February 27, 2019 / 4:33 PM / 6 months ago

Breakingviews - Hadas: The CEO guide to corporate old age

LONDON (Reuters Breakingviews) - The fact Kraft Heinz’s share price has fallen almost one-third since last Friday suggests investors were shocked by its jumbo serving of bad news, which included a dividend cut and a big goodwill writedown. They should not even have been surprised.

Various Heinz sauces of U.S. food company Kraft Heinz are offered at a supermarket of Swiss retail group Coop in Zumikon, Switzerland December 13, 2016. REUTERS/Arnd Wiegmann

The U.S. food giant is part of a longstanding stock-market tradition of investors seeking companies with invincible management that guarantees incredible prospects. This time the magic was supposed to come from the cost-cutting and debt-loading genius of the company’s second-biggest shareholder, Brazilian investment group 3G Capital.

While the fervour had already cooled - Kraft Heinz’s share price before its latest plunge was already 50 percent below where it had been two years earlier – investors were still pricing in a triumph of hope over experience. The slowdown in economic growth in developed economies ought to have been a clue that things were going to get tougher.

Think back to the beginning of the century. In 2000, the United States was coming out of a five-year period where real GDP grew at an annual compound rate of 4.3 percent. Even if that seemed unsustainably high, something close to 3 percent seemed plausible. In the subsequent 18 years, the actual rate has been 2 percent. Demographics suggest a decline from here.

Kraft Heinz is one of the American companies which have been caught in the downdraft. Despite extensive foreign operations, the annual inflation-adjusted growth rate of revenue per share since 2000 for all the constituents of the U.S. S&P 500 stock-market index has been a meagre 1.1 percent, just over half the rate at which real GDP grew.

It’s not just bottles of ketchup that are subject to economic gravity. Consider the big basic consumer goods of transport and housing. Average light vehicle sales over the last five years have been merely 8 percent higher than they were between 1996 and 2000. For housing starts, the same comparison shows a 24 percent decline. In such sectors, there is just not much growth for companies to capture.

Most economists and stock-market forecasters claim to accept something like this dull reality. Vanguard Research, for example, says that the long-term real growth rate of U.S. GDP is 2 percent. And consultants at McKinsey have suggested that it is reasonable for average companies to plan on a 2.5 percent real growth rate in profit.

Those numbers are far below what many corporate managers promise and many stock-market investors expect. The average is too often taken as a bare minimum, leading to unnecessary Kraft Heinz-style disappointments. Even after analysts reset their expectations, the Velveeta cheese maker is expected to report $2.97 of earnings per share in 2019, according to I/B/E/S estimates from Refinitiv. That’s equivalent to almost 8 percent annual growth since 2015, largely thanks to tax-rate cuts.

There are three ways to better align operations and expectations with reality. First, give up on excessively positive thinking. It’s foolish to believe that strategies which have worked on a small scale, for example the 3G Capital approach, can be expanded infinitely. A wise manager remembers that aggressive expansions rarely pay off when overall growth is slow or non-existent, and is not afraid to cut capacity when demand in an industry is shrinking.

Second, try less hard to please financial markets. Overly demanding and optimistic investors often do not really understand what is in the best interests of companies. For example, shareholders were wrong to be miffed when Unilever rejected a merger with Kraft Heinz in 2017. The Brazilian shock therapy might have juiced up profits for a little while, but the Anglo-Dutch consumer conglomerate needs to spend enough to stay competitive in industries which have little growth and a fair number of eager competitors.

Finally, shareholders may have become surplus to requirement at many companies. Solidly profitable enterprises which face neither enormous risks nor great opportunities are extremely unlikely to need new equity capital. Their dividends on existing shares look suspiciously like what economists call rents, unmerited cashflows from customers to equity holders.

Many of these companies have been buying back shares in significant quantities. While those transactions are disguised dividends, they could be made real. Imagine that shareholders were all bought out, and companies adopted a not-for-profit structure like a typical university or non-American hospital. Freed from outside pressure for growth, the trustees could decide to aim for steady and unspectacular results.

Such structural transitions are almost unheard of. But the number of industries that have moved from rapid growth to mature stability is also relatively few. Perhaps it is time to develop new corporate forms to serve the new economy better.

Slow growth is not everyone’s problem. Mature economies only account for about 15 percent of the world’s population. The opportunities for economic expansion remain large for enterprises which serve the other 85 percent. However, only a few companies from rich countries will succeed at that task. For most established industry leaders, dynamic opportunities are yesterday’s story. Corporate styles need to change with the times.


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