Last March, Charlie Munger was asked about Berkshire Hathaway’s partnership with 3G Capital that has resulted in an unspecified number (estimated to be in the 4,000-8,000 range) of jobs that have been terminated as a result of 3G operators taking the helm of the combinated Kraft and Heinz. Munger responded: “What’s interesting about 3G is that they’re teaching us something about reality.” Munger didn’t offer a detailed elaboration. This begs the obvious follow-up: What’s the lesson on reality we are supposed to take from this?
In my view, there are five things–two good, three bad–that 3G is teaching us about the 21st century large-cap food sector.
First, the good:
The rise of 3G lets shareholders reap the benefits of wealth creation that previously stood unexploited. Usually, M&A activity, activist investing, and shareholder agitation are most prominent in industries that are subject to market demand changes or regulatory changes. Look at the Paramount, QVC, and Viacom case of the early 1990s when the telecom and media industry sought to merge to improve their competitive balance. Look at TransUnion trying to shop itself in the late 1980s because it was sitting on a bunch of unexploitable tax credits because Congress had drastically cut railroad taxes to facilitate route-building and maintenace.
You see mergers between banks, telecom corporations, and media companies all the time because there is always some regulation or shifting consumer preference that triggers people in the investment community looking to unlock value.
In the food industry, you don’t see these types of shifts. This stability explains why the sector has historically provided reliable investment returns, but it also permits management teams to rest on the laurels more so than other industries. The absence of external threat provides room for inefficiency, and it lets management fall into the habit of paying out a 3% dividend, buying back 1% of stock, growing revenues 3%, and then trying to eke out a percentage point resulting from improved efficiencies.
The rise of 3G tells us that companies in the food sector like Kraft, Heinz, Mondelez, General Mills, and Kellogg have been sitting on some untapped, unexploited power to achieve faster earnings per share growth. 3G has proven that it can drastically reduce its capital structure while still getting a similar product to the end consumer, and this can shoot profit margins through the roof. Another way to do this is through price increases.
Michael Eisner inherited a Disney Corporation that wasn’t charging the maximum that visitors were willing to pay to visit the theme park, and he effectively doubled the price in his first few years. Earnings shot through the roof, and he looked like a genius for realizing the value that had been created by previous generations of Disney management.
Usually, the increased efficiency of one firm in an industry leads the other firms in the industry to copy-cat and mimic the moves to remain competitive. This is why you have seen Kellogg, General Mills, and Mondelez announce layoffs since 3G assumed control of Kraft-Heinz. To the extent that this increases profitability by removing redundancies, it creates shareholder wealth and is a pro-social value (you will see below the extent to which this is an anti-value below).
The second benefit of 3G is that it can create distribution networks that will be more profitable as a result of the combination. Ronald Coase, the late Chicago professor, often wrote that anything of value eventually flows to the person or entity that values it the most. You know this intuitively when you see a vacant piece of land in an attractive area and you think “This is going to be a shopping district or apartment complex some day.” You are recognizing that the monthly rents collected by the develop will cause them to value the land more than the guy who sits on the property and doesn’t do anything to generate income with it.
Well, the value of Kraft is almost certainly going to be highest to a corporation like Heinz because it has strong international distribution networks that it can easily plug Kraft products into and pick up market share. If General Mills acquired Kraft, it would have to build many international distributions from scratch and incur significant capital costs to grow it internationally. Heinz has a much lower marginal cost because it has existing factories with the space and technology to manufacture Kraft products, and therefore, Heinz management should value Kraft more highly than General Mills management because Kraft will be more immediately profitable to Heinz than it would to General Mills.
I generally disfavor the use of the word synergy because the benefits are often overstated and it is often used indiscriminately in any merger, but this is an example when the word synergy applies. Just as 3G will find it easier to sell Anheuser-Busch products in African markets after purchasing SABMiller and assuming its already constructed distribution networks on the continent, the Kraft acquisition is of tremendous value to a firm like Heinz with the international capabilities to sell Kraft products in countries where it has a negligible (if any) presence.
Now, for the three downsides of what 3G seems to be teaching us about reality.
The first is that human nature, as applied to corporate activity, tends to give rise to empire-building. 3G often makes things more profitable, but after that, it has no alternative of actually growing revenues and increasing consumer demand for the branded products. This suggests that there is an “end of the line” for these mega consumer food group corporations. After the SABMiller acquisition is fully consumed and the costs are cut, what’s left? Maybe Diageo, maybe Brown Forman, maybe Heineken. There’s not a whole let else that moves the needle. It would probably have to look towards Coca-Cola or PepsiCo and expand its focus beyond the alcohol industry (that would be my advice if 3G wanted to extend its current strategy for the next 3+ decades).
With Kraft-Heinz specifically, it can try and acquire Kellogg, Mondelez, and General Mills. The risks with this strategy are: (1) you run out of things large enough that you consume, or the things that are large enough to consume trigger anti-trust concerns that make the strategy legally impossible to execute; (2) you settle for lower quality assets in an effort to stick to the formula script, and this can cause devastation such as when Ken Lewis added Countrywide to the Bank of America portfolio, and this is something from which the bank still hasn’t recovered. In the food sector, the risk is that you turn your attention towards companies with weak brands and overpay because it’s the only strategy you know how to execute.
