Late last week, KHC reported 2Q18 earnings. The figures were disappointing. More importantly, the company announced it is:
–cutting the $.625/quarter dividend to $.40,
–writing down the value of its intangible assets by $15.4 billion (about 28% of the total) and
–involved in an SEC inquiry into the company’s accounting practices for determining cost of goods sold. Apparently prompted by this, KHC boosted CoG for full-year 2018 by $25 million in 4Q18.
The stock declined by 27% on this news.
What’s going on?
broadly speaking…
KHC is controlled by famed investor Warren Buffett’s Berkshire Hathaway and by 3G, a group of investment bankers behind the consolidation success of beer maker Anheuser-Busch Inbev.
As I see it, Buffett’s principal investing idea continues to be that markets systematically undervalue “intangible assets,” accounted for as expenses, not assets–namely, successful firms’ brand-building through advertising/marketing and superior products/services. This explains his preference for packaged goods companies and his odd tech choices like IBM and, only after all these many years of success, Apple. All have well-known brand names cemented into public consciousness by decades of marketing expenditure.
3G believes, I think, that in most WWII-era companies a quarter to a third of employees do no useful work. Therefore, acquiring them and trimming the outrageous levels of fat will pay large dividends. Remaining workers, arguably, will figure out that performing well trumps office politics as a way of climbing the corporate ladder, so operations will continue to chug along after the initial cull.
These beliefs account for the partners’ interest in KHC.
My take here is that the investing world has long since incorporated Mr. Buffett’s once groundbreaking thinking into its operating procedures, so that appreciating the power of intangibles no longer gives much of an investing edge. (Actually, KHC suggests reliance on the fact of intangibles may make one too complacent.) As to G3, it’s hard for me to figure how companies fare after the dead wood is eliminated.
the quarter
The most startling, and worrying, thing to me about the quarter is the writedown of intangibles. My (admittedly quick) look at the KHC balance sheet shows that total liabilities and tangible assets–working capital and plant/equipment–pretty much net each other out. This means that shareholders equity (book value) pretty much consists solely in the intangibles that drive customers to buy KHC’s ketchup and processed cheese foods. That number is now 28% lower than the last time the company looked at these factors. Did all that decline happen in 2018? Is this the last writedown, or are more in the offing?
The fall in the stock price seems to me to correspond closely to the writedown. I’d expect the same to hold the in the future. And it’s why I think the risk of further writedowns is a shareholder’s biggest worry.
–A dividend reduction is always a red flag, especially so in a case like this where the payout has been rising. It suggests strongly that something has come out of the blue for the board of directors. However, KHC appears to be indicating that cash cows are being divested and that loss of associated cash flow is behind the dividend cut. I don’t know the company well enough to decide how cogent this explanation is, but it’s enough to put the dividend cut into second place on my list.
–an SEC inquiry is never a good sign. In this case, though, it seems that only small amounts of money are at issue. But, if nothing else, it points to weaknesses in management controls, supposedly 3G’s forte.
Final thoughts:
–Experience tells me the whole story isn’t out yet. I’d want to know whether KHC is taking these actions on its own, or are the company’s lenders, its auditors or the SEC playing an important role?
–This case argues that the intangible economic “moats” that value investors often talk about have less protective value in the Internet/Millennial era than in earlier, slower-changing times.
