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March 15, 2019 —
Perishable Pundit Overview:

Was Kraft Heinz Saving Money Or Eating The Seed Corn?




Was Kraft Heinz Saving Money Or Eating The Seed Corn?

For a while, zero-based budgeting — a business management tool pioneered a half-century ago by Pete Pyhrr — was hot; then it was not, and then it came roaring back with a focus on the food industry. The Wall Street Journal highlighted this history back in 2015 with a profile: Meet the Father of zero-based budgeting:

Five decades ago, a young Texas Instruments Inc. (TXN 1.00%) accounting manager named Pete Pyhrr pioneered a technique to help businesses shave costs. It led to a book deal, a People magazine interview and some consulting gigs, including as an adviser to then-Georgia Gov. Jimmy Carter.

Then things mostly turned quiet for Mr. Pyhrr and his arcane tool, known as zero-based budgeting, until the Brazilians behind private-equity firm 3G Capital Partners LP came along.

3G’s embrace of the system — a centerpiece of the firm’s strategy to reshape the U.S. food industry through deals like this week’s proposed $49 billion takeover of Kraft Foods Group Inc. — has thrust Mr. Pyhrr’s method into the spotlight after years in which it struggled to gain traction among Fortune 500 firms.

“I think it’s great in my old age to say something that was a major part of my life many, many years ago is being adopted — hopefully successfully,” the 73-year-old Texan said in an interview on Thursday, his first in many years.

Zero-based budgeting is a “tremendous” tool, Mr. Pyhrr said, “especially in times of economic problems, when you need to make reductions, or when you have significant and rapid technological change.” But he doesn’t know how widely it is used. “Most companies don’t talk about what kind of budget process they have,” he said.

3G and companies it controls, including Burger King parent Restaurant Brands International Inc. and H.J. Heinz Co.—which it plans to merge with Kraft—have used the technique to slash costs in everything from jobs to corporate jets and the use of color photocopies. Some such cuts seem obvious, Mr. Pyhrr said, but the tool goes deeper than that, he said. On corporate travel, “it’s really saying: Why are we going to all these places and how many of us are going?”

In zero-based budgeting, managers plan each year’s budget as if starting their department from scratch — a contrast with the prevailing method of adjusting the previous year’s spending. The system calls for managers to break programs or activities into individual “decision packages,” including all associated costs, to help identify how funds are used. The technique forces them to justify the costs and evaluate benefits every 12 months, and to scrutinize whether dollars should be shifted from less-profitable to more-profitable projects.

Now, giant write-downs at 3G Capital, causing a big write-down at Berkshire Hathaway, have caused many to re-think the practice. Another Wall Street Journal piece tells the story: It shook the Food business by Snagging Burger King, Kraft and Heinz. Now 3G Is Reeling:

Now, after transforming the American consumer landscape, 3G’s financial strategy appears to be running out of juice.

The latest, starkest example: On Thursday, 3G-run Kraft Heinz Co. wrote down the value of its Kraft and Oscar Mayer brands and other assets by $15.4 billion, disclosed an investigation by federal securities regulators and slashed its dividend, sending its shares down nearly 28 percent.

Among the problems, 3G underinvested in its brands at the expense of future growth, rivals and analysts said. Especially at Kraft Heinz, 3G failed to see the speed of the decline in consumer interest in legacy food brands — Americans now want to buy healthier items, focusing on natural and organic ingredients, and are less loyal to the brands they grew up eating.

3G’s aggressive approach to savings turned off possible acquisition targets and squelched the innovation that might have helped its brands like Maxwell House coffee and Lunchables adapt to industry trends.

In abstract, zero-based budgeting makes a lot of sense. It only means that you don’t keep doing things just because you did them in the past. So rather than saying a company has had a sales office in St. Louis for 100 years and adjusting the budget up 3 percent to deal with inflation, executives are supposed to justify the need for the St. Louis sales office. Can the sales process be handled more efficiently out of the Chicago office? Does new technology, facilitating digital meetings, etc., reduce the need for people in the territory, etc.?

