Kraft Heinz: when desperate times call for desperate measures

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Kraft and Unilever: a union that makes sense

From meals to household chores, we can do everything in a house with Kraft Heinz and Unilever. The two giants must have come to the same conclusion last year as the idea of joining forces and becoming allies came on the table.

On Friday, February 17th of 2017, Kraft Heinz offered to take over Unilever. It was quite a surprise. Not because it did not make sense since, as we know, horizontal mergers are sought after. However, it was perceived as an extremely hostile takeover. Indeed, there were no known negotiations taking place and no long processes had started as we are accustomed to in Mergers and Acquisitions. But most importantly, Unilever never showed interest and felt as if Kraft Heinz Co (KHC) was taking advantage of its weak position at that time.

Furthermore, the approach of this US company attempting to acquire a European one sent out a political message to certain as the acquisition by Kraft of the British company Cambridge in 2010 left a bitter taste. The promises made by Kraft in terms of employment and environment back then have not been fulfilled, which caused a lot of debate and gave rise to the suspicion of American companies buying into Europe.

 That is one of the many reasons that could explain why, only two days after the bid, Unilever refused the offer. This extremely leveraged deal was initiated by Warren Buffet and 3G Capital who had worked on the merger of Kraft and Heinz two years prior. The private Equity firm 3G capital is specialized in transactions with high leverage and its expertise lies in creating significant cost savings. However, in this transaction, it seems as though not much cost cutting could be made especially when looking at how successfully Unilever is currently managing its production.

Moody’s Ratings estimated that the transaction would seriously damage Unilever rating as they believed that the geographic expansion would be offset by the potential Brexit and increase in costs of production in Great Britain. Thus, the current bondholders who benefit from the A1 grade would have to suffer from Kraft Heinz’s lower rating of Baa3 (as of February 2018).

A hostile takeover?

“We will not make hostile takeover offers and we did not intend that to be hostile but it turned out it was, and we immediately, the next day, called it off. It was a misunderstanding,” Warren Buffet, (August 2017)

Warren Buffet made several disclaimers stating that the takeover was not hostile. And even though, he had an additional month to make a final offer as per English rules, he decided to restrain from doing so. Representatives from the two companies had met a few days prior and Warren had instructed that an offer be made if, and only if, Unilever showed interest. He later explained that the situation was the result of a tremendous misunderstanding. Eventually, M. Buffet retired from the board of directors of KHC in February 2018.

On January 26th of the 2017, Unilever’s share had plummeted by 4.5% after showing even lower sales that it has been experiencing. That is when Kraft Heinz seized the opportunity and had offered $50/share for the British-Dutch transnational, which was valued at $143 billion at the time. This constituted an 18% premium, but Unilever did not consider that the price was fair. After the news of a possible merger broke, both companies saw their share prices increase.

Was the KHC’s attempt at a takeover hostile? I do not believe so. I would argue that the hasty decision was motivated in part by the drop in Unilever’s share price and in part by the lack of diplomacy. But most importantly, these strategic errors are a glimpse of a deeper issue that KHC will have to dwell on.

Should M&A be Kraft Heinz’s only recourse?

Kraft is well positioned in North America, but with Unilever’s presence in Europe, Latin America and Asia, would provide the American brand with a worldwide presence. Furthermore, the two companies combined would have a turnover of $84.8 billions and potentially compete with the current leader of the industry: Nestle. That would explain why this poorly orchestrated merger was rather a cry for help as Kraft was yearning for an ally in order to achieve a better position in this extremely competitive industry  the voracious markets. Furthermore, there are some obstacles that need to be considered. In 2017, the company already had $30 billion of long-term debt and no healthy cash flows to service it. And although KHC is known for its ability to cut costs, it will not be able to rely on it this time. Several times in the past, the conduct of a very lean manufacturing as well as a great deal of cost cutting allowed the company to reduce its COGS and thus boost its results. But this is not a sustainable strategy and it needs to rethink its approach.

The food processing industry enjoyed a growth of 20% in 2017 and is expecting to grow at a 11.8% CAGR between 2018 and 2022. But not only had the growth slowed down and is expected to keep that trend, the industry is volatile. It is highly impacted by trends such as organic, gluten free and food sustainability in general. And last but not least, the overall climate has caused a strain on agriculture and a spike in production and commodity prices. As a result, lot of companies merge in order to avoid costs related to R&D and gain competitiveness in this industry. On another note, the climate is also to blame for the low performance of Kraft & Heinz. Ever since the two companies merged in 2015, they have known a year on year revenue increase of 0.29%, which is one of the lowest between the major industry players. Their revenues amounted to $26 billion in 2017. It seems as though the merger of the grocery store and the famous ketchup maker Heinz did not yield the results expected and as we mentioned previously, merging can save costs and Unilever was desperate attempt for KHC to save its empire.

A little after the Unilever fiasco, it was rumored that KHC considered the acquisition of Mondelez which owns brands such as Oreo cookies or Ritz. It appears as a logical choice since Mondelez was formerly owned by Kraft Foods Inc. However, Warren Buffet denied this allegation but investors as well as recent company reports seem to predict that the company will try and add to its portfolio competitors with enough market shares and sales to sustain its demand such as Coca-Cola and Pepsi.

I, however do not believe that KHC should acquire Coca-cola or Pepsi as I am convinced that geographical expansion is imperative. The company has exhausted its cost cutting and must expand its geographical footprint. Unilever, with its presence in 100 countries with 57% of its business coming from emerging markets, would have been a great target if the negotiation had been held properly. So, who will be the next one? That is a very critical question. But the main issue remains the need for the company to look at its own structure and come up with a new strategy, especially now that Warren Buffet that played such a huge role in its operations left the board.

In a nutshell…

The strategic mistakes that Kraft Heinz did with Unilever is a reflection of internal issues that the company is facing. Only two years after uniting, Kraft and Heinz are at a crossroad and it must find a way to overcome the situation. As I said before, chosing visely the next acquisition for the group which will allow them to expand their business within, but most importantly, outside North America as well. As the situation urges and KHC is in dire need for change, we will soon get to see how this plays out.

Sources: Fortune articles, Financial Times References, Bloomberg Markets


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