Is 3G the future of consumer firms?

With increased volatility, managements best suited to create moats around businesses might lose out to frequent changes

The firm 3G Capital, a private equity shop, and its principals have an enviable track record in creating shareholder value across consumer businesses. They have been instrumental in creating and operating ABI (Anheuser-Busch InBev), the world’s largest brewer with 28 per cent global market share, Burger King (now Restaurant Brands International), and Kraft Heinz (KHC).

Across the three companies they have created significant shareholder value. This has come largely through margin expansion. In the case of ABI, US earnings before interest and taxes (EBIT) margins went from 23 per cent to 36 per cent. For Burger King earnings before interest, taxes, depreciation and amortisation (Ebitda) margins rocketed from 18 per cent to 69 per cent (went entirely franchised) and in the case of KHC, Ebitda margins have improved from 18 per cent to 30 per cent. These margin gains have been both organic and driven by cost takeout after acquisitions. In the typical 3G capital deal, they have managed to take out 16 per cent of the target company sales as synergy benefits.

How does 3G capital do this margin expansion? First of all, they aim to create a culture of ownership. Their transformation of companies is as much cultural as financial engineering. They come into companies with entrenched ways of doing things and bring in their own people, put in their own operating philosophy, and incentive structures. The ownership culture means employees are encouraged to think long term and be accountable. Compensation is skewed to variable pay and stock incentives are aligned with a minimum holding period of five years. Creating this ownership culture is the biggest piece of the secret sauce. They aim to minimise the agent-principal problem.

They are also very focused on inculcating best practices from both within their portfolio companies and across industries.

They scrutinise in exquisite detail all expenses dubbed as non-working money — money spent not directly growing the business. Everything in this bucket has to be justified on zero-based budgeting principles, with ownership of every cost line. This is where the bulk of the cost cuts occur. 

The other bucket of costs, dubbed as working money, any expense used to directly grow the business, is actually supported and in many cases increased. In this bucket we have advertising and new plants for example.

Then we have other people’s money, basically leverage, which is used to boost equity returns and fund acquisitions and make it a virtuous circle.

3G Capital, through its acquisition of Heinz and then Kraft, has now targeted the consumer packaged food (CPG) space for disruption and value creation. The failed acquisition of Unilever, however, indicates that they will not stop at food; the entire consumer space is in its crosshairs.

When looking at KHC, 3G Capital saw a very complacent and inbred culture affecting the entire packaged food industry. These companies were used to limited change and disruption as the barriers to entry for a new player were very high. They were able to deliver years of double-digit shareholder returns with only 1 per cent volume growth (in line with population growth). These companies had no need to focus on their cost base and complacency led them to become complicated, inward looking and flabby organisations. All the major companies were run by long-term industry veterans and insiders, with almost no senior talent coming from outside.

Illustration by Ajay Mohanty

The stable annual double-digit shareholder returns delivered across the consumer space are now under question, as the barriers to entry of limited retail shelf space, need for national TV, and slotting fees are falling by the wayside. Consumer stocks are having to fight fragmentation, distrust of large brands and millennials’ focus on health and wellness. The new shareholder return mantra seems to be negative volumes and zero returns at best. In such a scenario there seems little else that consumer companies can do except follow the 3G Capital template of cutting costs, raising margins and using leverage to boost returns and consolidate the industry. Cost cuts are the only way to overcome the headwinds of declining volumes. However 3G Capital was able to implement these cost cuts by bringing in new management and an ownership mindset. The average age of the KHC leadership is only 43 years compared to 53 years for its peers. About 70 per cent of the KHC leadership has come from outside the food industry, compared to sub-20 per cent for its peers. These figures highlight the difficulty other consumer stocks will have in implementing the 3G Capital game plan. The 3G Capital template requires gut wrenching changes in culture and significant social costs. Management teams which have grown up in the security and stability of high barrier to entry consumer businesses, may not have the experience or skill sets to execute cost cuts, manage leverage and implement genuine zero based budgeting, all needed to drive shareholder value in the new paradigm of consumer disruption. 

If the existing management teams cannot deliver, expect activists or companies like KHC (through acquisitions) to force the changes needed. 

Disruption has arrived in the consumer space. Understanding your company’s management team and its adaptability to handle a fast-changing consumer environment may be the single biggest determinant of stock success in the coming years across the consumer space. The very stability of revenues and margins of the past create the difficulty in adjusting to the new normal of vastly greater competition and limited barriers to entry. As disruption spreads, many of the champions of yesteryear will fall by the wayside. Variability of single stock returns will increase dramatically. The better the business and the stronger it’s moats the more difficulty it will have in adjusting to disruption. The management teams best suited to strengthening the moats around the business may be the most ill-suited to drive organisational changes needed to grow and survive in the new paradigm of increased volatility.
 

The writer is with Amansa Capital