The Kraft Heinz Company (NASDAQ:KHC) unloaded a bombshell with its latest Q4 2018 earnings report complete with eye popping writedowns, a dividend slash, and even a SEC accounting probe for good measure. 3G Capital's simple plan of extreme cost cutting for most of their acquisitions appears not to be working in the present consumer age where tastes are shifting even faster than companies can cut costs. Companies need to innovate and find growth with changing consumer wants and General Mills Inc. (NYSE:GIS) is setting a great example on how to change and grow with its Blue Buffalo acquisition leading the charge a year after the deal.
Jorge Paulo Lemann's private equity firm 3G Capital and Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) bought Heinz in 2013 in a $23 billion dollar deal, at $72.50 a share. Then in 2015, Kraft merged with Heinz where Kraft shareholders received stock in the combined company along with a $16.50 per share special dividend. Little did they know that in 2019 the stock of the company would be about half the price it was just a couple short years ago.
3G Capital's modus operandi usually includes bringing a new acquisition into the fold of its conglomeration and cutting costs drastically as it seeks efficiencies from scale while eliminating legacy positions in the former company that might not be needed any more. Apparently, some of the divisions in Kraft Heinz that were cut too deeply over the past handful of years were its R&D and innovation departments.
This has resulted in Kraft Heinz playing ketchup (or is it catchup?) as consumer tastes have changed in recent years with continued advancements in the natural and organic and animal humanization movements. Kraft Heinz's failure to keep up with trends means that they are starting to lose some market share to competition with new innovative products even though overall consumption continues to slowly grow. This means that management expects to see margin pressure in the short term on some of its core brands as it's hard to maintain pricing power when competition continues to impinge on its core legacy brands. When you factor in rising commodity costs across the industry for many basic goods due to the continuing trade and tariff "war" with China, there is little room to err for conservative packaged food companies. Thus, even though management is seeing some mid single digit growth in consumption in some key brands in 2018, this has not been enough to keep the company from writing off over $15B of value in its big name brands in its Q4, 2018 earnings report.
With 2019 here and the armageddon earnings report off its chest, the question is can Kraft Heinz right the ship and get back to value creation instead of decimation going forward even as it maintains a massive debt load. Management's plan is to go to market in 2019 with its strongest innovation pipeline ever backed by marketing dollars all while trying to maintain some of its industry leading margins in key products. This tends to contrast starkly with 3G Capital's slash-and-burn cost cutting over the past five years, which is probably one reason the market has sold off Kraft Heinz shares so sharply following its recent Q4 report. Management can say all it wants, but processes like this, especially going against the grain, can often times take several years to realize if they emerge at all.
Kraft Heinz's Q4 report was only the tip of the iceberg for its shareholders as it also conveniently came with a 36% decline in its annual dividend rate as well as a deeply troubling SEC subpoena as part of an investigation into Kraft Heinz's accounting policies. Kraft Heinz plans on facing off on all of these challenges going forward while continuing to try to address its strikingly large total debt load of over $32B with only a little over $1B in total cash, giving it fewer options than if it had financial ability to head to the market to just try and buy a growth company. Kraft Heinz's debt load might necessitate some divestitures in the near future including a possible sale of its Maxwell House coffee franchise.
This perfect storm of bearish news brought down not only Kraft Heinz shareholders, but also many industry peers as the sell button is a much larger and easier button to hit for many investors than that all important buy button. This also might mean that there is a potential short term buying opportunity for investors to "buy the dip" in some of Kraft Heinz's peers that were hit by its bad news even though they are wading the shifts in consumer tastes with much more luck. One of my favorites in the space, especially for recent Kraft Heinz sellers, is General Mills which had a small pullback from recent highs on Kraft Heinz's bad news although it has already regained a lot of the lost value.
General Mills has 8 iconic brands that bring in billion dollar global revenues each and many of them are facing pressure from changing consumer tastes as well according to the company's latest CAGNY conference transcript.
Slide from General Mills CAGNY conference
However, General Mills is doing a lot better job of changing with the times as its Häagen-Dazs’ retail sales are up double digits fiscal year to date as it focuses on natural and organic trends with new flavors and premium pricing for ice cream based on simple pure ingredients. Some other new innovations amongst its product lines include first half launches such as Cheerios Oat Crunch, YQ Yogurt, Annie’s sour bunnies, and Betty Crocker mug treats as well as second half new items, including Cinnamon Toast Crunch churros and Go-Gurt dunkers. Contrast this with Kraft Heinz's conference call transcript where they only talk about the great upcoming innovation with very little to nothing in specifics.
General Mills's ace in the hole is the company's $8B Blue Buffalo dog food acquisition which happened just a little over a year ago. Blue Buffalo is capitalizing on the animal humanization global trend and is positioned as the global #1 wholesome natural pet food brand. Blue Buffalo's retail sales grew ~ 9% in 2018 and in the back half of 2019, General Mills expects to expand into new Food, Drug, and Mass (FDM) customers that could double its All-Commodity volume (ACV) distribution by the end of the fiscal year and lead to double digit top and bottom line growth for Blue Buffalo by the end of fiscal 2019.
Slide from General Mills 2019 Q2 slide
Time will tell how soon General Mills's Blue Buffalo acquisition starts truly paying off, but after a year of integration, the growth and potential of the brand is easier to see than the more vague promises of Kraft Heinz's management. Consumer tastes and preferences are changing fast and investors should consider dropping dead weight like Kraft Heinz, if they haven't already, and buying more into a company focused on growth and innovation in the food and pet services industries like General Mills. One day Kraft Heinz might be a good value buy, or Warren Buffett might decide on a full takeout of the company years in the future, but I would think that there is a decent chance the stock spends the rest of 2019 going nowhere fast, unless there are big trade and tariff war advances, as the market sits to patiently see if the company's management can restart its innovation after years of cost cutting. Best of luck to all.
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Disclosure: I am/we are long GIS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.