Mark Ritson: Kraft Heinz is in 57 varieties of trouble

It’s been an awful week for Kraft Heinz. The giant food conglomerate born from the $49bn merger of Kraft Foods and Heinz four years ago is reeling from a disastrous close to 2018. Last week the company posted a net loss of $12.6bn for the final quarter.

That is a huge loss by any corporate standard, even the heady numbers that surround Kraft Heinz. It represents around half of annual net sales of the company, for example. The financial markets reacted immediately to the news, wiping 27% from the company’s share price last Friday.

Success, we have so often been told, has many fathers while failure is an orphan. But there are usually also plenty of people lined up to explain to the lonely child why she lost her parents. That’s certainly true of Kraft Heinz. Since Thursday’s shock announcement several competing explanations for the sudden drop have started to circulate.

The DTC threat becomes real

For many, this is part of the broader narrative of the rise of direct-to-consumer (DTC) brands and their ultimate ability to dethrone the formerly untouchable category giants. By now you know the script: the old rules of marketing and brand building do not apply anymore in traditional categories like beauty and FMCG.

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There is a rising tide of independently-created disruptors that use a new tactical playbook to promote and distribute their products to target consumers and sidestep established brands. These DTC brands largely avoid the channel costs and branding challenges wrapped up with selling through big retail and opt for direct delivery to consumers, which also ensures a repeat buying cycle is created. Most DTC brands also spend heavily on search and digital media while turning their back on the traditional TV approach that built the brands of the 20th century.

Brands like Casper (mattresses), Honest (baby care), Dollar Shave Club (grooming) and Soylent (food) are cited as examples of the DTC revolution. And while there has certainly been a rash of new packaged food startups, especially in America, as yet the jury is still out on how much the DTC revolution is a genuine threat to traditional marketing methods and how much it is overstated bullshit.

Much of that debate focuses on Dollar Shave Club, which is seen as a spectacular example of both the potential and bullshit of DTC. Yes, it built its business from viral digital communications and a DTC model. No, it has not yet made a profit despite its fame and billion-dollar price tag.

The main criticisms of the DTC model are that profitability appears to be singularly difficult to achieve despite the much-touted savings that this business model should deliver. And despite all the claims that these DTC brands approach marketing in new ways, that only appears to be true during the scale-up period.

Once they achieve a specific size, they turn to mass retail and TV to continue their growth. Indeed, for many DTC brands their ultimate acquisition by one of the 20th-century giants they were meant to displace appears to be the ultimate path to riches.

The big retail squeeze

Another potential explanation for the current pain at Kraft Heinz is the tension between it and big, competitive grocery retailers, and the impact that has on both their margins. The supermarket business has always been competitive. But the gradual, python-like squeeze of Aldi and its largely non-branded approach has made things even tighter. Then there is the arrival of Amazon and its growing interest in all things grocery. Finally, there is the constant unwavering focus on pricing and costs from Walmart. 

And it’s not just price that is squeezed by the big bad boys of retail. Private labels have proven to be the ultimate thorn in the side for most big consumer goods companies. In the last two decades private label sales have come to dominate most grocery categories.

That’s partly because big players like Tesco and Carrefour derive around half their total sales revenue from their extensive private label ranges and partly because Aldi’s continued growth is based on a model in which 95% of all sales are private label. Not only are the supermarkets difficult customers to sell to and through, they are also Kraft Heinz’s biggest competitive threat.

It’s certainly a tricky situation for Kraft Heinz to handle. Warren Buffet, the legendary investor who owns 25% of the company, pointed the finger in the direction of retail this week. Lamenting the loss in value that Kraft Heinz has caused for his company Berkshire Hathaway, Buffet made it clear he sees big retail and the “struggle” between private label and brands as the main cause.

“When you have Amazon and Walmart fighting it’s a bit like the elephants fighting: the mice get trampled,” Buffet observed. “I don’t see the retailers’ position getting weaker.”

Not only are the supermarkets difficult customers to sell to and through, they are also Kraft Heinz’s biggest competitive threat.

Buffet is right. But private label has been a constant threat for the past decade and to cite its impact as the explanation for Kraft Heinz’s sudden woes seems a little disingenuous. Plus, there is a handy exception to the private label threat that big brands have always enjoyed.

If you study the impact of private labels in most categories, they tend to destroy the number 3, 4 and 5 manufacturer brands. The top one or two brands in the category aren’t victimised. If anything, the number 1 and 2 brands actually prosper more in a private label-dominated category.

The store brands need a reference price and many consumers still prefer the leading brand over a generic alternative, so plump for the market leader. Heinz ketchup is a potent example of a brand that is better off now than ever before because it is virtually the only branded alternative to store brand ketchup.

Zero-based budgeting

A big target this week has been Kraft Heinz’s application of zero-based budgeting (ZBB) as the central explanation for the company’s sudden decline. The company is also part-owned by investment firm 3G Capital, which is famed for the acquisition and then optimisation of organisations using the ZBB approach. In a scathing editorial in the Wall Street Journal, the newspaper concluded that the share price was clear evidence that the company’s “experiment in radical cost-cutting has failed”.

It’s clear that since the 2015 merger of Kraft with Heinz the combined company has been cutting back. The company has cut its workforce by 20% and overheads by 40%. But these are not unusual numbers for a merger of two large, relatively similar firms. Back-end synergies were a big motivator for the merger and Kraft Heinz has merely been realising them.

As for ZBB, it gets a bad name among those that have not applied it. The zero in the name suggests some kind of pressured attempt to reduce investments to as little as possible. In reality, zero is merely the starting point and ZBB avoids the ridiculous method of using an  arbitrary percentage of forecast sales (pulled directly from the posterior of the CFO) to set marketing budgets.

