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The 100 billion dollar Heinz-Kraft deal

Isabelle Chaboud

Isabelle Chaboud is Professor at the Department of Accounting, Law and Finance, Grenoble EM, Grenoble, France.

Introduction

The merger of Heinz and Kraft, finalized on July 2nd, was one of the largest mergers to take place in 2015. Warren Buffet via Berkshire Hathaway and the Brazilian, Jorge Paulo Lemann, orchestrated the deal, at the headquarters of 3G Capital. What were the motivations and objectives of this merger? A few months after the deal, what measures have been introduced?

Marrying two American giants

Heinz and Kraft are two major brands in the American food and beverage industry. With over a hundred years of history each, the brands have conquered markets around the world thanks to products such as Heinz® Ketchup, Philadelphia Cream Cheese, Velveeta and Maxwell House.

By merging HJ Heinz Co. and Kraft Foods, the group has a portfolio of highly recognized brands (Heinz, Velveeta and Maxwell House each reported over 1 billion dollars of turnover in 2014). Yet, the group will still be only a middleweight player in the food and beverage industry. In 2014, Heinz’s turnover was 10.9[1] billion dollars for a net profit of 0.7 billion dollars. Kraft had a turnover of 18.2[2] billion dollars and a net profit of 1 billion dollars.

Kraft Foods acquired HJ Heinz Co. to create The Kraft Heinz Company, a new giant in the American industry. The group should report more than 28[3] billion dollars in turnover, be valued at 97 billion dollars, and employ 46,000 people. The group is now the third largest North American food and beverage industry player and the fifth worldwide in terms of turnover (still far behind Nestlé, the number one Swiss giant with 91.6 billion dollars of turnover in 2014 – followed by PepsiCo, Unilever and Mondelez).

Why merge?

Although both companies have widely recognized brand name products, they have suffered from stagnating or even decreasing demand in the USA. As customers have become aware of the artificial, fattening or sugary characteristics of the groups’ products, they have turned towards more natural and healthier products. In this context, why merge two slowing middleweight players?

Warren Buffet and 3G Capital are counting on Heinz’s international distribution network to develop Kraft’s international sales. While Heinz sells more than 60 per cent of its products outside of North America with 650[4] million bottles of Heinz Ketchup being sold across 140 countries every year, Kraft only distributes its products in the USA.

In addition, the two groups have different products and act in different market segments. For example, Kraft’s main markets are meals, convenience foods, desserts and cheeses.

This is a translated and adapted version of an article originally published in Le Cercle les Echos in French March 27, 2015 www. lesechos.fr/idees-debats/ cercle/cercle-129954-heinz- kraft-le-deal-a-100-milliards- de-dollars-1106149.php

DOI 10.1108/SD-03-2016-0035 VOL. 32 NO. 6 2016, pp. 5-7, © Emerald Group Publishing Limited, ISSN 0258-0543 STRATEGIC DIRECTION PAGE 5

For Heinz, Ketchup and other sauces represent almost 10 per cent of turnover. The complementary nature of the two groups’ products limits the risk of in-house competition. By combining their brand portfolios, the new group will also have better bargaining power with suppliers and therefore improve profitability. Warren Buffet and 3G Capital have forecasted 1.5 billion dollars in savings by 2017 owing to lower supply costs, an optimized distribution network and greater power to negotiate.

A change in Warren Buffet’s investment style

Warren Buffet is one of the richest investors in the world (ranked 2nd in 2014 according to the Bloomberg billionaire ranking). Known as the “Oracle of Omaha”, Warren Buffet would appear to have moved towards a new investment strategy. Up until now, his investments have always been very diversified (except for new technologies which he avoids) and guided by similar principles: invest in companies whose stock value is underestimated as compared to real value (patents, assets [. . .]); make long-term investments; and in particular, even if Warren Buffet participates in management, never force restructuring or changes in management.

By partnering with 3G Capital, Warren Buffet has accepted a completely different kind of investment. 3G Capital is particularly well known for its ability to implement operational changes and reduce costs (in particular via restructuration and closing down locations when necessary). Warren Buffet first engaged in “partner” investments with 3G Capital in June 2013 when they bought Heinz. Jorge Paulo Lemann, the founder of 3G Capital, and the new management team at the Heinz Company used managerial methods that are very different from Warren Buffet’s usual approach.

