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Kraft foods and Heinz, two Fortune 500 giants, merged in 2016 to form one of the largest companies in the processed foods space. More than 50% of the shares of this company are owned by Warren Buffet’s Berkshire Hathaway and Brazil’s 3G Capital.
The two giants had merged together in order to implement a ruthless cost-cutting strategy. Experts believed that this strategy was likely to be the growth engine for these companies who found themselves in the middle of stagnating revenues.
However, two years later, the story seems to have changed for the worse. Kraft-Heinz, the merged entity has written down over $14.5 billion in impairment charges. This has resulted in panic amongst the investors. The stock is down by over 25% in a single day! Kraft-Heinz has also cut its dividend significantly. The company had paid $0.62 per share in the last quarter. However, now, the company plans to pay only $0.40 per share. This means that the dividend has declined by almost 33% leaving the investors confused and jittery.
Warren Buffet’s company Berkshire Hathaway has lost close to $4 billion in a single day as the impairment has been announced. The impact has been significant for Berkshire Hathaway although it doesn’t seem to be an existential crisis since Berkshire Hathaway has only lost 1% of its market capitalization.
In this article, we will have a closer look at some of the reasons that have led to this huge debacle at Kraft-Heinz.
#1: Cost Cutting: Kraft-Heinz has become synonymous with ruthless cost-cutting in the past couple of years. The company famously implemented a policy of zero-based budgeting. This meant that every manager had to justify every expense in a new year. This is opposed to the age-old practice where previous budgets are tweaked in order to arrive at the new budget. This meant that the managers were constantly under pressure to lower their costs.
Hence, a lot of managers may have avoided expenses such as advertisements and brand building. This may have appeared to be a victory back then since the cash flow out of the company was lowered. Kraft-Heinz claimed that it had reduced its operating expenses by $1.7 billion. However, over a period of time, it has lowered the brand value of the company.
Most of the $14.5 billion which have been written down belong to the intangible assets such as goodwill. This is what makes the impairment ever more important. These intangible assets enable the Kraft-Heinz company to consistently sell their products at higher prices in the market. An erosion in this goodwill means that the company is admitting that it expects its sales and profits to be 25% less as compared to the previous results! This could totally change the cash flow situation and hence the valuation of the company.
Ruthless cost-cutting and short-sighted behaviour seem to have ruined the entire business model of this global behemoth.
#2: Change in Consumer Behaviour: The American consumer has become increasingly health conscious over the last decade or so. Earlier during the 1990s and 2000s, the products being sold by Kraft and Heinz were being consumed in large quantities.
However, medical research has proved that processed food products have severe medical consequences. These researchers have stated that packaged food products are one of the main reasons behind the drastic increase in the number of lifestyle diseases such as diabetes and hypertension. These food products have also been shown to have a high correlation with cancer.
As a result, consumers have started buying more fresh and organic produce. This means that the supermarket has been forced to give more shelf space to organic produce and less space to canned products. The sudden and rapid decline in the consumption of processed foods has spelt financial trouble for Kraft-Heinz. Also, consumer mindsets take years to be built and change. Hence, this fall in sales can be considered to be semi-permanent.
#3: Questionable Accounting Practices: The entire drama at Kraft-Heinz started after the Securities and Exchange Commission (SEC) decided to subpoena some records from Kraft-Heinz. The journalists got tipped off that there was something illegal which was taking place at Kraft-Heinz.
Finally, the company disclosed that the SEC was investigating some of the accounting practices which were being followed. Kraft-Heinz has started an internal investigation in this matter. It has not admitted to any wrongdoing as of now. However, the fact that $25 million has already been reclassified to increase the cost of goods sold makes investors believe that there may still be worse news in the future.
Kraft-Heinz is trying to cover up the mess as much as possible. They have started internal investigations to get to the root of the situation. Also, the entire accounting department is being revamped to ensure something of this sort doesn’t happen in the future.
The bottom line is that the company is facing several other challenges as well. The entry of Amazon into packaged foods space means that the supply lines are about to change pretty soon. Kraft-Heinz finds itself in a precarious situation and may have to do some out of the box thinking if it wants to exist as a multi-billion dollar corporation in the future.
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