The reality, though, is that zero-based budgeting suffers from three serious flaws:

First, to actually do it well is enormously time-consuming and expensive — and this itself, this draining of executive talent, makes it very easy for the process to result in poor results. The classic example is paper clips. In his explanation of how zero-based budgeting works, Shin Shuda, one of the managing directors at Accenture Strategy, explains the 3G system:

How ZBB works

1. After 3G acquires a company, it asks for a full accounting of spending, down to specifics like paper clips.

2. Items are separated into companywide ‘packages,’ such as office supplies, and assigned a manager.

3. Every budget year, each package starts at zero and is assigned a cap, forcing managers to keep track of details such as paper use.

4. Bonuses for managers, and their reports, are tied to their success in meeting ZBB targets.

The problem is that when important and expensive people are focused on reducing expenditures on paper clips and keeping copy paper to a budget, they are not focused on building the business.

Paper clips are relatively easy. But reviewing R&D or marketing expenditures requires enormous data collection, long-term projections and countless meetings.

And one of the classic problems in business is that information is expensive. The famous quote attributed to department store titan John Wanamaker — “Half the money I spend on advertising is wasted; the trouble is I don't know which half” — is not an argument against advertising, nor is it an argument to extend massive efforts to learn which half is wasted. It is really a call for the necessity of executive judgment.

Let us imagine that a captain of the industry is being honored and a dinner is being held. A page in the journal and a table at the dinner costs $3,000.

There are so many variables. The influence of this important industry leader — how will it be impacted by your company not supporting the dinner? His friends and colleagues in the industry? The willingness of other individuals to work with your company in the future? What will your own employees, and perspective employees, think of your company?

Now we could get answers to this. Hold focus groups, do survey work, etc. But the research might cost $50,000!

Then executives have to read the research reports, assess them, meet to discuss, etc.

In the end, the company will spend tens of thousands to save $3,000!

And because it is zero-based — the center of which is the idea that things change from year to year — they may have to actually do it again next year!

Second,  it focuses on the wrong thing. Look at Shuda’s fourth point: “Bonuses for managers, and their reports, are tied to their success in meeting ZBB targets.”

These targets are solely on the expense side though. So, if, say, a new marketing opportunity becomes available mid-year, in order to get their bonuses tied just to expenditures, executives may pass on what they believe to be a great opportunity because the bonuses are not tied to profitability but just to constraining expenses.

Third, anyone doing zero-based budgeting requires some kind of framework within which to assess success or failure. Over what  time period? Seeking what hurdle rate of return? With what tolerance for risk of failure or delay in areas such as R&D? How important are non P & L items  say making the company a desireable place to work or a desirable place for an entrepreneur to sell his or her company?

If you have a fixed number of Oscar Mayer wieners that are going to be sold year after year at a fixed price, then one can maximize profitability by constraining costs.

That may be the case in business for a period of time, but it’s almost never the case long term.

That is why zero-based budgeting — done in the context of a company doing acquisitions and applying the technique to the new acquisition — has just a hint of fraud in it.

If a company operates on a “going concern” basis, knowledgeable executives will choose to do many things that do not result in a positive return this year but that, over time, maximize sales and profits. To, say, halt all brand building for a year and announce record profits, speaks more to the limitations of accounting than the virtues of zero-based budgeting.

Even some “obvious” extravagances — boxes at sporting events or private planes — don’t really tell any story themselves. Maybe these perks attract the best employees, and those employees produce great profits. ZBB doesn’t have any answers — this year, getting rid of these things will create profits, but will it mean the company is more profitable 10 years from now?

In some ways, zero-based budgeting redefines a business. If you view the business as selling Budweiser beer, then zero-based budgeting may maximize profits. But the business will shrink as consumers move to craft beers or switch to cocktails or as competitors ramp up marketing and promotion.

