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Uncertainty Looms for Kraft Heinz Investors

By Asit Sharma – Updated Dec 7, 2017 at 11:48AM

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Can investors bank on the vision of Warren Buffett and 3G Capital to lead the food and beverage giant to growth?

Kraft and Heinz merged just two years ago, but the massive deal hasn't exactly been paying off in spades since then.

In this week's episode of Industry Focus: Consumer Goods, Vincent Shen and senior contributor Asit Sharma talk about the struggles the company faces and the uncertainty that lies ahead for shareholders.

The cast also looks at Etsy (ETSY 0.79%), which has put up two strong quarters of results after transitioning to a new CEO. Find out what changed after Josh Silverman took over, and how the changes are clashing with the company's original vision.

A full transcript follows the video.

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This video was recorded on Dec. 5, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, Dec. 5, which means the consumer and retail sectors are on tap for today. I'm your host, Vincent Shen and I'm joined via Skype by senior contributor, Asit Sharma, who's calling in from Raleigh, North Carolina. Hey, Asit! Great to have you with us!

Asit Sharma: Thanks! Always fun to be back, Vince! Listeners, what up, Fools?

Shen: Asit, I'm going to start this off with an update on a story that we first discussed three weeks ago. On Nov. 14, you and I talked about the buyout offer of Buffalo Wild Wings (BWLD). They received that from private equity firm, Roark Capital. On that show, we covered some of the challenges that B-Dubs has encountered over the last few years. Things like declining comps and traffic, things that have affected a lot of the restaurant industry.

Over the summer, there was a battle for control between management and activist investor Marcato Capital. CEO Sally Smith would soon be stepping down. Marcato was pushing the company to refranchise its stores. Now, we have details of the official offer from Roark Capital -- or, I should clarify, one of its portfolio restaurant brands, Arby's Restaurant Group. The two companies have agreed to a deal at a cash offer price of $157 per share, which represents a 34% premium to the last closing price of B-Dubs stock before all these deal rumors made the news.

The board of directors at both companies have signed off. Marcato Capital supports the deal. They have a 6.4% stake in Buffalo Wild Wings. Asit, are you surprised at all that Marcato was so quick to hop on board with this deal after they fought with management for almost a year to win board seats, to win greater control of the company's future direction, and now they're just ready to sell out a few months later?

Sharma: I'm not surprised at all, Vince. I think execution is always harder than pointing out what a problem is. When you're growing up and your parents are ferrying you around and you're in the back seat, you can't wait for the day that you get into the driver's seat. But when you're in the driver's seat in traffic, things change, those first few months. I think what Marcato sees is that Roark Capital, which owns Arby's, which is actually going to be the owner of the new company. They are an experienced restaurant operator and have the tools to address some of the problems that we've been talking about, including the traffic, how to deal with soaring wing prices. This is something that is best left in the hands of a company which can execute the day to day and is in the field already. So I'm really not surprised that they're going along with this.

Shen: Part of me wonders, Marcato spent so much time and effort forcing Sally Smith out of the company, overall giving the management team there a lot of grief over the work that they've done and some of the roadblocks that they've hit in terms of challenges and headwinds for this industry. Then, they made promises of some of their operations, stronger financials. Was this all bluster on Marcato Capital's part? Kind of what you mentioned, actually being in the driver's seat, it's a very different situation to find yourself in. Marcato has an average cost basis of $142 per share for their stake, so at $157 per share in this buyout, it's only a 10% return for their investment. I think this really does come down to the fact that, they won the board seats, they started to implement their plan, but maybe realized, to turn around this business, and as they previously mentioned, doubling or tripling the stock price as they believed Buffalo Wild Wings could do in the next few years, would not be nearly as simple as they thought.

