Reports are surfacing that Abercrombie & Fitch (NYSE:ANF) is in ongoing talks with multiple entities for an acquisition, and that Kraft Heinz (NASDAQ:KHC) is looking to roll another major consumer goods company into its portfolio.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Fool.com contributor Asit Sharma take a look at these potential deals -- find out who is looking to buy out the teen-focused apparel brand, and why the leadership behind Kraft Heinz is so eager to pursue another multi-billion dollar acquisition.

A full transcript follows the video.

This video was recorded on May 30, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and it's Tuesday, May 30th. I hope everyone enjoyed their holiday weekend. If you haven't heard yesterday's special "Behind the Curtain" episode of Industry Focus, check it out to learn more about the team and what it's like in the studio. For today's discussion of potential merger and acquisition activity in the consumer and retail world, I've recruited senior Fool.com contributor Asit Sharma to join the show. Hey, Asit, thanks for calling in. How was your weekend, man?

Asit Sharma: It was wonderful, very relaxing, a long four days, the highlight of which, I beat my middle child 15 year old in one-on-one basketball. Chalk one up for Father Time. How about you?

Shen: Very nice. I was talking to Austin before the show. We got rained out a few times. I was up in New York. Did you guys have to deal with that at all in North Carolina?

Sharma: No. We got a little bit of cloud cover here and there. It was just a gorgeous weekend. So, we escaped some serious rain. It was very pretty.

Shen: Alright. I'm glad you had a good weekend and were able to show your son that you still have what it takes in the court.

Sharma: I still got it, thanks.

Shen: Kicking off our discussion for today, we have recent reports that American Eagle Outfitters (NYSE:AEO) is considering a potential acquisition of its apparel rival, Abercrombie & Fitch. These are both apparel brands focused on teenage and young adult consumers, with stores largely located in malls all across the country. So, retail weakness and headwinds have been in the headlines quite often and discussed on the show. We have a series of bankruptcies from other mall-based chains hit the news recently, including Wet Seal, Aeropostale, American Apparel and BCBG. And with the Coach-Kate Spade deal announced a few weeks ago, we're also seeing some consolidation in the apparel space, as well. So, Asit, there are a lot of moving pieces and potential suitors right now who are pursuing this deal, and I would like to cover this one at a time. To start things off, can you give us a quick rundown of what has been going on in Abercrombie? The stock enjoyed a $7 billion market cap a decade ago, and has since declined to about a tenth of that size. Annual revenue peaked at $4.5 billion. That is down to $3.3 billion last year. What happened?

Sharma: One of the things that you and I talked about in regards to retail companies is having a market that's strong enough to pull your product through. Retailers who are focused on the teen segment work with fickle fashion gods. Going back to the weekend briefly, I went with my family and saw the Pirates of the Caribbean. The gods of the sea are fearsome, there's curse after curse, and you have trouble, sitting in the theater, unraveling which curse is directed at whom and how do they break it? But they're nothing compared to the fashion gods, especially where teens are concerned. The fashion gods are brutal. This company has been in an industry in which it enjoyed a long surge of interest in mall-based traffic, and teens propelled that for years. As you and I discussed many times, online has shifted the retail landscape. Mall traffic has disappeared, and Abercrombie & Fitch, along with many of its retail brethren, is locked into long-term operating leases and purchase commitments for material and leases that are based in malls, which are quite expensive, not very lucrative if you're trying to break them. It's stuck in this fixed cost position with that smaller traffic base.

On top of that, the company has had to try to move with the fashion trends, and it's been out-hustled by the fashion-forward fast fashion houses like Zara, which have a lower economic footprint, a lighter capital footprint, change their fashions much more quickly. So it's really a victim of a couple of these larger forces. Operationally, the company has done a decent job. It was always somewhat profitable. That profit margin has now declined to near flat. But it's in a fairly liquid position. And a little bit later, we'll get into the differences between liquidity and solvency, which is speaking to Abercrombie & Fitch's long-term future. Basically, we're looking at entrenched trends that this company is trying to battle against with not a bright outlook looking forward.

