is working and has a lot of potential for the future.”  The company is considering dropping failed brands, a step that would allow Hees to pave the way for a merger, which could achieve more savings and boost profits. The company approached Unilever, which makes Lipton tea and Dove soap, in 2017 but withdrew its $143 billion offer after news of its talks with the Anglo-Dutch giant became public.