Last few details for this deal, Buffalo Wild Wings will operate as an independent subsidiary and brand under Arby's, as you mentioned. That's assuming that Buffalo Wild Wings shareholders approve the deal. The merger is expected to close in early 2018. As a customer, I'm still pretty disappointed. I brought this up before, their wing Tuesday promotion is now Boneless Tuesday. So, if a former B-Dubs customer can dream, the first thing I hope on the to-do list for Roark Capital and Arby's is to bring back their Wing Tuesday promotion, and they will find me back in the stores as a happy customer. If we have any other updates on that deal, other things that come up, we'll be sure to share them with listeners, but the information we'll be able to get from that company will only decrease as they are taken under the wing of private Arby's.

Our next topic is another company that has not quite found its footing after coming together in a massive deal, and that's Kraft Heinz (KHC 0.86%). This is a big food and beverage company with a huge portfolio of brands that our listeners will recognize from grocery store aisles -- $100 billion market cap, $26 billion of revenue in the past 12 months. At the same time, sales growth is negative. Consumer preferences are gradually moving away from the packaged and processed foods that Kraft Heinz is best known for. Asit, to kick off our discussion of this company, can you introduce us to the players? There are some really important, well-known investors in leadership behind this company. Who's pulling the strings?

Sharma: Let's go back to 2013. That's the year that an investment company called 3G Capital teamed up with Warren Buffett to acquire the Heinz company. 3G Capital is a Brazilian firm that has their fingers everywhere. They are investors in the world's largest alcoholic beverage company, which is Anheuser-Busch InBev. They own Restaurant Brands Internationalwhich is the company in charge of Burger King and Tim Hortons. So this is a very experienced team which uses Warren Buffett's endless checkbook, boundless checkbook, to acquire major companies and improve them.

3G Capital's whole modus operandi is to cut costs, to cut overhead, to budget every quarter from a zero-based budgeting concept, which means that you start without looking backwards. You look at what your current needs are and budget from there, manage supply chains that are all about optimizing operations. These are an experienced group of players. At the same time, in 2013, in that 3G Capital and Warren Buffett bought the Heinz company, Kraft, the old grocery store supplier, decided to shave off its most important brands, they call them power brands, so Oreo cookies, Tang, Ritz crackers, those all went to a new company which investors will be familiar with, now called Mondelez. The old grocery business stayed as Kraft.

In 2015, the Heinz company, now owned by 3G and Warren Buffett, merged with the Kraft company to create the Kraft Heinz company, and that was in July of 2015. So this is the history behind the company that we look at today, which has a broad range of condiments, everything from Kraft mayonnaise to Heinz ketchup and mustard, and plus a whole stable of smaller brands.

Shen: Warren Buffet, 3G Capital, they have significant stakes in this combined entity. 3G Capital, their partners and a lot of people involved with that firm, they take up major leadership positions at the company, including CEO. As you mentioned, 3G Capital is known for taking a knife to any company's cost structure that they become involved with. Management has cut about $1.5 billion of expenses so far since the 2015 merger, and I think that amount is expected to increase to about $1.7 to $1.8 billion by year end. Those efforts have certainly helped the company become more profitable. Their gross margins are wider, operating margins have expanded, and their earnings growth is in the double digits recently.

But the question mark is in terms of their revenue growth. That has not really materialized since Kraft and Heinz came together. I think there's a point when investors in the market want to see, for example, the international growth that a lot of people were pointing to when this deal was initially announced, the idea that Heinz could open its overseas channels to Kraft products. But how do you think the company and management can deliver here? In this case, the 3G team obviously has to rethink their approach a little bit. They've cut costs now, but what about growing that top line? They've already implemented quite a few changes. For example, in the leadership structure, there's been some new positions and promotions and changes in the leadership team at Kraft Heinz that were announced in the last earnings call. So it seems like they're already starting to rethink things a little bit.

Sharma: Yeah, it's a great question that you pose, Vince, where is this revenue going to come from? Investor expectation ever since 2015 was that Kraft Heinz was going to act as 3G Capital companies typically do. So cut overhead cost and then go out and acquire revenue by other companies. In February of this year, very shortly after initial talks with Unilever for a $143 billion deal that broke down, following this, there was no other merger that looked good, either to investors or Kraft Heinz management, and that's because of some of the headwinds on the industry that you mentioned earlier.

