From Burger King to Heinz, our favorite food brands are increasingly making their way from dinner tables to Wall Street headlines.
On March 25, Brazilian private equity firm 3G Capital teamed up with billionaire investor Warren Buffett’s Berkshire Hathaway again and announced the Heinz takeover of Kraft Foods, one of America’s most beloved food brands with a whopping $52 billion market cap. While the final transaction value is still in flux, the deal, once completed, will create the world’s fifth largest food and beverage company with $28 billion revenue and eight $1-plus billion brands such as Kraft, Jell-O, and Maxwell House.
While the deal clearly shook up the industry, it didn’t come as a complete surprise. Investors have been speculating likely targets for 3G Capital since its acquisition of Heinz in 2013, and Kraft was long seen as a potential candidate as it struggled with low margins and disappointing sales. One bright spot of the Kraft-Heinz deal is the promise to cut $1.5 billion in operating costs by the end of 2017. Known for its cost discipline, 3G Capital has strengthened investors’ confidence by significantly improving Heinz’s margins since its takeover with Buffett. The company’s EBITDA margins jumped to 26% in fiscal 2014 from 18% pre-deal in mid-2013, according to Morningstar MORN +0.75% senior analyst Erin Lash.
While flat sales growth and falling margins have been warning signs for Kraft Foods, it is not the only food company facing such difficulties. To find companies in similar plight, we screened through U.S. food and beverage companies with at least $1 billion market cap looking for those with less than 20% operating income margin and 1% one-year sales growth. From Kellogg K +0.37% to General Mills GIS +0.64%, these companies represent some of America’s prominent but struggling, slow-growth food brands that could benefit from cost synergies and the potential of overseas growth that a merger could bring.
With 18.5% operating margin, Kraft Foods actually has better profitability than other members of our list. Mondelez International, a long rumored M&A target which spun off Kraft Foods in 2012, has merely 11.3% operating margin. A few other food giants, such as PepsiCo PEP -0.16%, Kellogg, and General Mills, aren’t better off, with 15% operating margins. Compared to those industry giants, some smaller players in the space are having an even more difficult time. Flowers Foods (maker of Wonder breads), Diamond Foods DMND -0.09% (known for Kettle Brand Potato Chips and Diamond Nuts), and Snyder’s Lance all notched less than 10% operating margins last year, making them particularly vulnerable to takeovers.
“The 3G model seems to be to cut costs as much as possible – into the bone, so to speak – and add back resources only when and where necessary. This strategy, though likely a headwind to revenue growth, appears to generate significant EBITDA improvements,” JP Morgan analysts Ken Goldman and Joshua A Levine wrote in a note. “Besides KRFT, other companies that might look attractive to 3G may include Kellogg, General Mills, Campbell Soup CPB -0.84%, and Mondelez, among others.”
Slow sales growth has also been a major headache for big food and beverage companies, as consumer tastes shift away from high fat, high sugar foods toward healthier and organic brands.The average one-year sales growth for S&P 500 Food, Beverage, and Tobacco sector has fallen to a negative 0.8%. A few companies on our list, such as J.M. Smucker, Mondelez, and Kellogg are also grappling with negative year-over-year sales growth. Other food giants aren’t faring better. Sales at PepsiCo, General Mills and Tootsie Roll have flat-lined in the last 12 months.
In the Kraft-Heinz deal, potential revenue growth is just as important as cost reduction. Morningstar’s Lash noted that the deal could boost annual sales growth of the combined company to 3%-4% thanks to international potential. “We also surmise that revenue synergies are attainable, as Kraft, the bulk of whose sales come from United States and Canada, can now sell its fare across Heinz’s vast global distribution platform, which derives 60% of sales outside of North America,” she said.
The Kraft-Heinz marriage probably put 3G Capital on the sideline as an acquirer for the foreseeable future, but don’t expect merger activities to wane. “We view this as part of an ongoing, and long overdue, process of consolidation in the US Food sector,” Nomura’s David Hayes and Greg Pendy wrote in a note following the Kraft-Heinz announcement. “We will be interested to see … if the deal prompts more consolidation in the market (from 3G or otherwise) as names are forced to lower unit costs to remain competitive.”
For investors looking to take a chance on these food stocks below, you should also note that one benefit of investing in these well-established food companies are their ample dividends. For example, both General Mills and Kellogg have about 3% dividend yield. This way you get paid to wait while the takeover target sits in your portfolio.
By Liyan Chen