I once heard a story from an old Marine who managed two tours in Vietnam before getting a one-way ticket home after losing his arm. The first time he was wounded (the first of four Purple Hearts), he was getting some quick first aid from a field medic while lying flat on his stomach with his ass up in the air. He said the last thing he remembered before the morphine took hold was the medic saying, “This ain’t no touch football. Out here it’s a contact sport.”
Most of the people invested in Kraft Heinz this last week have realized Wall Street is a contact sport. The company announced earnings last week where they threw everything but the kitchen sink (and some might say the toilet was part of the inventory tossed) at investors. The company wrote off more than $15 billion related to previous acquisitions and revealed a Securities and Exchange Commission investigation. Kraft Heinz also reported a fourth-quarter loss of $12.6 billion, or $10.34 a share, on sales of $6.9 billion, up from $6.84 billion a year ago. Much of that loss was due to non-cash impairment charges of $15.4 billion to lower the carrying amount of goodwill in certain reporting units.
There isn’t a really nice way to report numbers like those reported by Kraft Heinz. Results like these can create permanent capital losses for investors and put a huge dent in long-term investment returns. As an investment manager or individual investor, this is a gut-wrenching time to decide whether to add, hold or sell some or all of your position.
As investors face enormous losses like some holders of Kraft Heinz today, there are some key questions that are helpful moving forward. But before we get to these, there are a couple of areas that I think investors missed in their initial valuation of the company. Warren Buffett did a great job describing his errors in this interview and walked through where he made some mistakes.
Consumer buying habits didn’t change -- their brand choice did
Costco’s Kirkland brand is an example of a competitor stealing a march on their core competition. Kirkland Signature (its in-house brand), is enormous. Last year, it brought in roughly $40 billion in revenue, which was an 11% increase from 2017. That number represents more than Campbell Soup, Kellogg and Hershey combined. Think about that for a moment. The Kirkland brand is only 27 years old versus Campells (started in 1869 and currently selling in 120 countries), Kellogg (started in 1898 and currently selling in over 160 countries) and Hershey (started in 1894 and sold in 60 countries.) Compare these statistics to Kirkland (founded in 1992 and sold in only 760 Costco stores in 11 countries). Kirkland accounts for roughly one-third of all Costco revenue and is growing at nearly double the rate of total store sales. In summary, a brand only 27 years old lapped some of the most respected and oldest brands in the world.
We continue seeing the financial failures of M&A
In his interview with Becky Quick, Warren Buffett was quick to point out he (or they - meaning Berkshire Hathaway and 3G) paid a great price for Heinz but a terrible price for Kraft. This overpaying came into clear focus after Berkshire announced it will write down $3 billion and Kraft Heinz will write down $13.5 billion in brand value.
I have written previously about how and why most mergers and acquisitions fail. Most of the errors lie with management overestimating the amount of synergies they can achieve with growth and underestimating the difficulty in achieving cost savings without doing long-term structural damage to the company. Another problem lies with management – listening to those consultant and investment banker faeries on their shoulder – when they conduct a merger at exactly the wrong time. Either consumer habits are changing, markets are reaching nose-bleed price levels, or they simply see a need to create a larger empire.
Berkshire and 3G were guilty of a little bit of the first two. They obviously thought they could trim significant fat and jump start growth. After all, 3G had made itself a specialist in acquiring companies, cutting costs dramatically and producing surging earnings. Revenue per share has been $21.6 billion (2016), $21.4 billion (2017) and $21.5 billion (2018). Earnings per share have been $2.81 per share (2016), $8.95 per share (2017) and -$8.39 per share (2018). I wouldn’t count any of these numbers as something to particularly boast about.
With the misjudgment in the adoption of in-house family brands (like Kirkland) and the financial missteps in the Kraft acquisition, it’s a good time for investors to ask themselves what to do when faced with such a large impairment in both the company’s books as well as its investment portfolio. I find that asking several questions can help me sort out the problem and help make my choices clearer.
Is this your problem, the company’s problems, or both?
Sometimes an impairment can be caused by the investor by paying too much, overestimating revenue, market sizing or similar. Other times an investor may pay a reasonable price (or what they think is reasonable) and see the price drop for no apparent reason or have Wall Street not understand the quarterly earnings. Finally, there is the most painful: when both you (the investor) and the company get something terribly wrong such as regulatory approval failure, a huge earnings miss and a particularly bad M&A deal.
In the first case, it’s critical the investor consider what they got wrong and check its impact on valuation. Only the investor can help make a decision in this case. In the second case, if the investor runs the numbers and sees no impact in their valuation, then by all means purchase more if it makes sense. In the last case, it’s imperative the investor not fool themselves by reading too much into management’s investment case, completely rerun their valuation model and make the call whether management’s failure is worth maintaining a partnership.
Is the loss permanent in nature?
Another question to ask is whether the loss in permanent or temporary. Reading through the Kraft Heinz earnings report, it would certainly seem the loss is going to be very long in nature – if not permanent – without much guidance going forward in how it will right the ship. In these instances, your tax status (taking the loss) or your inability to wait potentially years to return to growth might recommend you sell. But, should you feel the losses can be made up and they are mere bumps in the road, then it might be best to continue to hold.