Consumer packaged goods companies in the food sector are having a rough time as grocery shopping changes. People start ordering their groceries online, so they're not in the stores to see the marketing attached to these products. And smaller brands, which have a more sustainable bent, have more natural ingredients, are popping up on shelves when customers do go in. If you look at the potential candidates that Kraft Heinz could conceivably buy -- let's take Campbell Soup, for example. Campbell Soup is struggling, its revenues are declining. So that doesn't look so great. Other candidates have similar problems. I think Mondelez is one as well that I've often thought could be an interesting merger, but they also struggle with revenue. So the trick for Kraft Heinz might be for this next year to go back to the drawing board. The one criticism I've had about 3G over the years is that there is no tool for revenue in the playbook. There's every tool for making the operations better, but when it comes to growing the top line, 3G companies always look to acquire. That's why, and Vince, you and I talked briefly last year on a podcast about Anheuser-Busch's massive acquisition of SABMiller, you can't just grow until you've acquired every other fish in the industry. At some point, you have to learn how to increase sales organically on your own.

For this company, I think, maybe look to Europe. That's where they've had some success with packaging innovations in condiments across a more active consumer, especially in the U.K. and Western Europe. They can try this year to extend those gains and translate some of those earnings back into the U.S. Which goes back to what you were mentioning, that there are opportunities to take brands in the U.S. into Europe. Me, I would love to see them focus on the business next year. Maybe the last thing they need is to acquire a company and have this whole long process of merger and finding synergies, optimizing operations. Go back to basics would be my hope for this company in 2018.

Shen: Yeah, and everything else that goes along with the integration process. In terms of organic growth, you think about the traditional levers that a company in this industry might consider. You mentioned a few of them -- additional marketing, they might innovate with new products, might try to revitalize some brands. But those are all things that require investment, spending more money, not so much the cutting costs playbook that 3G has become known for operating with.

Getting some closing comments from you, Asit, we talked about some of their challenges, their headwinds, their opportunities, things that lie ahead. But the stock trades at about 22x forward earnings right now. Shares are in negative territory year-to-date, and that's the same as a lot of the other food and beverage companies, packaged goods that are in this industry like Unilever and Mondelez, we talked about those, Kellogg's, General Mills. They're all in the same boat, too. But I guess what an investor will probably ask, then, is about faith in Buffett and the 3G Capital team. Is that something that you have, with such a strong lineup of experienced investors, in terms of taking over these companies, and they've had a lot of success in the past, eventually being able to come through? What do you think?

Sharma: That's one persuasive reason for an investor to hang on to this stock, that the bank of Warren Buffett is next door. In terms of acquisitions, those are always open to Kraft Heinz. It would just take a little bit of organic growth, some resumption into the low single digits. And that seems like a very small number. You're talking about 1% to 2% organic growth. But in this industry, with all the disruption that's going on, that would actually be a very positive sign. If they could hit that next year, it gives investors a rationale to see this combination of higher earnings per share from really good operations and their experience, plus just a little bit of growth in terms of customers wanting to buy these products and demand pulling their products more off the shelves, as Heinz enjoyed in past years before all these mergers started. I think you combine just a little bit of resumption with organic growth with what you mentioned, Vince, what better partner would you want than Warren Buffett in the future?

It's still a good stock to hold, but for investors who think that maybe it's going to pop back next year, I think we're probably looking at a 2019 story. But it's certainly not a stock that you would have to shake out of your portfolio. Just monitor it and keep an eye on it, and hopefully next year, they will resume some of the top line growth that investors have been looking for.

Shen: Absolutely. Thanks, Asit. Next up, we'll be talking about another really interesting business, Etsy.

