3G Capital has brought its hyper-aggressive cost-cutting model to Big Food with promising early returns.
By Saeculum Research
Following a failed takeover bid of Unilever, Kraft Heinz may be on the prowl again. The company, which is majority-owned by Brazilian consortium 3G Capital and Berkshire Hathaway, is reportedly looking to add another Big Food name to its coffers. This consolidation is the ultimate sign of weakness: When 3G sees a slow-growing industry, it unleashes a wave of extreme, barbarians-inside-the-gate cost cutting. Big Food has come to a fork in the road, and firms must make a choice: Invest in healthier upscale products, or drastically slash expenses to preserve the bottom line (either on their own or through 3G).
Founded in 2004, 3G Capital specializes in mass consolidation, bare-bones efficiency, and low prices. The Brazilian private equity firm regularly partners with Berkshire Hathaway to finance bids for large public companies. By merging Kraft and Heinz, 3G created the fifth-largest food and beverage company in the world. But 3G has made its mark on more than just Big Food. Through a spate of deals spanning three decades, 3G’s principal investors traded up from small Brazilian brewer Brahma to multinational conglomerate Anheuser-Busch InBev—which now brews nearly one-third of the world’s beer. 3G is also transforming fast food. Following its highly profitable purchase of Burger King in 2010, the firm acquired Canada-based Tim Hortons in 2014, joining them under Restaurant Brands International (RBI). In February, RBI announced plans to buy Popeye’s for $1.8 billion.
3G’s business method is simple: Achieve profitability by cutting all but the most vital expenses. The company’s core philosophy hinges on “zero-based budgeting,” by which budgets are built from scratch each year. These newly constructed budgets inevitably call for drastic overhead reductions and massive job cuts: Since the Kraft-Heinz merger, the company has closed six factories and eliminated 5,150 jobs, including 11 of the top 12 leadership posts. 3G realizes better than the Big Food companies themselves that the brand premium which once justified lofty marketing budgets and endless product proliferation has largely disappeared—in an era when consumers are perfectly willing to buy a private-label brand for a few pennies less.
There’s no room for sentimentality in 3G’s playbook. Among the shuttered Kraft-Heinz factories was a legacy plant that once employed more than 4,000 workers. Other cost-cutting measures involve trimming the fat on everyday expenses—including removing free food from company offices, forcing employees to bunk together on road trips, and even printing double-sided to save paper. The moves have paid off: Even with near-zero revenue growth, Kraft Heinz increased its cash flow by $2.1 billion YOY as of Q3 2016. Likewise, in fast food, RBI earns a profit of 45 cents on every $1 on the menu at its outlets—double the industry average.
If any market is ripe for 3G’s extreme measures, it’s Big Food. North American packaged-food companies experienced just 0.2 percent YOY sales growth in Q4 2016, the lowest mark since 2009. PepsiCo’s Frito-Lay snack division saw its North American volume drop in Q4 2016 for the first time in five years. Nestlé registered just 3.2 percent organic YOY growth in 2016, the slowest rate in two decades. Because of these tough conditions, Unilever wants to divest its margarine and spreads division worth as much as $8.5 billion. Conagra, which owns brands such as Slim Jim and Chef Boyardee, sold its frozen potato business last year.
More than just a temporary blip, Big Food’s troubles have been simmering for decades. Boomers were the first generation of consumers to push back against the prepackaged middle aisles of the grocery store. (See: “What’s Eating Big Food?”) They remain skeptical of processed foods with long, complex ingredient lists. Millennials, likewise, are shying away from the sugar-laden, additive-filled products that Big Food manufacturers have long counted on. In response to this generational shift, many grocery stores are even paring back shelf space devoted to Big Food in favor of more space given to deli counters and other natural offerings.
Some packaged-food companies have responded by doubling down on healthier fare. On a recent earnings call, PepsiCo executives said that the company’s growing “guilt-free” product lineup accounted for more than 45 percent of its Q1 2017 revenue. Hormel has spent billions since 2011 to acquire natural brands including Wholly Guacamole and Applegate Farms—and now sells items like a pea-based protein shake. John Bryant, Kellogg chief executive, said earlier this year: “There’s probably more change today than at any time in my history of the industry.” (Kellogg recently rolled out snacks containing teff, a gluten-free, high-fiber Ethiopian grain.)
Others are attempting to stave off 3G by preemptively cutting costs. Since 3G’s Heinz acquisition, every major U.S. foodmaker has announced an initiative to significantly reduce its overhead. One of the first to do so was Mondelez, which itself adopted zero-based budgeting. The company is also adding efficiencies to the production process and eschewing underperforming products. General Mills (GM) hopes that its own “holistic margin management” will save a cumulative $4 billion by 2020. As part of its cost-cutting push, GM recently announced that it would be closing five plants and eliminating 1,400 jobs.
These homegrown efforts to improve margins may lower the chances of another 3G takeover. 3G’s business model hinges on a “lather, rinse, repeat” cycle of acquiring a company, slashing costs, and moving on to the next target. A director of an unnamed foodmaker says of 3G: “It’s like the shark that can’t stop swimming.” But the more that Big Food companies can grow their margins on their own, the less work is left for 3G. Sanford C. Bernstein analysts recently wrote that “the number of attractive U.S. [Big Food] targets is getting smaller.”
Nevertheless, investors seem to have priced in the possibility that Kraft Heinz will acquire someone. According to consultancy EVA Dimensions, the economic value of Kraft Heinz should generate a stock price of $59. Instead, the company costs around $90 a share. Similarly, investment research firm New Constructs gives Kraft Heinz a lofty price-to-EBV ratio of 2.8. Thus, not only do investors place a premium on the companies that Kraft Heinz may acquire, but also on Kraft Heinz itself—due to the expectation that its future acquisitions will drive high returns.
Big Food is suffering from a prolonged “death in the middle,” whereby cost-conscious consumers are buying discount products and health-conscious consumers are buying high-end options. In order to survive, firms in this industry must move either up or down. Moving up means investing in healthy brands that can support a premium—and gradually selling off the remainder. Moving down means abandoning brand premium along with the associated costs, and instead becoming a low-margin commodity producer. If firms fail to do one or the other, they will go belly-up. Or they will be bought up by 3G, the shark that truly knows how to spot a struggling fish and will not hesitate to make the choice (going down) for them.
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