Shen: Thanks, Asit, that's a really great rundown of what the company has been facing. I think, as you mentioned, it's really important to note that Abercrombie & Fitch is not alone in this. We've mentioned some of the other chains that have declared bankruptcy or closed their doors. These are headwinds that a lot of these mall-based stores are facing. Abercrombie, for four years running, the revenue has declined about 6% to 9% each year. I'd like to run down a list of different things that management has tried to do to face declining traffic to its stores, but also the changing trends.

It has recently announced that it will be closing dozens of its stores, about 60 of its U.S. locations. In 2014, they tried to rebrand, going from the big logos on its clothes, seeing that now, places like Zara and H&M, these fast fashion houses, they give you less branding and logos on their clothes so that you can design your own style, that seems to be what's popular with their customers. So, rebranding itself a few years ago, changing the look of its fashion. They're trying to market to older shoppers, moving away a little bit from their core teenage base. And they've also recently ousted Mike Jeffries, who was the former CEO who kind of put Abercrombie & Fitch on the map, taking over the brand in the early 90s when it was part of The Limited conglomerate. They've also implemented other changes to its executive team and the board of directors. One thing I will note in terms of bright spots for the company, it's not all bad, in that they have their Hollister business, which is actually, at this point, a bigger part of revenue than the namesake Abercrombie & Fitch brand is. But that has at least managed to maintain flat same-store sales. So, you can see, even in this situation, flat is better than the double-digit same-stores sales declines that they've seen with the Abercrombie brand. They also recently announced a wholesale partnership with Asian e-commerce retailer Zalora, to sell its merchandise, which I thought was an interesting way for the company to expand its international reach. 

Next up I want to establish a little bit of a timeline for what we know so far regarding the buyout process, and the negotiations that are going on between Abercrombie & Fitch and the potential buyers. On May 9th, the company confirmed that it has employed an investment bank to help navigate buyout talks with multiple interested parties. The following day, some initial reports indicated that at least two of the interested buyers for Abercrombie & Fitch were American Eagle and Express (NYSE:EXPR). In the meantime, Abercrombie shares initially jumped over 12% on the news, before gradually losing those gains until an update made headlines last week. Last week, May 24th, there was news from American Eagle, which not only was still interested in a deal, but it may be presenting a joint offer with Cerberus Capital, which is a private equity fund known for its interest in these distressed businesses. I think it would be fair to say Abercrombie is part of that category. 

So, the named suitors we have so far potentially negotiating this deal include Express, American Eagle, and Cerberus, and there are likely other entities as well. Express -- just a breakdown of who some of these potential suitors are -- is actually a smaller business than Abercrombie. It has a market cap of just over $600 million, Abercrombie is about $850 million. The revenue in Express' most recent fiscal year was $2.2 billion. Abercrombie's was closer to about $3.3 billion. So, if the companies were to agree to a deal, it would be more so a merger of equals, with a combination of probably cash and stock-based consideration. But, if I were a gambling man, I would have to put my chips on American Eagle and Cerberus rather than this deal, just because I think they have the more substantial resources, and also the aesthetic and branding fit that's more complementary between the two brands. Asit, if you're an American Eagle shareholder and you see this news, how are you thinking about this acquisition and evaluating it?

Sharma: I think you're pleased. If you're an American Eagle shareholder, then you, too, have seen the ravages of the retail industry in recent years, especially if you've held the stock for quite a while. But, looking at American Eagle's balance sheet, the company has around $225 million worth of cash. It's liquid. What does liquidity mean? Liquidity means that you have enough current assets on hand to cover your short-term obligations. It's also solvent, meaning that American Eagle doesn't have a lot of debt. However, because that profit margin has declined in recent years, I think last year's net profit margin was just over 5%, the company isn't really throwing off enough cash flow to cover its own operations, grow its business, and then take over an Abercrombie & Fitch. So, you must be pleased that this very deep-pocketed private equity firm, Cerberus Capital, is stepping in. Without that, it's going to be a tough deal for American Eagle. 

