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3G Capital, magicians of the consumer industry, need to learn a new act

3G Capital, magicians of the consumer industry, need to learn a new act

OCCASIONALLY a business idea emerges that is so simple you cannot believe it works. Consider the five founders of 3G Capital, an investment firm. Warren Buffett co-invests with them and calls them “among the best businessmen in the world”. They use debt to buy consumer-product firms, then they revamp their brands and slash costs. In total, since 1997, they have launched $470bn of deals, through 3G Capital or earlier entities (for simplicity this article lumps these all together and calls them “3G”). That makes 3G the second most acquisitive organisation in modern history. It sells every Budweiser slurped, Whopper burger munched and bottle of Heinz ketchup squirted on the planet.

Yet despite its superb long-term record, 3G is losing steam. In the past two years its total portfolio has lagged slightly behind the S&P 500 index, Schumpeter estimates. Its two biggest firms, AB InBev, a beer giant, and Kraft Heinz, a food company, have returned 6% and 16% respectively, well behind the S&P 500 (29%) and a basket of 20 big rivals (24%). On November 1st shares in Kraft fell after poor results. Once, 3G seemed to be reinventing the consumer industry. Now a better description is that it brilliantly took advantage of a window of opportunity that is closing.

By their own description 3G’s founders started out, in Brazil, as mere “finance guys”. The first big deal was the acquisition of Brahma, a local beer firm, in 1989. In the booze industry they bought Interbrew in 2004, Anheuser-Busch, maker of Budweiser, in 2008, and SAB Miller in 2016. The resulting beer colossus, AB InBev, is Europe’s third most valuable company. In the food business, 3G took control of Heinz in 2013 in partnership with Mr Buffett. Heinz then bought Kraft in 2015, and the combined firm tried and failed to buy Unilever in February. 3G also controls Burger King, which it has merged with Tim Hortons, a Canadian fast-food chain where hypothermic Torontonians huddle in winter.

3G is expert at “zero-based budgeting”, a technique that involves scrutinising consumer firms’ bloated costs. But its magic rests on two simple insights formed decades ago. First, it noted that although the cost of debt financing was low, the yield on consumer firms’ shares was quite high, meaning a juicy spread. Second, conventional managers underestimated how resilient consumer-product firms’ sales are thanks to strong brands and oligopolistic market shares. So costs could be cut (including marketing) without prompting a fall in the top line.

The takeover of Anheuser-Busch, worth $62bn, shows these principles in action. The deal was mostly financed by debt with an annual post-tax cost of 3%. The firm being bought yielded 6% (its annual cashflow after capital spending, as a share of its market capitalisation plus net borrowings). Cost cuts eventually lifted that return to 8%. Normally such high leverage is reckless, because profits are volatile. But Anheuser was different. It had a 48% market share in America, with famous brands that people would keep chugging come hell or high water. After the 2007-08 financial crisis, share prices and interest rates fell, pushing the gap between the cost of debt and consumer firms’ yields wider still. 3G pursued big deals around the world, eventually paying $123bn in 2016 for London-listed SAB Miller.

Those two original insights are getting tired, though. First, the gap between the cost of debt and the yield of consumer firms has narrowed as their market values have risen. The median yield for a basket of 20 big consumer firms has fallen from 7% in 2010 to 4% now, making deals less profitable. Some firms are pricier than they would otherwise be because their share prices reflect speculation that 3G might make a bid. Mondelez and others have all been rumoured targets in a Wall Street game of “who’s next?”. The cost of debt may start to rise as monetary policy normalises.

The second intuition—that consumer firms’ sales are near-indestructible—is no longer safe. Many customers are opting for niche brands; craft ales instead of Bud Light, or organic take-home meals instead of Kraft’s classic Macaroni and Cheese. In the last quarter, both AB InBev and Kraft Heinz reported stagnant volumes globally and shrinking sales in America. In the medium term e-commerce could reduce the power of big brands. Instead of having a privileged spot on Walmart’s finite shelf space, established consumer companies must now slug it out with smaller brands on Amazon.

Such shifts will not threaten 3G’s current firms. Cost savings are still going to help their bottom lines. Profits at AB InBev and Kraft Heinz would have to fall by two-thirds or more before they struggled to make interest payments. And their combined debt pile, though huge (equivalent to the fourth-largest of any non-financial firm in the world), is well-organised, with repayments spread out over years. Even so, a decade of mediocrity beckons.

The number’s up

One option is a final flurry of deals. The possibility cannot be ruled out—which is why consumer-product firms must stay on their toes. But as well as being expensive, cross-border deals and job cuts have become more politically sensitive (Kraft Heinz has cut 10,000 jobs since 2013). 3G’s bid for Unilever caused a stink in Britain and the Netherlands. Trustbusters would block another big beer deal. Perhaps reflecting this, 3G is trying a new approach, of expanding firms through investment and innovation. Here, AB InBev is in a reasonable position, given its exposure to fast-growing emerging economies and its experience of turning niche beer brands into big sellers. Energising Kraft is a taller order, since creativity is not in its DNA and 69% of its sales are in America.

3G’s pivot will be a struggle. But what a run it has had. It took advantage of a time when rates were low, stockmarkets were cheap, protectionist instincts subdued, anger over job losses muted and digital competition still nascent. Its adventures have not necessarily made the world a fairer place, but as a piece of intelligent, opportunistic investing they deserve three cheers.

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