How can the loss be redeemed?
Of vital importance in understanding the nature of the loss, the investor should have a clear understanding of how management expects losses to be redeemed. Some might be able to do so with additional cost cutting (seems unlikely at Kraft Heinz) or by revenue growth (equally hard as driven by the Kirkland example or relationships with retailers). It seems that without some major strategic shift and hit to pricing, Kraft Heinz is in quite a bind to develop a plan for strong growth going forward.
Does the impairment have a tail wind or head wind?
It’s important to ascertain whether the holding is facing head or tail winds going forward. In some cases it might even be mixed. I think it would be hard to find evidence to suggest Kraft Heinz’s industry is looking at a strong or even weak tail wind. The evidence we’ve seen to date – combined with Kraft Heinz’s management comments on their call – would suggest the company sees a slight to moderate headwind over the next few years.
As an investor considers their position, knowing what long-term trends predict is critical. If the industry portends future strength in industry patents, this would be quite different than Kraft Heinz facing long-term pricing, product placement and demographic nutritional focus. When looking for a turnaround, always try to find one with a good following industry tailwind.
Is management sharing in your losses?
Last, but not least important, is whether management is suffering along with shareholders. If board members reprice options to reflect lower prices, or the company increases grants as shareholders suffer, look for a new holding. Investors should partner with management who suffer to the same extent as their shareholders. All too often you will see management’s compensation be finessed to make sure they receive the same – if not more – than the previous year’s compensation. C-suite management works for the board of directors and the board of directors look out for the fiduciary responsibility of their shareholders. Make sure everyone is sharing losses equally.
Before concluding, I want to say up front this isn’t a knock on Warren Buffett, 3G or the Kraft Heinz management team. I know very little about the industry, the company and all the work that has gone into building the company. I also know very little why you – the investor – might be either a holder of the stock or a bystander. Only those with skin in the game can really make these very tough decisions.
Conclusions
There’s an old saying that you never take a loss until you sell. Like all well-aged adages, there’s quite a bit of wisdom in it. The difference between a paper loss (the price is down but you haven’t sold) versus an actual loss (the price and down and you did sell) can be all the differences between a successful and non-successful value investor. Understanding when your capital is well and truly impaired can help you make some difficult decisions. Like our Marine learned (in a far more difficult way), this ain’t no touch football. The decisions that are the most disastrous are when you listen to the fear in your gut as well as to some charlatan who hits a button with the sound effect of someone screaming “SELL! SELL! SELL!”.
Investing in Wall Street can be a contact sport. The better your game plan, the better your reasoning, and the better your understanding of the potential loss you face, the better your results will be over time.
Most of the people invested in Kraft Heinz this last week have realized Wall Street is a contact sport. The company announced earnings last week where they threw everything but the kitchen sink (and some might say the toilet was part of the inventory tossed) at investors. The company wrote off more than $15 billion related to previous acquisitions and revealed a Securities and Exchange Commission investigation. Kraft Heinz also reported a fourth-quarter loss of $12.6 billion, or $10.34 a share, on sales of $6.9 billion, up from $6.84 billion a year ago. Much of that loss was due to non-cash impairment charges of $15.4 billion to lower the carrying amount of goodwill in certain reporting units.
There isn’t a really nice way to report numbers like those reported by Kraft Heinz. Results like these can create permanent capital losses for investors and put a huge dent in long-term investment returns. As an investment manager or individual investor, this is a gut-wrenching time to decide whether to add, hold or sell some or all of your position.
As investors face enormous losses like some holders of Kraft Heinz today, there are some key questions that are helpful moving forward. But before we get to these, there are a couple of areas that I think investors missed in their initial valuation of the company. Warren Buffett did a great job describing his errors in this interview and walked through where he made some mistakes.
Consumer buying habits didn’t change -- their brand choice did
Costco’s Kirkland brand is an example of a competitor stealing a march on their core competition. Kirkland Signature (its in-house brand), is enormous. Last year, it brought in roughly $40 billion in revenue, which was an 11% increase from 2017. That number represents more than Campbell Soup, Kellogg and Hershey combined. Think about that for a moment. The Kirkland brand is only 27 years old versus Campells (started in 1869 and currently selling in 120 countries), Kellogg (started in 1898 and currently selling in over 160 countries) and Hershey (started in 1894 and sold in 60 countries.) Compare these statistics to Kirkland (founded in 1992 and sold in only 760 Costco stores in 11 countries). Kirkland accounts for roughly one-third of all Costco revenue and is growing at nearly double the rate of total store sales. In summary, a brand only 27 years old lapped some of the most respected and oldest brands in the world.
We continue seeing the financial failures of M&A
In his interview with Becky Quick, Warren Buffett was quick to point out he (or they - meaning Berkshire Hathaway and 3G) paid a great price for Heinz but a terrible price for Kraft. This overpaying came into clear focus after Berkshire announced it will write down $3 billion and Kraft Heinz will write down $13.5 billion in brand value.
