On February 22, 2019, investors woke up to a shocking 27% decline at the opening bell of the stock price of The Kraft Heinz Company (Nasdaq:KHC). Overnight, the market capitalization of Kraft dropped $15.9 billion, from $58.8 billion to $43.0 billion. The sell-off was a result of Kraft Heinz’s announcement of fourth quarter and full year 2018 results, which revealed $15.4 billion of impairment charges related to goodwill and intangible assets created from the early 2015 mega-merger between food giants Kraft Foods Group and Heinz. The merger combined two food conglomerates, Kraft—which held an enormous portfolio of food brands including Maxwell House, Lunchables, A1 Steak Sauce, Kraft Macaroni & Cheese, Cadbury, and many others—and Heinz, the owner of the iconic Heinz Ketchup brand and other global food brands centered on condiments and sauces.
Source: Yahoo! Finance
At the time of the merger, there was a great deal of optimism among the management of both Kraft and Heinz. In its 2015 investor presentation, management touted the synergies of the merger, including $1.5 billion in annual cost savings, revenue synergy, international growth, and working capital efficiencies. In essence, management was hoping to leverage Heinz’s diversified global sales channels to sell Kraft branded food products, which are almost entirely sold in North America. In addition, the deal was backed by Berkshire Hathaway, the investment company owned by billionaire investor Warren Buffet. So what went wrong?
It may be instructive to first look at the purchase price allocation disclosed by Kraft Heinz in its July 3, 2016 10-Q and its January 3, 2016 10-K. A purchase price allocation allocates the purchase consideration in a business combination among the various tangible and intangible assets acquired and the liabilities assumed. This disclosure can be useful for investors for the purpose of considering the riskiness of the overall transaction based on different risk and return characteristics expected of the acquiree’s assets and liabilities. Below is a simplified presentation of the final purchase price allocation disclosed by Kraft Heinz (note that Heinz was considered to be the acquirer and Kraft the acquiree):
In millions of USD
|+ Other current assets||$||3,423|
|+ Property, plant and equipment||$||4,179|
|+ Identifiable intangible assets||$||47,771|
|+ Other assets||$||214|
|Equals: total invested capital||$||83,363|
|Minus: liabilities assumed||$||(33,726)|
|Equals net assets = total cash and stock consideration||$||52,637|
Source: Kraft-Heinz July 3, 2016 SEC Filing 10-Q
As illustrated above, total consideration was $52.6 billion, and adding liabilities assumed implies an invested capital value for Kraft of approximately $83.4 billion. The identifiable intangible assets of $47,771 was primarily comprised of trademarks. A comparatively small portion of the purchase consideration was allocated to tangible assets. 94% of total invested capital was attributable to the combined identifiable intangible assets and goodwill . Thus, the question of what exactly was acquired in the 2015 merger can essentially be thought of as portfolio of trademarks and goodwill.
From an accounting perspective, goodwill generally represents the aggregate purchase consideration, minus the fair values of the identifiable assets acquired. While goodwill is simply a residual value, it is important to consider what goodwill may actually represent from a valuation perspective. So with that said, what did the goodwill of $30.5 billion represent in the Kraft purchase price allocation?
According to Kraft Heinz financial statement disclosures, goodwill related “principally to synergies expected to be achieved from the combined operations and planned growth in new markets.” Here are a few additional thoughts:
- The investor presentation discussed earlier noted that management expected significant revenue and cost synergies as a result of the transaction. Kraft’s revenue growth had been low in the years leading up to the transaction, and management hoped to utilize Heinz’s global distribution channels to drive sales of Kraft outside of North America. Management likely assumed increased revenue growth in the years after the merger, particularly in international sales, but growth may have fallen short of expectations.
- Management hoped to improve margins by cost savings, which typically involves reducing overhead and improving operational efficiencies. Although this may seem a straightforward concept, successful execution can be elusive. In its February 21, 2019 earnings call, Kraft Heinz management admitted that its planned cost cutting measures fell short of expectations.
- In the accounting standards for business combinations, the only “market participant” synergies may be incorporated into fair value estimates for acquired assets. This means that any synergies that could only be realized by Heinz, and not by any other food company, as a hypothetical acquirer must be considered as goodwill.
Thus, looking at the overall transaction, management placed significant value ($30.5 billion out of total purchase consideration of $52.6 billion) on the above three expectations in justifying the 2015 merger to Kraft and Heinz’s investors. By impairing goodwill and acquired intangible assets, management is now acknowledging that going forward, expectations are materially below what was originally projected in 2015.
There are a few takeaways from the Kraft Heinz debacle for stakeholders in an M&A transaction:
- Stakeholders should understand exactly what assets and liabilities are being transferred. Purchase price allocations are performed by valuation analysts post-transaction, but it may be beneficial for stakeholders to go through the exercise of identifying all the tangible and intangible assets. If substantial value is allocated to an identifiable intangible asset (trademarks, in the case of Kraft), then consider testing the robustness of those assets. If substantial value is allocated to goodwill, consider what goodwill may represent and test the assumptions justifying the overall purchase price.
- Any premium paid above the fair value of identifiable tangible and intangible assets is goodwill, which can often be based on overly optimistic expectations. Valuation analysts assign greater risk to goodwill in a purchase price allocation than other identifiable assets. Acquirers would do well to heed this concept, as well.
- Even if synergies exist, execution risk is often underestimated. Here, the original transaction rationale was to utilize Heinz’s international sales channels for Kraft’s primarily North American food products. These efforts appear to have fallen short of expectations. In addition, efforts to take advantage of cost synergies also fell short, per management’s own admissions.
- Forecasting the future is inherently uncertain, and sellers have an incentive to be optimistic. While we may not know the exact revenue growth figures and profit margin improvements forecasted in 2015, the high level of goodwill disclosed in the 2015 purchase price allocation and the current impairment suggest that those expectations for financial performance fell far below what Kraft Heinz has ultimately been able to achieve.
These lessons are not limited to the mergers and acquisitions of multi-billion dollar international conglomerates. Middle market firms and small businesses and their investors face the same questions in attempting to reconcile a purchase price with the underlying fundamentals of a business. A thorough analysis of the identifiable intangible assets and considering the assumptions underlying the excess of value above all identifiable assets will aid buyers and sellers in reaching a deal that they will not regret in the future.
If you or anyone you know may benefit from a confidential consultation with one of our experts in Aronson’s Forensics & Valuation Services Group, please contact Jimmy Zhou at 240-364-2698 or firstname.lastname@example.org.