To investors, the Kraft-Heinz Company (NASDAQ:KHC) may seem like a can't-miss investment: A portfolio of beloved household brands, huge scale, and top-notch management in 3G Capital and Warren Buffett's Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), which combined own about 50% of the company.
However, even Buffett himself said in his 1987 shareholder letter, "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."
Right now, the consumer-packaged goods business is facing several structural headwinds, and even Kraft-Heinz is not immune, posting a 3.1% year-over-year sales decline in the first quarter. Here are two big dangers Kraft-Heinz shareholders need to be aware of.
Large consumer packaged goods companies mostly sell through brick-and-mortar retailers. Often, profit sharing between producer and distributor is determined through delicate negotiations. Thus, if a retailer has sufficient scale, it can afford to be a tough negotiator and drive supplier prices down. This is how Wal-Mart Stores was able to become a very profitable business while also maintaining a reputation for rock-bottom prices.
In this light, the ongoing price war in the grocery business combined with Amazon's recent buyout of Whole Foods is likely to spur much greater consolidation in a fragmented U.S. grocery industry. On a recent conference call, Kroger CEO Rodney McMullen stated, "Everything that we can see, we're probably at the front end of the next phase of consolidation. You're starting to see some competitors fall out."
This is not good for Kraft-Heinz. First, an Amazon-Whole Foods tie-up could result in Amazon bringing Whole Foods' prices from "Whole Paycheck" levels down closer to those of consumer packaged goods brands.
Second, consolidation could very well mean Kraft-Heinz will be weakened in producer-distributor negotiations. For instance, consumer packaged goods companies often get preferred shelf placements and end caps due to their ability to pay slotting fees, pay-to-stay fees, and display fees to grocery stores. If you have, say, the scale of Wal-Mart (25% market share -- by far the largest player), you are likely able to negotiate higher fees (or bigger discounts) for access to your large store base.
While Kraft-Heinz is a global company, it still gets almost 80% of its sales from the U.S. and Canada, where consolidation is likely to happen. That could be why the company has been trying so hard to purchase Unilever (NYSE:UN), which is much more globally diversified, getting only 17% of its sales from North America.
Private label's rise
Another trend threatening Kraft-Heinz's franchise is the rise of private-label brands. Private-label brands are owned by the retailers themselves, such as Costco's Kirkland, Kroger's Simple Truth, and Whole Foods' 365 Everyday. Retailers often give these brands prime placement on their own store shelves, while pricing them far below big-name brands. Since retailers don't need to spend vast sums on marketing and display fees as large consumer packaged goods companies do, these brands are still very profitable despite their bargain prices.
Since the Great Recession, cost-conscious customers have been turning increasingly to private labels. Credit Suisse analyst Robert Moskow estimates private label sales have increased 3.5% annually since 2012, taking market share from the rest of the industry. Moreover, the percentage of consumers who can name a favorite brand has declined, with the age of transparency enabling customers to seek out products based on ingredients and benefits, according to a 2015 Time, Inc./Yougov study. As such, many consumers are simply turning to the cheapest selection, which is usually a private label.
A dangerous combo
Putting these two trends together -- the consolidation of grocery retailers, all with their own private labels -- is a potentially dangerous mix for Kraft Heinz. To combat these headwinds, the company is turning to innovation to keep customers interested, including removing nitrates from Oscar Meyer hot dogs and artificial dyes from Kraft's classic macaroni and cheese. The company has also launched new products, such as Heinz Seriously Good Sauces, Cracker Barrel Mac & Cheese, and Devour frozen dinners, which the company claims are performing very well.
Still, with the company posting year-over-year sales declines, it remains to be seen if these new innovations can offset declines in legacy brands and these two large headwinds. While the company is in good hands, Kraft-Heinz investors should still proceed with caution.
John Mackey, CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Billy Duberstein owns shares of AMZN, KR, and The Kraft Heinz Company. The Motley Fool owns shares of and recommends AMZN, COST, and WFM. The Motley Fool has a disclosure policy.