Asit, last time that we spoke about Etsy, it was in the context of increasing consumer customization and that trend in the industry. Listeners, if you've never shopped with Etsy, if you're not as familiar with the name, this is an online marketplace that pairs the company's 1.9 million sellers of handmade and artisan style goods with more than 30 million buyers. The company makes money by charging sellers transaction fees on items that they sell in the marketplace, as well as additional fees for services like payment processing, shipping, and promotion. Revenue in the last year came in at $415 million. The stock has only been trading publicly for about 2.5 years. For most of that period, returns were poor, and the stock traded below its initial offering price. But year-to-date, the stock is now up over 50%. If we work our way from the beginning of the year, there's been some big changes at Etsy that I think contributed to the very bullish rally. That included some leadership changes, some layoffs and changes in terms of the organizational structure. What happened, Asit?

Sharma: In May of this year, a board member, Josh Silverman, was appointed CEO. The current CEO who had shepherded the company through its IPO process, and who was the former CTO, chief technical officer, Chad Dickerson, had to resign. At the same time, on the same day, the company laid off over 100 employees, and has had at least one round since then. Chad Dickerson represented the best aspirations of Etsy. The company was a certified B Corp, business corp, which is a really hard certification that points to a sustainable business ethos. Patagonia has the same certification. It was known to be an extremely accommodating work environment, and it was a company that proposed to change the world.

When Etsy went public, they wanted to both make money on the bottom line but push for social justice and sustainable goods and sustainable trade. The problem was, the company was spending a lot of money on marketing to increase its gross merchandise sales, the volume of business that Etsy takes a slice off of each transaction. Silverman, who was the board member I mentioned, was one of the people who was consistently questioning Etsy's business practices and its viability as an ongoing concern if you look over long-term horizons.

He was appointed in May, and since then, just look at the most recent quarter, the company has increased the gross merchandise sales 13% to $766 million. Revenue was up 22% to $106 million this quarter vs. the prior year. Etsy had a net income of $26 million in its most recent quarter vs. a prior year loss of $2 million. So it's had positive change out of the gates since May. The question for some investors who wanted to both profit from the stock and participate in this feel-good story is, has the original mission of Etsy been lost, and is it now more of a corporate-style entity? And Vince, I know you shop on Etsy, and I've shopped on Etsy before, what are your thoughts?

Shen: This is a really tough position, because it comes down to a balancing act of values and ethos, as you mentioned, that the company, the work force wanted to maintain. They often boast, for example, in their financial statements, in terms of facts about the business, how a large majority of sellers on Etsy are women, and trying to empower the sellers on their platform to be entrepreneurs and build up these businesses and the supplemental income, and maybe become their primary career or whatever it is that they're working on.

At the same time, in terms of when Silverman took over in May, the six months or so before then, there was already tons of pressure growing on the company to not only increase its top line growth but also potentially seek out other strategic alternatives, for example, putting themselves up for sale as a result of certain activist investors and hedge funds taking positions in the company. Ultimately, when Silverman took over from the prior CEO, Chad Dickerson, he applied much more conventional guidelines and practices to lead the company into the next stage. As you mentioned with the latest quarterly results, they seem to be working, two strong quarterly reports now, accelerating growth for some of those really important company metrics like total revenue, gross merchandise sales. They've had positive earnings for two quarters, they're growing their number of sellers and buyers on the site. But this all comes at a price.

Asit, you shared a great article with me before the show from the New York Times that covered some of the changes, both good or bad depending on who you ask, that Silverman implemented when he took over as CEO. I think, despite the stock gains and improving results we've seen from his initial six-month tenure, he seems to be pretty controversial within the company itself.

Sharma: Yeah. I think there are supporters of his style who see that there's new accountability at Etsy, and there's more risk taking in the culture. This was brought up in the New York Times article. But there are also those who feel that the way the company conducts business doesn't look much different than other e-commerce companies that we're used to analyzing on the show and that investors are familiar with.