The second unfortunate lesson about food sector reality that we may be learning is that we may be sacrificing long-term excellence in exchange for “decently good” right now. In the pharmaceutical industry, you will have many scientists working in R&D departments that will never create anything of economic value compared to what they are being paid by the corporation. But all it takes is one person to come up with the next blockbuster drug to justify the existence of the whole department. Paying off all the employees that didn’t come up with the next great idea was worth it in exchange for getting to reap the magnitude of the benefits from the one who did.
The concern is that innovation gets stifled across the industry as management teams diminish investments in the long-term future to remain low cost today. Some Wash U professors recently studied the effects of “pay for performance” executive packages, and noticed that the number of executives missing their bonus by a penny per share was drastically lower compared to what you would expect in a normal distribution. That’s because you can do things like cut R&D costs to boost short-term profits to meet bonus goals.
As a corollary, corporations may reduce the likelihood of finding those blockbuster products in the future because it is cutting costs now. If 3G entered the toothpaste industry twenty years ago, would the specialized mouthwashes, whitening strips, and electronic toothbrush with rinser technology exist today? Maybe. But the sophistication of it might be less. The food industry has a lot of market dispersion and curious participants that put it in a position where it can take a lot of abuse and still come up with new products that delight the tongue, but that doesn’t mean it’s desirable to welcome trends that diminish this natural vibrancy.
And thirdly, from a society point of view, shareholders are not the only stakeholder whose claims need to be evaluated. You also have to take into account employees, contract creditors, suppliers, and the taxpayer class. The rise of 3G has been no good for these other stakeholders. In Chicago, Kraft Heinz is closing down a factory in laying off hundreds of workers workers with 10+ years of experience at Kraft, an act that violates the implied promise of job security if you show up every day and do your job well.
The 3G-ificiation of America is not good for the typical employee with a great work ethic but lack of a highly specialized and sought-after labor market skill, as 3G does not provide job security and compensation based on the question “What’s a fair wage given the value created?” but rather asks “What’s the lowest dollar we can pay a revolving cast of characters and still get the job done?” Job turnover outside of the top 3G ranks that receive bonuses is over 7x greater than the average turnover of a Berkshire Hathaway employee. Interesting, no? And although 3G executives do fly coach, this is mostly window-dressing that hides the underlying reality that they have less than 100 executives with performance goals that can total $1 billion if all are met. They can tolerate the abusive workstyle because there is an imminent payday that creates an option to ride off into the sunset–other employees do not get an abuse payout.
Secondly, when I read the latest Berkshire letter from Warren Buffett, he mentioned that 3G is good for America because it eliminates redundancies. If 3G made money by figuring out where employees were idle and remedying that situation, it would be one thing. But that’s not how 3G makes its money. It also takes advantage of its relationship with suppliers.
If you sold ingredients to Anheuser-Busch in 2007, or leased a truck to help it deliver beer to remote areas, you would get paid in a month. You’d create an invoice, sent it to Anheuser-Busch, set a payment date a month later, and then collect your money in exchange for the good or service you provided. This is how a civilized society with basic virtue behaves. After 3G took over Anheuser-Busch, the supplier payment terms were extended to 60 days. Then 90. Then 120. Now, 3G is trying to pay the suppliers that are most reliant on them 280 days after the good or service is rendered. Going to perform maintenance repairs for 3G next week? Hopefully you’ll get paid by Christmas. But, depending on the terms you signed, that may not even be contractually guaranteed (the alternative view is that 3G provides notice of its payment schedule upfront, and if you find it intolerable, then you don’t have to conduct business with 3G.)
Thirdly, 3G doesn’t just take the cash sitting in the bank to executive its acquisitions. It has to borrow gobs and gobs of money from banks to leverage the balance sheet and execute these mergers. These have two effects. First, the tax burden of companies like 3G-controlled companies diminishes because the interest payments on these debts are tax deductible, lowering the amount of money that 3G companies contribute towards public funding. And the shareholders now own an inferior business that is more susceptible to economic downturns or any threats to cash flow (the alternative view is that the diminished quality of the business from high debt will be accounted for in a lower stock price and contract creditors like banks can charge higher interests to compensate for this risk, and no corporation or individual owes a moral duty to pay higher than required by law, and food industry profits are notoriously stable and not really susceptible to a cash flow crunch at a time when debt payments come due.)
Generally speaking, investors have wanted to achieve returns that are about six percentage points higher than you can get from government bonds (see the historical stock returns of nearly 10% in the U.S. compared to 4% from U.S. debt). Munger’s statement about “reality” is that the immediate trajectory of food companies does not lend itself to revenue growth that put it on pace to deliver those 10% annual returns that stock market investors expect over the very long term. With fast-growing firms, it is easy to take into consideration other claimants like taxpayers, employees, contract creditors, and suppliers because everyone affiliated with the corporation is getting rich at a fast pace that it’s not necessary to sweat the pennies.
But when you start generating only 1-4% annual revenue growth, you start to sweat the pennies. And the management teams do have fiduciary duties to shareholders, and often have stock options tied to the delivery of growth beyond that 1-4% hurdle. The unfortunate lesson about “reality” in the food sector that I believe Munger was alluding to is that the expanded pie is taking on some characteristics of a zero-sum game, and as a result, management teams like 3G are seizing larger chunks of the pie at the expense of other stakeholders like employees, suppliers, contract creditors, and the taxpayer base.
Sources Consulted:
http://www.bloombergview.com/articles/2015-09-30/big-companies-don-t-pay-their-bills-on-time
Originally posted 2016-04-09 15:54:49.
