What's up with Kraft Heinz?

How 3G's cost-cutting playbook starved a giant, and why a split might be the cure.

Over the last decade, Kraft-Heinz (KHC) has delivered a dismal -5.6% annualized total shareholder return. This performance lags not only the S&P 500's impressive 11% annualized gain but also the S&P 500 Food Sector's more modest 7.1% return over the same period.

The KHC story offers valuable lessons for investors on spotting red flags in the making. And with a recent, surprising demerger announcement, it’s the perfect time to take a fresh look at this consumer giant.

History of a Failure

In March 2015, Kraft and Heinz announced their merger, a blockbuster deal valued at an impressive $49 billion. The transaction was the brainchild of 3G Capital and Berkshire Hathaway, who had jointly acquired Heinz just two years earlier for $23 billion.

At the time, the Brazilian private equity firm 3G Capital was on a roll. It had built a formidable reputation by acquiring "sleepy" consumer brands and aggressively cutting costs to extract value. Their signature strategy was Zero-Based Budgeting (ZBB), a rigorous system where every single expense must be justified from scratch each year. Before KHC, 3G had seen success with the 2008 merger of Anheuser-Busch and InBev and the 2010 take-private of Burger King, which was later spun out as Restaurant Brands International (QSR).

With a reputation as "rainmakers" and the Oracle of Omaha in their corner, the investment community was overwhelmingly positive about the deal. Kraft's stock price jumped on the news. As the transaction closed and 2016 began, it seemed everything was going according to plan. But 2017 marked the beginning of the unwind, exposing a fatal flaw in the 3G playbook.

source: the elevator pitch

Following the 2015 merger, 3G Capital's aggressive cost-cutting strategy initially delivered impressive margin expansion but ultimately proved unsustainable, crippling organic growth.

The newly appointed CEO, Bernardo Hees—a 3G partner who had successfully managed the Burger King turnaround—swiftly implemented the ZBB playbook at Kraft Heinz. At first, the plan was a stunning success. EBITDA margins soared to 30%, a level unheard of in the food industry. For comparison, a best-in-class peer like Nestlé, operating in more attractive categories, only achieved margins around 20%. The strategy was so lauded that competitors like General Mills and Conagra Brands began to adopt similar measures.

By 2016, however, the cracks began to show. With its marketing and innovation budgets gutted, Kraft Heinz saw its organic growth turn negative. This stood in stark contrast to Nestlé, which had resisted the cost-cutting pressure and continued to post steady, low-single-digit growth. It wasn't until 2018, when KHC began reinvesting in its brands, that growth finally turned positive again.

But the damage was done. In early 2019, with its stock price having been halved over the preceding two years, KHC took a massive $15 billion impairment charge on its Kraft and Oscar Mayer brands. CEO Hees was ousted and replaced by Miguel Patricio, another 3G pick from their other major investment, Anheuser-Busch InBev (which was also struggling at the time).

source: the elevator pitch

Another critical issue was the mountain of debt taken on for the merger. Starting at 4.0x Net Debt/EBITDA in 2015, the company never managed to deleverage. In fact, by the end of 2019, net debt had climbed to 4.6x as KHC maintained its dividend and acquired Primal Nutrition in 2018.

The COVID-19 pandemic provided a temporary tailwind. More at-home consumption benefited KHC's brands, and food inflation allowed the company to push through price increases, which they largely maintained even after inflation subsided. Under the new CEO, margins contracted from their 30% peak down to a still-healthy 26% as Patricio reinvested behind the brands. However, organic growth has started to falter again as the challenging consumer environment in the U.S. has made shoppers more price-sensitive.

What's next?

In a surprise announcement this month, KHC revealed its plan to demerge into two separate companies, nearly ten years after the original merger.

1. Global Taste Elevation Co: This entity will house the crown jewels like Heinz sauces and Kraft Mac & Cheese. It's projected to have $15 billion in revenue and a strong 27% EBITDA margin.

2. North American Grocery Co: This company will hold the lower-growth portfolio, including Oscar Mayer, Lunchables, and Kraft Singles, with around $10 billion in revenue and a 22% EBITDA margin.

From the outside, it looks like the board is taking a page from the Kellogg playbook. The Kellogg split into the fast-growing Kellanova (Pringles, Cheez-It) and the slower-growth WK Kellogg Co (U.S. cereals) paved the way for their acquisitions by Mars and Ferrero, respectively. Before the split, Kellogg's enterprise value was around $30 billion; the announced deals value the combined businesses at nearly $40 billion, unlocking a 33% premium in about two years.

Applying that logic here, the "Global Taste Elevation Co" would be a great strategic fit for McCormick (MKC), a company that dominates seasonings and is eager to expand its sauce portfolio beyond its hot sauce brands (Frank's RedHot, Cholula). The "North American Grocery Co" could then be an attractive target for a legacy food player like J.M. Smucker or Campbell's.

The main reason to believe acquisitions are the end goal is that the demerger makes little sense otherwise. While not a high-growth business, KHC benefits from its massive scale. Having all its brands under one roof gives it negotiating power with retailers and allows for shared marketing and back-office costs. Operating these companies as standalone entities would likely create significant dis-synergies.

While merger arbitrage isn't my specialty, a simple sum-of-the-parts analysis suggests significant hidden value. KHC's better brands are not getting a fair valuation compared to peers like McCormick and Mondelez. If we assign the "Global Taste Elevation" division a more appropriate 15x EV/EBITDA multiple (compared to KHC's current blended multiple of 7.5x), the potential upside could be as high as 86%.

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