For example, they chose to introduce zero-based budgeting. When applying zero-based budgeting, managers start from scratch instead of using past year’s budget as a baseline. They plan a budget in which they have to justify every single expense. If an expense does not add value, it must be minimized or eliminated, which is why the method is seen as a cost-cutting strategy. The measures implemented by 3G Capital have been successful in mature and highly competitive markets. They allowed Heinz Co. to improve profitability.

In his letter to shareholders, published in February 2015, Warren Buffet stated:

I’m not embarrassed to admit that Heinz is run far better under Alex Behring, Chairman, and Bernardo Hees, CEO, than would be the case if I were in charge. They hold themselves to extraordinarily high performance standards and are never satisfied, even when their results far exceed those of competitors.

According to an article in the Financial Times (Brazil 3G Trio as Eager for USA Food as Beer, March 26, 2015), these new management methods led to the closure of at least five factories and cut 7,400 jobs, or around a quarter of the number of employees present when 3G Capital invested in Heinz.

First changes implemented after the merger

Top management for The Heinz Kraft Company (HKC) was primarily chosen by 3G Capital with Bernardo Hees (a 3G Capital partner) as CEO. The group began trading on NASDAQ on July 6th, 2015 at US$72.96 per share. On July 31st, the group paid out a dividend of US$0.55 per share. Following a drop in sales of 4.5 per cent in the second quarter of 2015, HKC announced on August 12th a plan to cut 2,500 jobs (mostly Kraft employees). In addition, we can note that such a plan had already been implemented at the Heinz Company after it was acquired by 3G Capital-Berkshire Hathaway.

While we may question the new group’s ability to grow, its portfolio of well-recognized brands will certainly allow HKC to better negotiate deals with distribution networks and even penetrate new markets. According to Crédit Suisse, Heinz’s net working capital in June 2013 was evaluated at 12 per cent of sales (when 3G Capital acquired Heinz). By the end of 2014, it only represented 3.5 per cent of revenue. The group managed to push back

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supplier payments while collecting customer payments sooner. Crédit Suisse notes that if the same practices are implemented with HKC, this should generate 650 million dollars in additional operating cash flow. However, it is still a work in progress. The group also needs to lower its debt. Berkshire and 3G Capital are aiming to reduce the group’s debt by two billion dollars over the next two years which would allow it to restructure its balance sheet and reduce its financing costs.

In the mean time, shareholders appear to expect substantial value creation, yet whether the business will be worth almost 100 billion dollars is still to be determined. On January 29 2016, HKC shares traded at US$78.06 (7 per cent higher than its initial share value). However, on February 18, 2016, share prices decreased to US$73.45 (only 0.7 per cent above their initial listing price). It remains to be seen if the Berkshire Hathaway – 3G Capital partnership will continue and manage to achieve their predicted 1.5 billion dollars in cost reduction by the end of 2017. Such predictions should be taken with a grain of salt, given the fact that even though Heinz has improved its profitability, it is not yet on a path towards growth. In addition, it is worth asking whether or not customer demands for healthier products will permit Kraft to develop its sales, in particular outside of the USA. In any case, cost reduction will not be sufficient. The new group will have to invest part of its savings in innovation to invent or reinvent future iconic products and brands.

Notes

1. Available at: http://ir.kraftheinzcompany.com/secfiling.cfm?filingID�1600508-15-11&CIK�

1600508

2. Available at: http://files.shareholder.com/downloads/ABEA-3QV6OO/1786544917x0x730413/145 F2E19-6958-4EA2-9111-B31F2E8CEF47/filing_10K.pdf

3. Available at: www.kraftheinzcompany.com/company.htm

4. Available at: www.heinz.com/our-company/press-room/trivia.aspx

Reference

Chaboud, I. (2015), “Heinz - Kraft: le ‘deal’ à 100 milliards de dollars”, Le Cercle les Echos, available at: www.lesechos.fr/idees-debats/cercle/cercle-129954-heinz-kraft-le-deal-a-100-milliards-de-dollars- 1106149.php (accessed 27 March 2015).

About the author

Isabelle Chaboud is a Professor at Grenoble Ecole de Management within the Accounting, Law and Finance Department. Isabelle Chaboud can be contacted at: isabelle. [email protected]

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Keywords: M&A, Acquisition, Merger, Heinz, Kraft, Warren Buffet

VOL. 32 NO. 6 2016 STRATEGIC DIRECTION PAGE 7

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