The Kraft Heinz Company: Margins First, Volumes Later

A sample of Kraft Heinz' "Big Bet" innovations, a zesty line of sauces introduced in Europe. Image source: Kraft Heinz UK.

The Kraft Heinz Company reported its fourth-quarter and full-year 2016 earnings on Feb. 25. On a pro forma basis, that is, looking at the prior year as if the Kraft and Heinz businesses were already combined (they merged in July 2015), the company's net sales declined 5% to $7.1 billion. The packaged food behemoth attributed most of this revenue decline to a 6.1 percentage point impact from foreign currency translation.

Yet organic sales, measured without regard to currency effects, decreased 3.1% during the quarter as well, keyed by weak volumes. On the earnings call, COO Georges El-Zoghbi summed up Kraft Heinz's thoughts on spurring volumes, perhaps through price adjustments, in one succinct phrase: "Our focus is on profitable growth."El-Zoghbi pointed out that investors would see higher volumes where Kraft Heinz is selectively reformulating products to keep up with changing consumer tastes.

This wasn't just a platitude thrown out to analysts. It's crucial to the strategic formula CEO Bernardo Hees reminded listeners of at the outset of the call:

These three objectives will be achieved by following a standard operational template which3G Capital, the private equity fund that has invested alongside Warren Buffett in Kraft Heinz, is fond of using.

A first step is the implementation of zero based budgeting, or ZBB. ZBB is just what it sounds like a budgeting process that doesn't rely on what happened last year, but seeks to determine what a given department needs in the current year from the ground up, without a prevalence of prior assumptions. ZBB can be an extremely effective budgeting tool at the outset of a merger, as it helps joined divisions and departments take a fresh look at actual monetary requirements to meet specified goals.

Kraft Heinz's other major actions will be to control overhead, revamp the merged supply chain, and raise marketing spends. In taking these steps, which place acute emphasis on operational efficiency, it's clear that in management's view, revenue growth can wait. Streamlining systems and tackling profitability at current sales levels are the first items of business. El-Zoghbi relayed as much about the near-term, when he stated during the call that "maintaining a stable[emphasis mine] top line for 2016 is our priority."

Pushing the top line with Big Bet innovation

A retail bet to take on market-leading French's mustard. Image source: Kraft Heinz Company.

Through merger synergies and the operational initiatives discussed above, Kraft Heinz projects that it will deliver annual cost savings of $1.5 billion by 2017.While this program satisfies investors for the moment, at some point, management will be obliged to show meaningful volume growth, coupled with healthy pricing power.

One path to rejuvenating revenue is to tweak product lines with rather significant changes in formulation and packaging. 3G's management has shown a willingness to innovate in the form of what they term "Big Bets," such as the reformulation and retail launch of Heinz Yellow Mustard, the marketing of Oscar Mayer P3 (Portable Protein Packs), and increasing variations of the popular Heinz Hot Sauces in Europe.

Now something as simple as a recipe revision may seem like tame innovation to you or me. But on a global scale, the wagers truly become bigger, as even minor fine-tuning of a beloved product can cause a sales decline rather than an increase, if the product scientists and marketers fall short of customer tastes. Hees acknowledged on the Q4 2015 call that while Big Bets entail a good deal of risk, it's calibrated risk, derived from consumer insights the company collects and analyzes.

This type of innovation, which is characterized by heavy promotion, can pay off handsomely by reviving flagging interest in core items. Products in a Big Bet are also usually designed to flow smoothly through current manufacturing line setups, preserving or improving profitability.

For example, while Heinz has sold its mustard commercially for some time, launching its retail version was quite margin efficient, as the company utilized the same squeeze bottles it popularized for Heinz Ketchup, as you can see in the image above.

Executives are drawn to the concept of Big Bets because an evolution of recipes and packaging in a brand can, at best, create enough differentiation from competing products to lift the lid of pricing constraints.

To put this another way, the more a product is differentiated from directly competing goods, the less the ability of the consumer to make a purchase decision based on price alone. Better yet, if you can capture the consumer's imagination and taste buds, you've planted the seeds for price leverage down the road.

Kraft Heinz isn't confining Big Bets to its most successful product lines. During the quarter, the company blamed volume and mix weakness underlying the 3% organic sales decline on four product categories: ready-to-drink beverages, boxed dinners, frozen meals, and powdered beverages. Where is the company placing its next round of Big Bets in the U.S., its biggest market by far? Ready-to-drink beverages, boxed dinners, and frozen meals. The organization may be honed in on margins for now, but it's incurring appropriate risk to circle back to revenue growth later.

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