In truth, done right ZBB can and often does result in increased investment in marketing, albeit with a focus on the brands and opportunities that deliver the best returns. But that does not appear to have been happening in the case of Kraft Heinz. Data from Advertising Age and Kantar Media suggests that in their biggest market of the US, advertising investment levels have dropped annually by 10% since the merged company was created.

While it’s unfair to point the finger at ZBB, it does appear that Kraft Heinz has reduced its investment in communications, which, as we know, can very quickly impact on market share and sales in the consumer goods categories.

Changing consumer tastes

While it’s true that Kraft Heinz represents a collection of some of the world’s best known brands, the portfolio does come with something of a disadvantage too. Big brands like Maxwell House, Heinz Beans, Planters nuts, Kraft cheese and HP Sauce are known and trusted but also sound like the kind of things you would use to decorate the set of Grange Hill back in 1985.

These are iconic brands for sure, but therein lies the problem. While icon status means reverence, trust and a showreel of decades of classic ads, it often also represents a significant barrier to staying contemporary and straddling the consumer tastes of today. All too often brands become successful and then assume that the same tactics and product offer will enable them to remain that way.

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The ancient lesson of running brands that have survived for more than three or four decades is that while their fundamental identity and image might remain the same, the core offer has to evolve and alter as markets change and age. What convenience, nutrition and healthy meant to a household in 1979 means something entirely different to the families of 2019.

There is a sea change taking place in family eating in which sugar, tinned food and mass-produced products derived from the hell that is factory farming are steadily being replaced by fresher foods with a cleaner and more transparent provenance. The heritage of the Kraft Heinz portfolio allows them one step forward in terms of consumer share of mind and two steps back in term of core competence and brand image. Everything that enabled Kraft and Heinz to dominate the grocery categories of the mid-20th century now leaves it vulnerable to the changes endemic some 50 years later.

Jorge Paulo Lemann, the Brazilian billionaire behind 3G Capital and the architect of the Kraft Heinz merger, admitted as much last year. “I’ve been living in this cozy world of old brands and big volumes,” Lemann observed at the Milken Institute Global Conference. “We bought brands that we thought could last forever. You could just focus on being very efficient. All of a sudden we are being disrupted.”

The degree to which the disruption in market tastes is affecting Kraft Heinz can be seen in the origin of the company’s gigantic loss for Q4 2018. The company’s operations were actually profitable during the quarter; the $12bn loss comes from a goodwill impairment charge of $15bn.

That’s finance talk for write-downs of intangible assets or, to put it in marketing terms, the company admitting that some of its brands are not worth what they thought they were and adjusting their value accordingly. Specifically, the company has reduced the book value of Kraft and Oscar Mayer – two of its biggest brands in America – to reflect lesser price premium and cost-lowering potential.

The Kraft brand is synonymous with mass-produced dairy products and its iconic dried macaroni and cheese dinner, which provides you with around half your daily intake of salt with a single large serving. Oscar Mayer makes bologna and sausages for Americans – or “mystery meat”, as my old college roommate used to call it. It’s a polite way to refer to a product that comes from a range of ‘mechanically recovered’ meats. Yummy.

Consumers were once happy to eat this sort of stuff and whatever else was put in front of them with a nice logo. But people are increasingly pushing back, questioning where their food comes from and how it has been made. Quality is a notoriously fickle attribute to hang on to and while Kraft and Oscar Mayer continue to manufacture products in the same manner they always have, consumer expectations are moving rapidly.

In many ways, Warren Buffet is the perfect exemplar of Kraft;s issues. The Oracle of Omaha remains one of the great financial minds of this or any other decade. But his dietary tastes were born a lifetime ago and he has, he admits, the food preferences of a six-year-old.

On top of his five regular Cokes a day, Buffet starts every morning with a trip to McDonald’s and a sausage McMuffin with egg and cheese. He avoids vegetables, snacks on candy and consumes what one fellow CEO once referred to as a “snowstorm” of salt every day.

Clearly the diet has done Buffet, now 88 years old, no harm. But while he may pride himself on buying into a company that has some of the world’s leading food brands, one might respectfully argue he has actually bought a slice of a company that an octogenarian regards as having some of the world’s leading brands.

Kraft Heinz may have underinvested in advertising in recent years but the bigger issue is that it appears to have underestimated the degree to which market tastes are changing. Like Coca-Cola and AB InBev, it faces an existential threat from that most fundamental foe – shifting consumer needs.

Too often we forget the prime directive of marketing and its role within any company. Before we get to tactics and communications and the management of brands, good marketing connects the needs of the consumer with the company servicing them. Something has gone wrong at the most basic marketing level for Kraft Heinz. Its portfolio is increasingly not what its target consumers want.

Whodunnit?

Despite the search for a single culprit, the reality is that a combination of many factors has combined to afflict Kraft Heinz. It certainly seems to have underinvested in its brands and enjoyed a short-term hit to profitability as a result, followed by the start of the prolonged hangover that always comes after.

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That short-termism has also blinded it to the rapid ageing of its brands and product portfolio, leaving it vulnerable to newer, more nimble entrants that – because they were created for a 21st-century target consumer, not one from 1950 – naturally exhibit the features, benefits and associations increasingly sought out by modern shoppers. That vulnerability and fading appeal will leave Kraft Heinz increasingly vulnerable to the big retailers it sells through and competes with too.

Like a bad Agatha Christie novel set on a train, we should not point the finger at any one suspect but, rather [insert a very long pause and twitch of the moustache for supreme dramatic effect], point the finger at all of the suspects. Kraft Heinz is a company beset by short-termism, underinvestment, disruption, ageing brands and the perpetual challenge of changing consumer tastes. It will take quite the strategy to fix the portfolio, the brands and the management system that surround it.