Looking at the market capitalization, Vince, you mentioned that Abercrombie's market cap is down to about $850 million. That looks sort of doable if you only look at the market cap. But American Eagle needs this private investor because there's more to the price tag of Abercrombie than meets the eye. Abercrombie has about $2.2 billion worth of long-term commitments. These are those operating store leases that I spoke about, and also materials purchased obligations for their inventory. That's a pretty big balance that you have to add on to the market cap, because whoever buys this company is on the hook for those obligations. When you look at total value, enterprise value, it's over about $3 billion, somewhere between $3 billion to $4 billion, once you consider some type of premium for the shares. Hooking up with a very well-resourced private equity group will help American Eagle not just acquire the company, but have the resources to realize the synergies that you mentioned, the fact that the product lines are similar, much more complementary than an Express and an Abercrombie. So, I think you have to be feeling pretty good if you are an American Eagle shareholder. But still, this larger question looms -- once you can buy into .these two companies, the same problem still exists. They have to find a way to reinvent themselves as a merged-up entity. What are your thoughts, Vince, on how these two companies potentially can combine and make something better out of these two parts? 

Shen: I've been thinking about some of the synergies, always a buzzword behind a deal like this, in terms of what these companies can realize. Definitely, the obvious benefits that jump to mind for any deal of this nature, where you have that larger scale, which gives the combined company stronger negotiating power, be it with its suppliers and its vendors. You have the opportunity to merge production facilities and corporate functions like finance and marketing, etc. to reduce costs. Also, this idea kind of reminds me of the Coach and Kate Spade's, operating in a similar space but ultimately diversifying the business with more than one established brand in the portfolio. Here, you would add Hollister and Abercrombie & Fitch to that portfolio for American Eagle. They also have their Todd Snyder and Tailgate stores, very small parts of their business but they're clearly trying to branch out and diversify the different storefronts that they have. It also seems to me like Abercrombie has been a bit more of a significant international presence that can be leveraged for American Eagle further abroad, not only with that Zalora deal that I mentioned earlier, but for a sales revenue breakdown, Abercrombie & Fitch international business was about 36% of total revenue, whereas American Eagle, what I could find, it's about 15% of their company operated stores are international locations, so most likely a smaller footprint. And for Cerberus to be looking at it, from their end, you get two well-known brands that, arguably, this is their business that they can help return to favor with consumers with, potentially, the right rebranding, cost cuts for profitability, and as you mentioned in terms of those deep pockets, Cerberus has about $50 billion or so in assets under management, giving it the pocketbook it needs to really pursue this deal. 

But, all in all, in terms of final thoughts for this, considering the bleak outlook that we've mentioned for Abercrombie & Fitch in terms of some of its comparable sales and trends and the headwinds that it faces, I think that even at some of the current depressed trading levels, a lot of investors have to wonder whether the ultimate buyer is getting that good of a deal, whether it's Express or American Eagle or someone else. I think it's understandable that the market has been a little skeptical. American Eagle's stock has been pushed down with these deal rumors. I think a lot of people would also be skeptical to buy into a business that seems increasingly out of touch as you have some of those fast fashion houses stealing market share, and as malls continue to lose foot traffic. Do you take a more bullish view in terms of the overall benefits that these two companies have together? Or do you think you also have a similarly more skeptical view in terms of whether or not this will actually pan out well for both of the entities involved?

Sharma: Vince, I have a slight sliver of optimism when I think about this deal. I'm skeptical about the industry. I'm skeptical about the market demand and these high fixed costs that both companies face, if we look at the deal being Abercrombie merging up with American Eagle backed by Cerberus. But, this private equity group is well-resourced, but contrary to what might appear on the surface, the company Cerberus is looking at a number of deals, and they have a great track record of extracting value for shareholders. They don't base the deal coming into it and helping out American Eagle on some projected numbers that the two companies can create together. They look at the deal according to their own internal rate of return, and they usually don't proceed with these types of deals until they think that, with this action plan, we'll work with management, we think we can hit our internal targets and get our value out in the deal. So, it's sort of a strong vote of confidence. That's why I have a slight bit of optimism. They're not going to pull their money into this merger and watch it sit. They will be a very active partner to make sure that value does get extracted, which will benefit current shareholders of both firms. I still think it's going to be an uphill climb, but I have a little bit of this optimistic feeling that value will be created.

