I have quite a few articles that I intend to publish on the Heinz-Kraft merger engineered by Warren Buffett’s Berkshire Hathaway in partnership with the Brazilian cost-cutters from 3G Capital (Jorge Paulo Lemann, Marcel Telles, and Beto Sicupira), but I have been distracted from the pure investment analysis of the transaction because I have been thinking about the moral and philosophical implications of 3G’s business strategy after taking over the management a company.
Generally speaking, businesses with high-quality profits experience megatrends that can last in five to twenty year increments depending on the industry. First, there is the successful era when revenues are growing by 10% or more. This is when everyone gets excited about the business, and cost controls are ignored with a Sodom & Gomorrahic zeal. Helicopters and Falcon jets for the executives? Sure, no reason you can’t reward the leaders of the team for good work. Wait, is that cubed ice coming out of the fridge? That just won’t do. If you want your scotch to roll in style, the ice should be shaped like a bird, ideally discernible as a St. Louis Cardinal. Items that look like they could come from a Skymall catalog start showing up around the office. That is hyperbolic side of things, but does accurately describe some of the expenses at Anheuser Busch in the 1980s and 1990s while revenues were growing at a very healthy clip.
But eventually, recessions happen, markets get saturated, and competitors make gains of their own. It may happen suddenly or gradually, but those revenue gains of 8% this year, 12% that year turn into 1-3% annual revenue gains. If profits only grow by 1-3%, shareholders become dissatisfied and journalists start snooping around to happily second-guess management’s decisions in the preceding years. To avoid this, companies cut costs. If you reduce costs by 10% and trudge your way to a bit of revenue growth, you can still report profit per share growth in the 8% range. You can raise the dividend by a similar amount to keep shareholders permissive of the status quo, and no members of the media will view the company as a carcass worthy of prodding at the bones. The original appeal of cost-cutting is that it smoothed out the downs of the business cycle.
A company’s culture really shines through when it is time to choose a strategy coming out of the revenue stagnation period. The temptation to try and double dip—keep costs very low while letting revenues pile up—is fool’s gold because it usually requires investment in advertising (if applicable) and product development to spur growth. The old adage that you cannot cost-cut your way to revenue growth usually holds true.
On page 131 of the book Barbarians at the Gate, John Helyar and Bryan Burrough mention the fate of Nabisco (now a part of Mondelez) after Adolphus Green died. Green was famous for investing in snacks and pioneering the Oreo, and simultaneously selling Nabisco workers steak, potatoes, and coffee for 11 cents (that would be a great $4 meal in today’s day and age). But after Green’s death, the executive team became risk averse and focused on cost-cutting and the elimination of employee perks to boost profits. To quote Helyar and Burrough: “Nabisco drifted, paying its dividend, keeping out of debt, and baking the same cookies and crackers it had for years. Eventually profits dropped, its bakeries aged, and so did its management.” It took a major growth initiative—the Ritz cracker and renewed factory reinvestment—to restore Nabisco to its former glory.
Those anecdotes were my way of saying that building a business meant to create wealth for the next half-century is going to different than running a business designed to create wealth over the next five years. There is little doubt that investing alongside 3G over the short and medium term creates wealth. The costs get slashed, the dividend gets raised, and the P/E multiple gets raised as the company reports higher profits. This is a philosophy established by Bob Fifer in his book “Double Your Profits: In Six Months Or Less.” As a reader pointed out, this book is 3G’s blueprint and offers advice on firing employees and delaying payments to vendors. There is nothing about this book that would make someone sit on his deathbed thinking “I’ve led a great, charitable life” and the book is about taking bigger slices of the pie rather than growing the size of the pie.
I am surprised that people pay little heed to the late-in-life declarations of individuals when they reflect upon their contributions after exiting the scene. Think about how many investors idolize Jesse Livermore and cite his quotes on stock-market speculation as a basis for making decisions. They completely ignore the fact that, after building a hundred million-dollar empire, Livermore lost it all, committed suicide, and stated: “It was never my thinking that made the big money for me; it was always the sitting.” How can you leave Livermore’s eventual bankruptcy and self-comdemnation out of the equation when analyzing his work?
Similarly, when people talk about Fifer’s influence on the 3G management style, almost no one brings up Fifer’s May 28, 2007 interview with U.S. News & World Report in which he stated: “I ran one company for 18 years. The company did very, very well, but we hit a wall. If I knew then what I know now, I would still be there, and the company would be 20 times larger. I would come into the office and, by force of my person and bravado, try to move the company by myself. If I had had more humility and been more principled in how I treated other people, I would have built an organization with depth. No CEO is good at everything, but when people perceive you as selfish and greedy, the holes remain exposed and don’t get closed. When you have a strong character, people rally behind you in a way that plugs those holes.”
The addition of Heinz to the Kraft merger is no coincidence—since 3G has taken over, the revenues at Heinz have dropped by a cumulative 12% while profits have grown by over 20%. Before the 3G takeover, Heinz was a company that would characteristically grow annual revenues in the 3-5% range, depending on general economic conditions. When cost-cutting is your strategy, there is “Then what?” component once you have cut all travelling perks, reduced the workforce size, and implemented policies restricting employees to 8 copies per day (if you need to make a ninth copy of a paper in a given day, you need management approval).
If I were asking Warren Buffett a question at the shareholder meeting, I would ask him what he envisions to be the biggest threat to Heinz and Kraft’s long-term story as the result of following the 3G approach. I’d also want to know why he is partnering with individuals that adopt an incentive structure so different from his own—this is a far cry from Buffett’s declaration when he handed off See’s Candies to Chuck Huggins with the declaration “I hope to write you larger and larger checks each year.”
How do you retain top talent at a company when they can work somewhere else that doesn’t offer these employee restrictions? Google is known for an especially permissive employee culture because they said top talent could just start their own business and succeed if Google’s rules ever became onerous. Does that logic apply to food executives? I would imagine that Heinz and Kraft will do especially well over the next ten years, and may even succeed over the super long-term because of brand name strength (and in spite of management). Eventually, costs can no longer be cut, and there are no more employees available to lay off. At that point, your bag of tricks eventually needs to find a way to grow revenues, and this is where the 3G management style has yet to prove itself.
Originally posted 2015-04-03 05:59:20.