Kraft Heinz Faces Existential Crisis After $16 Billion Rout

(Bloomberg) -- Kraft Heinz Co. might need a new recipe.

The packaged food giant reported a troika of bad news on Thursday -- profit that missed estimates, a $15.4 billion writedown on assets and an SEC subpoena -- that sent its shares plummeting 27 percent to a record low on Friday, a plunge that wiped out more than $16 billion in market value.

It seems to be more than just a bad quarter for the maker of Oscar Mayer hot dogs and Kraft macaroni and cheese. The results raise existential concerns about the investment thesis of a company that was created in a 2015 merger orchestrated by Warren Buffett and 3G Capital, a private equity firm known more for its cost-cutting zeal than its ability to nurture consumer brands.

Two years after the merged Kraft Heinz tried -- and failed -- to buy Unilever for $143 billion in a deal that would let it continue slashing costs and improving profit margins, it has struggled to boost sales with a portfolio of tired brands, including Capri Sun and Maxwell House. Now, after a massive writedown on assets including the iconic Oscar Mayer and Kraft trademarks, and a profit miss driven by higher-than-expected supply chain costs, questions are emerging about the zealous expense reduction at the heart of 3G's strategy.

“The cost-cutting mentality is coming back to bite them,” said Ken Shea, an analyst at Bloomberg Intelligence. “They need to get their house in order.”

Investment Thesis

When Kraft Heinz was created, analysts wondered where the growth would come with a suite of aging brands, which also includes Jell-O and Kool-Aid. Changing consumer tastes and shopping habits have decimated sales at the largest food companies in the U.S., as shoppers gravitate to more natural and organic options, rather than pre-packaged and sugar-laden products. But that wasn't supposed to matter for Kraft.

3G, with support from Buffett's Berkshire Hathaway Inc., had produced industry-leading margins after taking over Heinz in 2013 and slashing expenses. That was the plan at Kraft, and it worked for nearly two years. The combined company cut $1.7 billion in expenses, beating the target it released when the deal was announced. And investors cheered, with the shares rising north of $90 apiece to trade at a big premium to packaged-food peers.

But after the fat had been cut from Kraft Heinz, management needed another deal so it could start again on improving profit margins. Two years ago, the company made the blockbuster bid for Unilever, and when news of the proposal leaked, Kraft Heinz shares closed at a record high. Since Unilever rebuffed the proposal, though, the Buffett-backed company has been on a steady decline.

Old Brands

Kraft Heinz's inability to do a big acquisition under Chief Executive Officer Bernardo Hees has put a spotlight on its failure to boost sales. The writedown reported late Thursday, essentially a charge to reduce the goodwill value of its biggest-name trademarks, was more proof that the company has not managed its brands well, Shea said.

Related: American Cheese Is No Longer America's Big Cheese

The charges resulted in a net loss of $12.6 billion, or $10.34 a share. The company also slashed its dividend and flagged to investors a subpoena it received last year from the U.S. Securities and Exchange Commission related to its procurement practices. Kraft Heinz said that as a result of an investigation with the help of an outside lawyer, it recorded a $25 million “increase to costs of products sold.”

On the back of that bad news, the pressure will be even higher to do a deal. Over the years, speculation about potential targets has centered on food peers like Mondelez International Inc., General Mills Inc., Campbell Soup Co. and Kellogg Co. There have also been rumors it could look outside the food space in order to diversify its portfolio and grow into developing markets with the acquisition of a consumer products company.

M&A Need

Hees mentioned “industry consolidation” on the earnings call Thursday, saying Kraft Heinz was working to strengthen its balance sheet, presumably so it can pursue a deal. Kraft Heinz said it would return to profit growth in 2020 and its strong operating margins give it the “balance sheet flexibility for future consolidation.”

Related: Barbarian at Europe's Gate No More, Kraft Heinz Stumbles at Home

If the “Bank of Buffett” is still open, Kraft Heinz may still be able to get a transformative deal done. But with its shares plummeting to a record low and big questions emerging about the strategy, pulling off a big acquisition -- something that's already been tough -- may be even harder from here.

Berkshire Hathaway's investment declined from a valuation of about $15.7 billion to less than $11.4 billion as the stock plunged to $34.95 at the close in New York.

“Kraft Heinz needs to be a consolidator and they haven't been able to do it,” Scott Mushkin, a senior analyst at Wolfe Research, said in an interview on Bloomberg Television. “You are in an industry that has very significant structural headwinds and one of the things you can do to try to offset that is to put some of these companies together.”

--With assistance from Aviel Brown, Nancy Moran and Jonathan Roeder.

To contact the reporter on this story: Craig Giammona in New York at cgiammona@bloomberg.net

To contact the editors responsible for this story: Anne Riley Moffat at ariley17@bloomberg.net, Lisa Wolfson

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