Shen: Thank you, Asit, for bringing this up, in terms of the internal rate of return that all these private equity funds and firms will have before they look to invest in any deal like this. It's important to note that and, the idea that the vote of confidence that it provides. My last point before we move on to our next potential M&A deal is with American Eagle, for their business overall, something to highlight is that while their comps haven't suffered quite as much as Abercrombie & Fitch, and they're also seeing maybe 1% or single-digit declines in their comps during certain periods, but a big point of growth for them is their Aerie offshoot brand. It will be interesting to watch, if this deal goes through, how they can combine some of their more stable and high-growth brands and business with the struggles that we've seen from the portfolio brands at Abercrombie & Fitch. But, making sure we have enough time to cover our next topic. 

We know that Abercrombie is fielding acquisition offers. Our next company, Kraft Heinz, which is the $110 billion food and beverage company, actually appears to be shopping. Back in February, the company put up a massive $143 billion offer to combine with the Europe-based Unilever in what would have been one of the biggest deals in history. That would put major staples like Heinz Ketchup, Kraft Mac & Cheese, Jell-O, Breyers Ice Cream, Lipton tea, and Axe Body Spray all under the same roof. The $50 per share offer presented a 17% premium for Unilever, but the company soundly rejected the deal. And even if the two companies were able to agree on terms, the regulatory scrutiny would have been pretty intense due to their size and their overlapping geographic areas and businesses. But since February, after the Unilever deal fell through, Kraft Heinz have been planning its next move. Asit, before we talk about another deal that could be in the works, could you give us a little bit of background on who runs the show at Kraft Heinz, and why they seem so eager to close another acquisition?

Sharma: Sure. Kraft Heinz is really aggressively managed and invested in by 3G Capital. This is a Brazilian investment firm which has its roots, decades ago, in three Brazilian partners, of which Jorge Lemann is probably the most visible and well-known. These investors started with small conglomerates back in Brazil. Listeners will be very familiar with Anheuser-Busch Inbev. The company Inbev was a Brazilian beer company, and through a series of mergers, it's become the largest beer brewer in the world. As our listeners know, the company acquired SABMiller at the end of last year, and now there's nothing left for Anheuser-Busch to do in terms of acquisition, except maybe look outside of the beer industry. This is a good example of how 3G Capital operates. They love to build firms up through mergers, and have a certain playbook that they implement. This playbook is usually isolating a company which is not very well-managed with just mediocre margins. They'll acquire that company and then cut costs dramatically. They did that by reducing headcount, reworking the supply chain, by implementing something called zero-based budgeting, which means that every year, instead of looking at last year's budget, you create it from scratch to see what your costs really are, and execute accordingly. 

So, they increased the value of the company, but they're really not that concerned about growing revenues. To me, that's actually a harder thing to do in the business world. It's one thing to find a company that's doesn't operate quite as smoothly as it should and optimize it. But to actually increase sales is a harder task. So, what many investors have noted about 3G Capital is their tendency, after they optimize the cost side of a company, to go in and make another acquisition. It's been a very good vehicle for investment return. Another prominent one of their initiatives was the acquisition of the old Burger King brand, taking that from a private company back to a public company, merging that with Tim Hortons, and slowly trying to take over the quick-service side of the food industry. That, in a nutshell, is how 3G Capital operates. They and longtime partner and financier Warren Buffett love to do deals together. 3G provides the operational aspects and some of the capital, and Uncle Warren lends billions of dollars usually in preferred stock. And it's been a very successful formula. So, here we have Kraft Heinz, which was created by these partners. They are now trying to figure out, we've optimized Kraft Heinz. What else can we acquire? This is where their latest target, Colgate-Palmolive (NYSE:CL), comes into the picture

Shen: Rumors of another 3G-backed deal have been floating around since late last year, when the company began raising funding, about $10 billion worth for a consumer goods company, according to people who were close to the matter. You mentioned Colgate-Palmolive as the new potential candidate. The company, though, at least in relation to Kraft Heinz, has no food or beverage business that would mesh with Kraft, on top of its well-known toothpaste and personal care products, unless you count the dog and cat food business. So, why do you think Colgate-Palmolive is now in the crosshairs for 3G?