I'd like to pick out one thing from the recent conference call transcript that Etsy had, which to me crystallizes this push and pull between what employees want to see in the company's best iteration and the realities of the business world. This is Josh Silverman talking to analysts recently, in the beginning of November. He says, "We launched scarcity badges to alert buyers when items are only available in limited quantities. By creating a sense of urgency, we can leverage our unique inventory and nudge buyers along the shopping journey. We think scarcity badges are a particularly powerful tool for Etsy, given that so much of our inventory is made of unique, special items that, by nature, are scarce. It's also a response to a common buyer frustration, finding an item and favoriting it only to come back later and find that it's already been sold." You can look at this statement in a number of ways. It's like a Rorschach test. If you're an investor, that sounds great, because you're creating that sense of urgency which forces someone to click to buy the product and the sale is complete. But if you are an Etsy employee and you hear this, this sounds like the kind of practice that you didn't sign up for, because it's preying on this thing that we're all vulnerable to on the internet, which is the marketing messages, the feeling that you have to buy now. That isn't part of the original philosophy of Etsy. It's hard to say. Does this mean that the company is going to totally divorce itself from those founding principles? Probably not. But it reflects a reality. Listeners, if you want to look up that article in the New York Times, it's a very nice article, I think it was the 25th of November. 

One more point that comes to mind about Etsy is, maybe it should have just stayed private, although it's always hard to raise that capital. I have met Chad Dickerson a couple of times, actually through marriage related to a close friend of my wife's. He's a charismatic, very sharp guy, very capable, obviously exudes that holistic new CEO of the next sort, the kind that balances financial acumen with caring. And if they had stayed private, I think they could have done very well under someone like him. But going public changes everything, because you're not just accountable to those employees and private investors, you're accountable to you, listeners, who are investing in the stock. And that's a different ball game.

Shen: We've talked before about the changes when a company has gone public, and they need to meet the demands of Wall Street and to succeed in that kind of world where, a lot of times, you're going quarter-by-quarter, and we're not encouraging that viewpoint, but that is a viewpoint that a lot of investors take. We, of course, encourage you to take a longer-term view.

And maybe that's exactly what a lot of stakeholders in this company feel would have been preferable compared to "selling its soul" in order to meet the demands of being a public company. Overall, I think Etsy has proven itself as a viable and pretty compelling business. There were talks previously about how Amazon Handmade, which is kind of a direct competitor in terms of this more artisan craft marketplace, would essentially put Etsy out of business. They've thrived despite that. And as a frequent Etsy shopper myself, I think the company really presents a unique vibe that stands out from other marketplaces like eBay. Any last comments from you, Asit? Maybe thoughts on what lies ahead for the company?

Sharma: One of the things that Silverman has done is to curtail the international expansion that Dickerson was really pushing. Dickerson wanted to reach a lot of women in impoverished countries and also create business by opening up in different parts of the globe. I think we're going to see that resume over the long-term after a little bit more stabilization of the balance sheet. The company has a lot of opportunity. And let's face it, it's better than most in terms of its social goals and sustainability, still. It hasn't totally left behind why it was founded, to help people make a living, as well as provide beautiful products. Like you, I think the site is special, I think the products are unique and special. It should do well over the long term. You can still buy it and feel fairly good about yourself.

Shen: Alright. Thank you, Asit, for joining us! Always a pleasure. Thanks, Fools, for listening! Austin Morgan is the producer for Industry Focus. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any 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 of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Anheuser-Busch InBev NV, Buffalo Wild Wings, and eBay. The Motley Fool recommends Etsy and The New York Times. The Motley Fool has a disclosure policy.

Stocks Mentioned

Buffalo Wild Wings Inc. Stock Quote
Buffalo Wild Wings Inc.
Etsy Stock Quote
$140.49 (0.79%) $1.10
Kraft Heinz Stock Quote
Kraft Heinz
$39.83 (0.86%) $0.34

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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