Have you ever heard of 3G Capital? Maybe not, but I’m assuming you have heard of Budweiser, Burger King and Heinz (or Kraft Heinz as it’s now known). 3G Capital is an investment fund that controls these and some of the world’s best-known brands.
A brief overview
The 3G strategy is very focused around hard-hitting cost-cutting measures and zero-based budgeting strategies to boost financial returns. This strategy has seemingly worked successfully for them a number of times, but it’s not quite had the same effect at Heinz. Heinz has been through a barrage of embarrassing stories recently with SEC investigations, asset write-downs and its share price dropping off a cliff.
Here’s some relevant background…
- Oct 2017: Heinz names 29-year-old David Knopf its youngest-ever CFO
- At the same time, experienced CFO who was in role since 2013, Paulo Basilio moves internally
- Oct 2018: the SEC issues a subpoena relating to “accounting policies, procedures, and internal controls in procurement”
- Feb 2019: a $15.4bn write-down in assets leads to an immediate 28% fall in share price
- The above fall in share price lost major investor Warren Buffet $4bn in one day!
- Q4 2018: the company posts a loss of $12.6bn and cuts its dividend by 36%
- Miguel Patricio replaces Bernardo Hees as CEO in July 2019
- The new CEO immediately replaces Knopf with former CFO Basilio.
One thing that’s interesting to know is that both Bernardo Hees (former CEO) and David Knopf (former CFO) are from the same school of cost-cutting practice, and both are partners at 3G Capital.
Kraft Heinz Co share price, as listed on the NASDAQ: KHC
(52-week high $59.91, 52-week low $24.86)
There are some lessons from this very public battering of their share price and many of them circle around their recently exited CFO and CEO, and the strategy they pursued.
Zero-based budgeting and responsible cost-cutting
This is one of the tactics for which 3G has become famous. Zero-based budgeting (ZBB) is a method where all expenses must be justified in each new period. Each new budget starts with an absolute zero-base, rather than the traditional method of prior period costs and adjusting upwards or downwards.
It’s largely used to challenge ‘this is how we’ve always done it’ conventional thinking, to encourage innovation and to reduce overheads that aren’t bringing much value to the business. When 3G first applied this, they quickly cut costs and the share price increased.
When applied responsibly there are many advantages, such as:
- Challenge conventional thinking and resource allocations by challenging every line item and assumption
- Identify synergies in organisations that have recently merged or made acquisitions
- Eliminate non-value-adding costs
- Realign resources focusing on the vision and strategy of the business
However, the key here is to apply ZBB responsibly and to avoid short-term thinking. Reducing overheads at all costs is not a strategy conducive to getting the most from ZBB and will be at the expense of innovation and future growth.
At Heinz, this approach resulted in smaller marketing budgets for key brands and the loss of brand managers and market share. This was a very short-term view to appease the market, and possibly one stemming from a copy-cat 3G playbook and inexperience.
If you are going to adopt ZBB, then consider the impact on future growth, your business levers and where you need to innovate to maintain brand relevance.
Control versus insight: The CFO balance
I feel a little bit of a fraud writing this one as I constantly beat the drum on performance management and insight. However, there is still, and always will be, a place on the CFO’s agenda for control, compliance and governance.
While not fully on former CFO David Knopf’s watch, during his time in the role the SEC issued a subpoena in October 2018 relating to “accounting policies, procedures, and internal controls in procurement”. This ultimately resulted in a $208m understatement of cost of sales and restatement of prior year results. Again, investor confidence was hit by this latest scandal and accounting error.
As Kraft Heinz stated in their 10-K “these misstatements principally related to the incorrect timing of when certain cost and rebate elements associated with supplier contracts and related arrangements were initially recognized.” While there was no misconduct identified by senior management, who else is to be held ultimately responsible other than the CFO?
Knopf very much came from the school of investment banking and private equity, not a typical CFO route. From what I can see, he wasn’t a CPA or other type of qualified accountant. His background is geared to investors, which isn’t a bad thing, but the balance here was perhaps tipped just too far on the scales.
I would urge you not to forget the need for control in the pursuit of insight and performance. There is a fine balance between control, efficiency and insight.
Performance management: it’s about growth
I’ve already mentioned Knopf’s background. Presumably, the reason 3G and Bernardo Hees brought him in was to focus on performance management.
In this previous article from AccountingWEB, Heinz was celebrated for championing this diversity and repositioning the CFO role as a kind of performance officer: a view I also salute. But that role needs to be rounded and focused on top-line growth and performance.
Very importantly, performance doesn’t stop at cutting-costs (and you could argue it doesn’t even start there). While ZBB has worked well for 3G investments in the past, cutting costs in a business is a pretty basic approach that lacks imagination or, and this is where it’s very relevant for Knopf, experience.
Kraft Heinz is experiencing top-line growth pressures in a market where they are facing ever-increasing competition from ethically-focused brands. I would want to see a focus on insight around growth opportunities and certainly not a write-down of $15bn!
I totally advocate the focus on performance management but if any company is going to do this (other than a recession-hit business or one in demise) then focus on top-line performance!
Aggressive targets linked to high incentives
As well as ZBB, another 3G strategy they apply to their investments is “management-based objectives” (MBOs). Most of the time, MBOs are also linked to remuneration or bonuses. In other words, teams are financially incentivised to reach objectives set for them. This is quite a typical way to set a strategy and filter it through an organisation, so everyone is working towards the same goals.
When this does become a problem is when the targets are so aggressive that it encourages bad behaviour to achieve them. In the 2018 SEC investigation, it was identified that “multiple employees in the procurement area engaged in misconduct”.
I’ve mentioned the ‘fraud triangle’ in my previous article on Theranos (and I’m not suggesting there is any comparison between the two), but a combination of aggressive targets, high incentives and a governance framework that doesn’t detect this is a breeding ground for fraud.
For those interested, rebates on long-term contracts were taken in the current year rather than spread across the life of the contract.
Be careful of the balance between targets and incentives, and if they are aggressive leading to high rewards, ensure there is sufficient governance in place.
I really love to see a more performance-focused professional in the CFO role, driving the vision alongside the CEO. However, there is a balance to be had. A balance that also includes control and an accounting qualification.
The CFO still needs to steward the ship and the kind of performance I prefer to see from this role is top-line growth, not slashing costs or cutting experienced management. Ultimately that doesn’t lead to growth and there are only so many costs you can cut before you are out of options.
Clearly, as a 3G Capital partner and Fortune 500 CFO at 29, Knopf is a very talented professional. However, it’s disappointing that the strategy pursued under his stewardship was all about cost-cutting measures. To me, performance management is about growth.
The appointment was good in principle but, from the outside, executed at the wrong end of the equation. Bring on a performance-focused CFO that’s interested in insight generation and growth. Was David Knopf really equipped to be the Chief Financial Officer at a Fortune 500 company, or was he just re-using a 3G playbook?
I would love to hear your thoughts on this!