I have written previously about how and why most mergers and acquisitions fail. Most of the errors lie with management overestimating the amount of synergies they can achieve with growth and underestimating the difficulty in achieving cost savings without doing long-term structural damage to the company. Another problem lies with management – listening to those consultant and investment banker faeries on their shoulder – when they conduct a merger at exactly the wrong time. Either consumer habits are changing, markets are reaching nose-bleed price levels, or they simply see a need to create a larger empire.
Berkshire and 3G were guilty of a little bit of the first two. They obviously thought they could trim significant fat and jump start growth. After all, 3G had made itself a specialist in acquiring companies, cutting costs dramatically and producing surging earnings. Revenue per share has been $21.6 billion (2016), $21.4 billion (2017) and $21.5 billion (2018). Earnings per share have been $2.81 per share (2016), $8.95 per share (2017) and -$8.39 per share (2018). I wouldn’t count any of these numbers as something to particularly boast about.
With the misjudgment in the adoption of in-house family brands (like Kirkland) and the financial missteps in the Kraft acquisition, it’s a good time for investors to ask themselves what to do when faced with such a large impairment in both the company’s books as well as its investment portfolio. I find that asking several questions can help me sort out the problem and help make my choices clearer.
Is this your problem, the company’s problems, or both?
Sometimes an impairment can be caused by the investor by paying too much, overestimating revenue, market sizing or similar. Other times an investor may pay a reasonable price (or what they think is reasonable) and see the price drop for no apparent reason or have Wall Street not understand the quarterly earnings. Finally, there is the most painful: when both you (the investor) and the company get something terribly wrong such as regulatory approval failure, a huge earnings miss and a particularly bad M&A deal.
In the first case, it’s critical the investor consider what they got wrong and check its impact on valuation. Only the investor can help make a decision in this case. In the second case, if the investor runs the numbers and sees no impact in their valuation, then by all means purchase more if it makes sense. In the last case, it’s imperative the investor not fool themselves by reading too much into management’s investment case, completely rerun their valuation model and make the call whether management’s failure is worth maintaining a partnership.
Is the loss permanent in nature?
Another question to ask is whether the loss in permanent or temporary. Reading through the Kraft Heinz earnings report, it would certainly seem the loss is going to be very long in nature – if not permanent – without much guidance going forward in how it will right the ship. In these instances, your tax status (taking the loss) or your inability to wait potentially years to return to growth might recommend you sell. But, should you feel the losses can be made up and they are mere bumps in the road, then it might be best to continue to hold.
How can the loss be redeemed?
Of vital importance in understanding the nature of the loss, the investor should have a clear understanding of how management expects losses to be redeemed. Some might be able to do so with additional cost cutting (seems unlikely at Kraft Heinz) or by revenue growth (equally hard as driven by the Kirkland example or relationships with retailers). It seems that without some major strategic shift and hit to pricing, Kraft Heinz is in quite a bind to develop a plan for strong growth going forward.
Does the impairment have a tail wind or head wind?
It’s important to ascertain whether the holding is facing head or tail winds going forward. In some cases it might even be mixed. I think it would be hard to find evidence to suggest Kraft Heinz’s industry is looking at a strong or even weak tail wind. The evidence we’ve seen to date – combined with Kraft Heinz’s management comments on their call – would suggest the company sees a slight to moderate headwind over the next few years.
As an investor considers their position, knowing what long-term trends predict is critical. If the industry portends future strength in industry patents, this would be quite different than Kraft Heinz facing long-term pricing, product placement and demographic nutritional focus. When looking for a turnaround, always try to find one with a good following industry tailwind.
Is management sharing in your losses?
Last, but not least important, is whether management is suffering along with shareholders. If board members reprice options to reflect lower prices, or the company increases grants as shareholders suffer, look for a new holding. Investors should partner with management who suffer to the same extent as their shareholders. All too often you will see management’s compensation be finessed to make sure they receive the same – if not more – than the previous year’s compensation. C-suite management works for the board of directors and the board of directors look out for the fiduciary responsibility of their shareholders. Make sure everyone is sharing losses equally.
Before concluding, I want to say up front this isn’t a knock on Warren Buffett, 3G or the Kraft Heinz management team. I know very little about the industry, the company and all the work that has gone into building the company. I also know very little why you – the investor – might be either a holder of the stock or a bystander. Only those with skin in the game can really make these very tough decisions.
Conclusions
There’s an old saying that you never take a loss until you sell. Like all well-aged adages, there’s quite a bit of wisdom in it. The difference between a paper loss (the price is down but you haven’t sold) versus an actual loss (the price and down and you did sell) can be all the differences between a successful and non-successful value investor. Understanding when your capital is well and truly impaired can help you make some difficult decisions. Like our Marine learned (in a far more difficult way), this ain’t no touch football. The decisions that are the most disastrous are when you listen to the fear in your gut as well as to some charlatan who hits a button with the sound effect of someone screaming “SELL! SELL! SELL!”.
Investing in Wall Street can be a contact sport. The better your game plan, the better your reasoning, and the better your understanding of the potential loss you face, the better your results will be over time.
RSS Feed