If you view the business as an effort to retain and expand market share in the broader alcoholic beverage category, you need to invest a lot more in developing new drinks, marketing new brands, sustaining and enhancing brand positioning, etc.

The Wall Street Journal article suggests that 3G is actually changing the criteria by which zero-based budgeting is done:

In 2018, Kraft Heinz made a shift, spending $300 million on developing and marketing its products, reducing out-of-stock items and getting better shelf space in stores. Doing so accelerated what would have been three years of investments into one year, the company said. That “was a pivot moment,” Kraft Heinz Chief Executive Bernardo Hees said at a September conference. “We’re going from an integration phase to a more reinvesting phase.”

The company used the money to develop new brands, like its microwavable omelet mix called Just Crack An Egg, and revamp recipes of old ones, like Oscar Mayer hot dogs and Capri Sun drinks, to have simpler ingredients. It added 300 salespeople to visit stores, making sure products are in stock and promotional displays are correct. It also invested supply-chain logistics to increase its sales to convenience stores, restaurants, dollar stores and drugstores. And it spent more on advertising, including a Planters nuts Super Bowl commercial.

The focus on resuming and accelerating growth has come at the expense of profits. Comparable sales at Kraft Heinz rose 2.4 percent in the fourth quarter, but a key measure of profitability, adjusted EBITDA, fell 13.9 percent.

Note that this doesn’t necessarily indict zero-based budgeting, but rather points to the importance of using any budgeting tool with an eye on the future.

The truth is that many of the flaws of zero-based budgeting are expressed in companies that don’t do zero-based budgeting. For example, companies that give employees bonuses for meeting short-term profitability numbers are, often, incenting behavior that reduces long-term growth and profitability.

Warren Buffet points out how easy it is to lose market share without extensive investment. He gave an interview with CNBC in which he explained the enormous challenge of the rise of private label:

According to Buffett, the packaged-food icons in Kraft Heinz's portfolio are struggling to compete with private-label brands at retailers such as Walmart and Costco. These private-label brands have been winning over customers with lower prices as the stigma surrounding generic brands has lifted in recent years.

He said those hoping to go "toe-to-toe" with companies like Walmart, Costco and Amazon had a "weaker bargaining hand than you did 10 years ago."

Costco's Kirkland brand, in particular, is proving to be a dangerous competitor. While Kraft Heinz has spent billions of dollars on advertising over the past century, the company's sales totaled $26.3 billion last year. Sales of Costco's Kirkland brand, as Buffett pointed out, grew to $39 billion in 2018.

"Here they are, 100 years plus, tons of advertising, built into people's habits and everything else," Buffett said of Kraft Heinz's brands. "And now, Kirkland, a private-label brand, comes along and with only 750 or so outlets, does 50 percent more business than all the Kraft Heinz brands."

We would say Mr. Buffett is attributing too much to low prices. Today’s private-label environment draws strength from three things:

  1. Private-label assortment has changed. You go into a Wegmans and you look at their pasta, you see they offer private-label items that surround the national brands — they are less expensive, more expensive and a broader assortment. It is not about being cheaper all the time.
  2. Retail brands are stronger because they mean something.On the plane once, sitting next to the CEO of a tuna company, we were told that the Kirkland line included a better-quality tuna than this national tuna company sold itself. Anyone who knows Costco knows it seeks out not the cheapest product but product right for its customers.
  3. Failure of national brands to invest.The 2017 ad budget of Kraft and Heinz was 39 percent lower than what those companies spent before they were merged. Reputation is an asset that must always be replenished.

In the end, ZBB was a chimera — “a thing that is hoped or wished for but in fact is illusory or impossible to achieve.” The idea that massive amounts of spending are both wasteful and possible to identify is more a wish than a strategy.

In the end, the big profits in the first few years of an acquisition turned out to be not that ZBB identified waste — just that the company ate its seed corn. Without a constant flow of innovative products, backed up by strong marketing, 3G found its brands increasingly vulnerable to private-label alternatives. Now it is playing catch-up. And that is always a hard game to play.

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