Kraft Heinz And Why The D2C Revolution May Be Bigger Than You Think

Late last week, Kraft-Heinz, one of the largest global food conglomerates reported disappointing earnings, admitted to an SEC investigation, and wrote down the value of a couple of its iconic brands. The market responded by dumping their stock 30% – the single largest daily drop in its history – wiping out ~$15B of market value. Their (rather depressing) day looked something like this:


On the surface, it’s yet another data point in the continuing narrative that dinosaur retail brands are going extinct at the hands of millennials and their changing preferences. And I would largely agree with that take. But I wanted to take a few words to dig a bit deeper and hopefully provide some valuable clues to better understand how the value shift – specifically towards direct to consumer brands – is playing out, where it will accelerate, and what it’s actually worth.

Good Luck Good Will Hunting

There’s a curious accounting mechanism on every corporate balance sheet in this country that no one really loses much sleep over, but perhaps they should. It’s called “Goodwill,” and it basically means what its name suggests – a kind or considerate gesture above and beyond any realistic expectation or value. Goodwill and its sister, “Intangible Asset,” exist in order to ensure the appropriate balance of, well, the balance sheet.

The basics are that every balance sheet must adhere to the following accounting formula: Assets = Liabilities + Equity. Meaning that if you have $100 in your company bank account and no other assets, you are functionally required to have either $100 in some form of accounts payable, or else $100 worth of equity, from say a fundraise.

But a funny thing often happens on the way to the forum. Let’s say you’re a large multi-national conglomerate and you want to make an acquisition. So you find a super sexy, fast growing company you want to purchase and you transfer your hard earned cash for it. Now it may not have much in the way of earnings, but, as we mentioned, it sure is sexy and therefore has a really cool brand. And assuming you’ve paid cash for this company, your liabilities haven’t changed one bit, but your cash position is now short $1B, so you need to find another line item to increase in order to balance out that formula of Assets = Liabilities + Equity.

Enter Goodwill. Or intangibles. (There is a difference but we’re trying to keep this simple.) You mark down your cash position $1B, but you mark up Goodwill by $1B and voila, all is equal. (This is overly simplistic…most companies do have some assets, so the “goodwill” is technically the premium over their book value. The official formula is Goodwill = Purchase Price – (Assets + Liabilities.))

But after a few decades in business and a few dozen acquisitions, it begins to become a massive cluster of, well, something. Here is Kraft-Heinz’s most recent balance sheet:


While this is pretty typical, it’s also somewhat astounding if you take a step back and actually think about what’s going on here. Of Kraft-Heinz’s approximately $100B in gross asset value, only 1% is in cash, and 3% in some form of inventory. Instead, nearly 85% of their assets are tied up broadly in Goodwill or Intangibles.

What does this even mean? Well, you’re right to ask. It means that 85% of Kraft Heinz’s assets are reflected in their trademarks and brands. Actually, not even. These line items can mean even more than that: they can refer to customer lists, or they can refer to historically good customer service, or they can even refer to good Company culture. But let’s keep it simple: $85B in brands and trademarks. Which means: building better brands, for example launching a hot dog that consumers love more than Oscar-Meyer, a cheese better than Kraft, or a coffee better than Maxwell House unlocks $85B of asset value. (Of course, it’s not quite that easy, but you see where we’re going here.)

On Brands and Final Stands

So it turns out that “brands,” however you want to define them are worth quite a bit. At least at Kraft-Heinz. What about some other iconic American conglomerates? Well, Unilever has $28B of brand intangibles, GE has $84B, Proctor and Gamble has $80B, Newell has about $10B, and the list goes on and on and on. Even my beloved Hershey’s has $1B in intangibles (but let’s be real folks, that one is probably pretty safe.)

So in aggregate, today’s retailers and CPG conglomerates are carrying many trillions of dollars of “brand” asset values on their balance sheets. Interesting. But these are audited public filings so those valuations are all probably legitimate and valid, right? Wink, wink.

No, of course not. Although it’s true that external auditors require Goodwill to be evaluated on a regular basis, companies are pretty creative at “aiding” the analysis and generally try to delay write downs as long as they can without doing something wrong. Truth is, can anyone reasonably assess the difference between a $9 billion brand versus an $11 billion brand? As a friend and public company CFO noted to me when I asked him about this issue: “It’s human nature that you don’t want to admit something until the evidence is overwhelming.” Yup.

So what does this all have to with direct to consumer startups and the dizzying volume of emerging millennial brands? Well, I suspect the narrative – as recently expressed by Kraft Heinz – suggests that many of these new high growth brands are deeply, viciously, undervalued.

This is a contrarian view. When Allbirds, a 2.5 year old shoe company, recently raised financing at a nearly $1.5 billion valuation, a lot of eyebrows were raised. When Rothy’s another nascent shoe brand raised financing at a valuation above $1 billion, there were more eyebrows. When an ostensibly absurd “box of stuff” startup, FabFitFun raised $80M last month (also at a $1b valuation), I heard laughter. It is easy to eye roll. But it might overlook fundamental value creation.

If you’ve made it this far, and you’re an investor in some capacity, you might ask: “but aren’t companies valued by their earnings, not their intangible brand equity?” And this is true. Pick your variable – sales, EBITDA, etc – companies trade alongside benchmarks for these variables.

But how do you value a company growing 200-300% a year in a category where the incumbents are growing 2% annually? It’s functionally impossible. So typically they trade (are valued) at a material premium to the “market,” even though in this case the market isn’t even really a representative comp.

However, consider for a moment my CFO friend’s observation: “It’s human nature that you don’t want to admit something until the evidence is overwhelming.” Kraft may be only the first rock, but an avalanche is coming. So how do you value a company that is both growing 200% a year, and serves as a substitute for years of deferred write-downs that conglomerate X is carrying, but hasn’t yet admitted.

That company would trade at a material premium to the material premium.

We’ve seen this already begun to play out in the organic food industry – with Danone’s 2016 purchase of Whitewave at a 21x forward multiple (nearly 50% premium to an already over-heated M&A market) or Kellogg’s acquisition of RxBar at more than 6x sales (a more than 300% premium to the Company’s own multiple). But food is arguably the most mature of all innovation industries; consumers’ self-reported behavioral change has now been widely accepted for more than a decade. Not so much in other categories.

It’s an interesting time for the direct to consumer market. There’s been a lot of funding, but very few exits to date, and many investors I’ve spoken to are privately a bit nervous: what if all these brands aren’t worth as much we’ve thought? But – what if on the contrary, they’re actually worth a whole lot more? Which could very well be the case if trillions of dollars of corporate asset values are nothing more than deferred write-downs.

If, as I suspect, Kraft’s move forces discussions in many CFO suites to admit reality, it could catalyze an accelerated turnover of brands and an M&A boom in a variety of industries. And it’s likely we’ll start to know in as little as 2-3 years.

At my new fund, Starting Line, we are aggressively investing into these emerging brands, even in categories that may seem small, and are always open to connect.

Ezra Galston1 Comment