Kraft Heinz, the giant food company, has not had a good month. On Friday, they announced disappointing profits, a disappointing outlook for future profits, and a Securities and Exchange Commission investigation into their accounting practices. They also announced that they were taking a $15 billion write-down of their intangible assets: Essentially, saying the Kraft and Oscar Mayer trademarks are not worth as much as they previously estimated, and must be valued accordingly on their balance sheet.
The stock fell by 29 percent in one day. But the stock had been getting beaten up more slowly over the prior two years; it’s down by nearly two-thirds since its peak in February 2017.
What’s wrong at Kraft Heinz? There are two theories, and neither looks great for legendary investor Warren Buffett, who teamed up with the Brazilian private equity firm 3G to buy out H.J. Heinz in 2013, and then merged it with Kraft in 2015.
One theory is that Buffett’s Berkshire Hathaway and 3G have mismanaged Kraft Heinz. 3G is known for a strategy of profit improvement through aggressive cost-cutting, and one of Buffett’s investing ideas is that old and established but unsexy brands are undervalued by Wall Street. Together, Buffett and 3G have pursued a cost-cutting strategy at Kraft Heinz that relies on the established strength of the company’s famous brands to continue generating sales even as costs — especially sales and marketing costs — are slashed. But some of those brands are losing relevance as customers become more focused on fresh and healthy foods.
Critics say Kraft Heinz is failing to invest aggressively enough in updating its product lineup for changing tastes. In The Wall Street Journal, Aaron Back and Carol Ryan point to Conagra foods, which “successfully turned around aging frozen-food brands Healthy Choice and Marie Callender’s by incorporating fashionable ingredients like kale.” Maybe Kraft Heinz should be more like Conagra.
The other possibility is that Kraft Heinz has a fine strategy but was simply overvalued by investors, who had unrealistic expectations for its sales and profit margins. This is Buffett’s diagnosis, and he counts himself as one of the unrealistic investors, admitting in an interview with CNBC this week that he overpaid, at least for the Kraft part of the acquisition.
Buffett is more focused on the problem of a shift in power from manufacturers toward retailers than on shifts in consumer taste. The value of Kraft Heinz’s brands doesn’t just depend on consumers’ willingness to buy their products. It also depends on retailers’ willingness to pay a premium to carry recognizable Kraft Heinz brands alongside their store brands and other competitors.
In the CNBC interview, Buffett points to the explosive growth of Kirkland Signature, Costco’s house brand. Kraft and Heinz are both over 100 years old and can be sold at any retailer, while Kirkland is less than 30 years old and its products are sold almost entirely at Costco; yet, consumers spent 50 percent more last year on Kirkland products than on Kraft Heinz products.
The rise of private-label brands doesn’t just mean that companies like Kraft lose market share. Increased consumer willingness to buy private-label products also gives retailers a stronger hand in their negotiations with companies like Kraft. If Walmart or Costco can credibly say they will just drop Kraft mayonnaise if Kraft Heinz won’t sell it at the price they like, they gain leverage over pricing, and Kraft Heinz loses profit margin.
Of course, this leverage varies from brand to brand. Heinz Ketchup still has a 60 percent market share and is the sort of brand that enjoys a persistent margin advantage due to consumer preference. Do consumers have a similar preference for Oscar Mayer lunch meats over competitive brands? Accountants at Kraft Heinz apparently don’t think so.
Ideally, a company facing this challenge would develop new brands that consumers are willing to pay a premium for. Or, it can acquire such brands, creating value by marrying its skills in production and distribution with intellectual property created by someone else. Still, this approach doesn’t always work. General Mills bought a controlling stake in Yoplait in 2011, in an attempt to adapt to the shift in consumer preferences away from carb-filled cereals toward yogurt. But Yoplait has been outcompeted by competitors who better kept up with particular consumer fashions in yogurt.
Sometimes, the best approach to a valuable but declining business is simply to continue collecting the declining stream of profits. A lot of people still buy Velveeta cheese and Capri Sun drinks, even if they are not as fashionable as they used to be. The question, then, is: If that’s the right approach for Kraft Heinz, why did Buffett and 3G pay so much for the company to begin with?
