That’s not Heinz Big Red Tomato Sauce covering its financials
The latest most remarkable evidence of disruption of a global titan can be found within the Consumer Staples sector; Kraft Heinz (KHC). This was yet another favourite stock of professional investors, particularly after Warren Buffet’s 27% investment in the company. Owned by the Brazilian private equity group ‘3G’ and Buffet, the management team rapidly merged low/no growth businesses, smashing costs out everywhere and chasing margin. The ‘Greed is Good’ speech of Gordon Gecko in the 1980’s Wall Street movie rings familiar.
This approach saw innovation as an expense not an investment. Just 4% of sales spent on A&P (advertising & promotion), but driving operating margins a full 10%+ points higher than a prime competitor- Nestle at 17% vs their 29%. For a while this worked. They drove the current offer hard and cheap and tight. They had arguably changed the rules in the sector.
This led to ‘market darling’ status and fear within competitors who chose not to follow the same rule book. Such was the aura surrounding the company that they made an audacious and aggressive bid of US$143 billion for Unilever - a much more global and higher ROIC business. In the end they failed.
The lack of innovation and no desire to invest for growth made sure they failed to adapt to changing consumer tastes. In contrast Unilever spends circa 13% of sales on A&P, and Nestle, spending an estimated 8% to bring to market new products to adapt to changing tastes and buying behaviour. These two massive businesses ‘get’ the Demographic Megatrend. They ‘get’ long term disruption and the need to both invest and adapt. Without these two characteristics (that 3G and Buffet made sure they didn’t have) it was hard for Kraft’s management team to steer their product offerings to a successful outcome.
The ultimate test for the quality of a company is; does the company have a long run way of growth and can it generate high sustainable ROIC (Return on invested capital) into the future? Kraft’s ROIC is currently circa 5%, significantly below its peer group and barely covering their cost of capital (which is low because of the high levels of debt). The current payback period, based on the traditional measure of Net Debt/EBITDA, is 4.5x.
When debt is cheap and free cash-flow is strong, then this private equity financial model works well. This state of being however rarely persists long-term. When it reverses problems occur. And it has started at Kraft. A 36% savage cut in its quarterly dividend from 62.5 cents to 40 cents per share most recently has hit investors. A further blow is capital destruction, from a 2016 high near $100 USD to just $32.50 a share this month.
Insync’s view is that many big companies are now facing significant disruption. Large consumer brands like Kraft Heinz (KHC), which have historically enjoyed enduring business models, are no exception.
Its recent price fall is not an opportunity to buy but a ‘Value trap’. Value traps are missed when utilising traditional ‘rear-view’ financial measures in assessing a company’s prospects, as mostly these historical numbers are simply extrapolated forward to gain a view of tomorrow. Professional investors fail to recognise or attribute enough in their assessments the degree of change an industry, and its companies face. Insync’s core use of Megatrends in hunting for the right opportunities and avoiding the poor ones creates lasting returns and reduced risk.
Not only do incumbent companies have to have the mind-set to counter and even thrive from disruption they face; they must also have their financials appropriately positioned for it. Kraft is part of a growing majority of large powerful incumbents caught off-balance by disruption. There are however powerful large capable businesses with global reach that have their mind-set and their house in good order.
They are thriving because of disruption. It is these firms that we look for. These companies also tend to outperform their local market as well. Thus, Insync has less regard for ‘benchmark holding comparisons’, country weightings and performance measures most advisers, researchers and competitors focus on. We go where the opportunity lies wherever it is across the globe.