Kraft Heinz manufactures and markets food and beverage products, including condiments and sauces, cheese and dairy, meals, meats, refreshment beverages, coffee, and other grocery products throughout the world. Its portfolio of brands includes eight with over $1 billion in annual sales (Kraft, Heinz, Oscar Mayer, Philadelphia, Lunchables, Velveeta, Maxwell House, Planters) and five more with over $500 million (Kool-Aid, OreIda, Capri Sun, Cracker Barrel, Jell-O). With $29 billion in annual sales, it is the fifth largest food and beverage company in the world. Kraft Heinz’s business model certainly creates value, but as a mature company in an industry with slow growth, it is more squarely focused on capturing it through distribution synergies and margin improvement in its operating model.
Prior to their combination, Kraft Foods and H.J. Heinz separately had similar business models – they transformed raw materials into consumer packaged goods – but their operating models were quite different. The beauty of the merger is that their operating models intriguingly complement one another, and together, there is a wealth of value to be captured. According to company reports, 98% of Kraft products are consumed in North America. It is surprising that such iconic brands would have low global penetration, especially since 14 countries have 80% or greater brand awareness (i.e. China, UK, Germany, Australia). Where its distribution does exist, however, the portfolio of brands is large enough that Kraft can bypass traditional distributors and ship goods on full trucks straight to stores. The company achieves significant savings by handling distribution in-house.
In contrast, 61% of Heinz products are consumed internationally but unlike Kraft, the Heinz portfolio is not large enough to fill trucks that go straight to stores. As a result, Heinz must pay distributors to deliver their products along with those of other food and beverage companies.
The operating and synergy playbook is simple: Distribute Kraft products through Heinz’s international channels, and stick Heinz products in Kraft trucks going straight to the stores. Furthermore, the company is consolidating its manufacturing operations, procurement efforts, and supply chain footprint. These represent extremely effective improvements to the standalone operating models that existed before the merger. The combined operating model is not only aligned with the business model, it substantially improves it.
Margin Improvement Through Zero-Based Budgeting
Can Kraft Heinz leverage its operating model to capture even more value than can be achieved through its production and distribution synergies? Management’s answer is, yes. Hailing from 3G Capital, the management team is focused on Zero-Based-Budgeting (ZBB). ZBB was pioneered in the 1970s but had been largely forgotten in corporate America until Kraft Heinz’s owners resurrected the cost-cutting strategy several years ago. The WSJ explains: “In ZBB, 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 technique forces managers 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.” In a presentation at Harvard Business School, Kraft Heinz CEO Bernardo Hees said that every single cost item in the firm was decreasing, except for Marketing & Selling expense. Margin improvement is a stated goal of the company, which is targeting $1.5bn of annual cost savings by 2017. There is good reason to believe they will achieve it, since as owners of H.J. Heinz, 3G Capital cut $1 billion of run-rate operating expenses and increased EBITDA margins from 18% to 26% between June 2013 and December 2014 (18 months). By doing more with less, Kraft Heinz has enhanced the alignment between its operating and business models. Furthermore, these operating strategies are repeatable and it is easy to imagine that the company will continue to be acquisitive.
This business has many competitive advantages: iconic brands, high barriers to entry (manufacturing, distribution, limited shelf space capacity), low cyclicality, and stable cash flow. By combining Kraft Foods and H.J. Heinz, the operating models are able to further entrench these competitive advantages. I expect that Kraft Heinz will leverage its business and operating models to generate industry leading EBITDA growth, create long-term value for shareholders and the CPG industry more broadly, and perhaps become the largest food and beverage firm in the world.
 Company filings: SEC 10-Q Quarterly Report, 11/6/2015.
 WSJ: http://www.wsj.com/articles/meet-the-father-of-zero-based-budgeting-1427415074. Accessed on 12/6/2015
 “M&A Within the CPG Industry”, Bernardo Hees, Harvard Business School, 9/10/2015