February 20, 2017 / 6:29 PM / in 10 months

Kraft's failed Unilever bid shows it needs growth over cost cuts

(Reuters) - Acquire, slash costs, repeat. Billionaire investor Warren Buffet and buyout firm 3G Capital’s failed $143 billion bid to combine their food conglomerate Kraft Heinz Co (KHC.O) with Unilever Plc (ULVR.L) shows their winning formula now needs a growth boost.

Buffett and 3G built Kraft into the world’s fifth-largest food and beverage company through acquisitions followed by a relentless drive to boost profit margins. While this cost cut-driven business model wowed industry observers, it appears to be reaching its limits, with Kraft’s sales stagnating and margins flattening.

Kraft’s bid for Unilever was aimed at addressing these challenges. About 60 percent of Unilever’s business is comprised of household products and personal care (HPC) goods, rather than food. Not only would a deal give Kraft plenty of new ground on which to implement its cost-cutting model, it would boost its revenue by allowing it to expand in several emerging markets.

Investment bankers and industry analysts now say Kraft is more likely to pursue another company with a big, growing HPC business, rather than a peer in the food sector that would require it to repeat the same M&A cycle a couple of years later.

“Perhaps Kraft will now acquire another medium-sized U.S. food company, like General Mills Inc (GIS.N), Kellogg Co (K.N), or Mondelez International Inc (MDLZ.O). But after three years this M&A ‘beast’ will need to be fed once again, and the number of attractive U.S. targets is getting smaller,” Sanford C. Bernstein analysts wrote in a note on Monday.

Kraft declined to comment on which company it may seek to acquire next.

Investors are already adjusting their bets. Shares of Unilever peers Colgate-Palmolive Co (CL.N), Clorox Co (CLX.N) and Church & Dwight Co Inc (CHD.N) rose 4.3 percent, 2.8 percent and 1.6 percent on Friday, respectively, on hopes of them being acquisition targets.

Conversely, shares of General Mills, Kellogg and Mondelez dropped 3.8 percent, 2.4 percent, and 1.6 percent on Friday, respectively, as investors saw the chances of them being acquisitions targets for Kraft decreasing.

What is more, some of the food companies have been strengthening their takeover defenses by seeking to do themselves what Kraft would have otherwise done to them. Mondelez spent a portion of its latest quarterly earnings call boasting about its cost-cutting initiatives, while Kellogg recently made changes to its distribution model to cut costs even more.

Another reason Kraft is seeking to diversify its business is that consumers have themselves been gradually changing their diet, becoming more health conscious and moving away from the processed and sugar-rich foods that account for much of Kraft’s offerings.

To address this, Kraft would need to spend top dollar on inventing and marketing new food brands, which requires expertise not developed by its reliance on acquisitions. Moving into HPC, particularly by acquiring a global company that would help it diversify its U.S.-focused business, now looks like a more attractive option.

SHEDDING ITS REPUTATION

    To be sure, Kraft would need to overcome the same hurdles that resulted in it being spurned by Unilever. Under the stewardship of 3G, Kraft has developed a reputation for extreme cost cuts that risk hurting a company’s top line by stifling investment in innovation and marketing.

    Indeed, Unilever’s rejection of Kraft’s bid was not just based on price considerations. The company feared that a merger with Kraft risked eroding the value of its brands and could impede its expansion in emerging markets, which requires more investment, people familiar with the company’s thinking told Reuters on Sunday.

    After 3G teamed up with Buffett to buy Heinz in 2013, they closed six factories and cut 7,000 jobs in 18 months. Operating margins jumped from 18 percent to 26 percent, thanks to their zero-based budgeting, which dictates that managers must meticulously justify all expenses, from pencils to forklifts.

    But now Kraft’s top line is struggling. Sales were down 3.8 percent at $6.86 billion in the fourth quarter of 2016. Kraft has attributed the decline in sales to a pruning of its portfolio, as it weeds out non-profitable products.

    Unless Kraft can shed this image as a relentless cost-cutter, it could face similar opposition from other acquisition targets, particularly if it uses its stock as currency, thereby giving shareholders of the target exposure to the combined company.

    Last week, two days before it unveiled its acquisition offer for Unilever, Kraft appeared to acknowledge that investors were concerned about its lack of new investment, stating it was focused on innovation and marketing.

    “We will focus our investments in innovation, renovation and marketing on our leading brands,” Kraft Chief Executive Bernardo Vieira Hees said during the company’s latest quarterly earnings call on Wednesday.

    Reporting by Lauren Hirsch in New York; Editing by Greg Roumeliotis and Jonathan Oatis

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