Sharma: This is not just a great question for the podcast, Vince. This is a great philosophical question. Why on Earth would this company turn its attention to a totally different industry within consumer goods? I think the philosophical answer is that at some point, this particular business model that 3G employs, if you cannot improve revenue, you have to look somewhere, and I think they're out of options. There are only so many giant food conglomerates that are similar to Kraft Heinz that you can purchase. Mondelez International, which is, ironically, the old Kraft company, keeps coming up in conversation. That's a merger which may or may not occur in the future. There just aren't a lot of companies in the multi-billion market cap range that would make it worth their while. So, they have to look outside of their current wheelhouse. Colgate is an interesting option. You can't get deal synergies from complementary products, but you can diversify your revenue. So that's one optimistic way to look at this -- they're broadening out their product face and insulating themselves against possible future declines in their condiment and packaged foods business.

Shen: OK, that makes sense to me. I figured the diversifying aspect of it would be a key part of why Colgate-Palmolive is attractive. Another part that comes through is, they were recently rejected in that huge deal offer to Unilever, whereas with Colgate-Palmolive, they have a management team that seems quite happy to consider a sale of its company. I have a note here from CEO Ian Cook, who's reported to have stated his interest in selling the company at about $100 a share. That's a more than 30% premium to current trading levels. Ultimately, with a lot of the bigger names like you mentioned in these sectors, these huge portfolio companies are often dealing with stagnant or declining revenue. 3G Capital actually isn't the only company that's looking at Colgate-Palmolive, since there are reports that the company is considering a big move like selling itself. Unilever and Johnson & Johnson have also been named as potential suitors. To close us out, any final takeaways from you, Asit, in terms of the way that 3G Capital operates, but also what the deal might look like with Kraft Heinz and Colgate-Palmolive? Obviously, details right now are scarce. A lot of this is actually just breaking this morning and in the past day. Any final thoughts or takeaways?

Sharma: My final thoughts are, this company, Kraft Heinz, has extremely deep pockets, and they have financing on the side with Warren Buffett whenever they want it. So, they could pay the premium, and pay the $100 that Colgate-Palmolive wants. One not very fun aspect of the deal for Kraft Heinz is that they would like to find companies that have a much lower operating margin than they do and optimize that. Unilever would have been a great deal, because Unilever's operating margins are only around 14%, whereas Kraft Heinz's operating margin is about 23.5%. Looking at Colgate-Palmolive, their operating margin is already 25.5%, so there's not a lot of great work there to do in terms of the cost-cutting we talked about. However, final thought, and I've said this on the show many times, but I'm going to keep repeating it because it's a bit of a hard concept, when you are an acquiring company, you want to look for a target which has a lower enterprise value to EBITDA value to yours. That means the total value of the company divided by its earnings. If that multiple is lower than yours, there's some value creation that can happen afterwards. In this case, Kraft Heinz has a current EV to EBITDA value of just over 19. Colgate's EV to EBITDA is about 16.5. So, there's something in there for this very sharp management team at Kraft Heinz to work with. Like you said, they have the funds, we very well may see this deal go through, and this conglomerate only grow bigger in the near future.

Shen: Thanks a lot, Asit. Both of these deals, for Abercrombie and Kraft Heinz, are developing. As we get more details, or if something gets locked down and finalized, we will happily revisit and provide some more input in terms of what the final valuation came out to, and things along those lines.

But, thanks, Fools, for listening. You can reach out to us and the rest of the Industry Focus crew via Twitter @MFIndustryFocus, or send any questions to industryfocus@fool.com. Don't forget to check out podcasts.fool.com to hear our other shows. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

Asit Sharma has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Anheuser-Busch InBev NV, Johnson & Johnson, and Twitter. The Motley Fool recommends Unilever. The Motley Fool has a disclosure policy.