Unilever Rejected Kraft Heinz's Bid as Too Cheap — But It Wasn't Just About the Money

"Unilever does not see any economic or strategic merit for shareholders in the proposal, and the company does not see a basis for further discussion." Why was Unilever so unyielding?

This takeover ended as abruptly as it began.

On February 17, the Financial Times' Alphaville blog suddenly revealed that Kraft Heinz wanted to buy Unilever. Unilever quickly confirmed it had received a merger proposal: Kraft Heinz had offered $50 a share, valuing the company at about $143 billion, an 18% premium over its closing price on the 16th. Unilever turned it down, saying the offer "seriously undervalued" the company.

Kraft Heinz then issued a statement saying that although Unilever had rejected the proposal, it still "looked forward to reaching agreement on the terms of a transaction."

Capital markets were thrilled by the prospect. Unilever's shares on the London Stock Exchange rose 14.5% to £38.33, the highest level since 1983, while Kraft's shares in New York rose 10.7%.

Had the deal gone through, it would have been the second-largest cross-border transaction in history, behind only British telecoms group Vodafone's $172 billion purchase of Germany's Mannesmann in 1999. We would have watched the birth of a multinational giant worth about $225.9 billion, with 210,000 employees.

Then, on the 19th, Unilever and Kraft Heinz put out a joint statement: "Kraft Heinz has amicably agreed to withdraw its proposal for a combination of the two companies." Less than 48 hours had passed since Unilever said no. The reason Kraft Heinz gave was that the deal had surfaced too early: "We wanted to proceed on a friendly basis, but it was made clear Unilever did not wish to pursue a transaction."

But Unilever's reasons for refusing were not only about money.

Why did Unilever feel "seriously undervalued"?

Money mattered, of course. Kraft Heinz offered $50 a share, valuing the company at about $143 billion — an 18% premium over the closing price on the 16th.

As the chart below shows, premiums in recent large mergers have run far above 18%. AB InBev paid a 53% premium for SAB Miller. And in another deal driven by 3G Capital — Heinz's merger with Kraft — the premium was 27%.

Different companies and different moments do shape the price of a deal. But the size of a premium still shows how badly a buyer wants what it is buying — and by that measure, Unilever may well have found Kraft Heinz insincere.

By analysts' forecasts, Unilever's earnings per share (EPS) in 2018 will reach $2.27. At Kraft Heinz's price of $50 a share, that puts Unilever's 2018 price-to-earnings ratio (P/E, market value divided by revenue) at 22 times.

Kraft Heinz's own 2018 P/E is 21 times. In other words, Kraft Heinz thinks Unilever's prospects are about the same as its own.

That does not match how the two companies are actually doing. Kraft Heinz's 2018 revenue is projected to grow 2% over 2017, to $27 billion. Both figures are less than half of Unilever's.

Look at the consumer goods industry as a whole and the $50-a-share offer starts to look stranger still.

Unilever's 2018 revenue is expected to grow 4.5% year on year — twice the rate of Procter & Gamble, and level with Colgate-Palmolive. Yet its P/E today is only 18 times, below the 21 times that is common among consumer goods giants.

If Unilever's P/E could reach 21 times as well, then at projected 2018 earnings of $2.27 a share, the stock should eventually trade around $49.

Against that, Kraft Heinz's $50 leaves almost no room for a premium at all.

By another measure, the price-to-sales ratio (P/S, market value divided by revenue), Unilever's 2.1 times also sits below the more than 3 times of the other two companies.

So to analysts, whether judged by P/E or by P/S — both measures of what a company is worth — Kraft Heinz's offer did not reflect Unilever's value.

That may have something to do with how weakly packaged food has performed in the M&A market in recent years. In this business, big money now prefers brands that feel high-quality, command loyal customers and fit the turn toward healthy eating.

Yet food is only 24% of Unilever's total revenue. Even in packaged food, Unilever has spent recent years buying its way upmarket, pulling away from mass-market, budget brands — as with its 2014 and 2015 purchases of the premium Italian gelato brands Talenti Gelato & Sorbetto and GROM.

"Unilever does not see any economic or strategic merit for shareholders in the proposal, and the company does not see a basis for further discussion." That was Unilever's stated reason for saying no. So leave price aside: how far apart are the two companies' strategies?

Unilever grows mainly in emerging markets; Kraft Heinz is basically a North American company

In 2012, Kraft Foods split in two: Kraft Foods Group, which kept the North American grocery business, and Mondelez International, which took the global snacks business.

In 2015, Kraft — which drew 98% of its sales from North America — grew interested in international business again, and agreed to merge with Heinz, which drew 61% of its sales from outside North America. The result was Kraft Heinz.

Even so, the United States is still Kraft Heinz's most important market by far, at 70.38% of net sales.

Unilever, headquartered in Europe, has long depended on emerging markets instead. Over the past dozen years it has spent heavily on marketing and promotion in India, Brazil, China and elsewhere — giving local retailers discounts to keep products in plain sight on the shelf, handing out samples by the crate, and reworking and selling products for different regions and income groups.

Between 2008 and 2014, 90% of Unilever's global growth came from emerging markets; today those markets are 57.31% of its sales. Emerging markets are widely treated as insurance for the future.

Jonathan Feeney, an analyst at Consumer Edge Research, which studies the household and personal care industry, said the deal would be a key strategic move for Kraft Heinz, because it would widen the company's international reach: "This isn't just a chance at profit — Kraft Heinz would also get a long-term growth opportunity in very, very attractive emerging markets."

Had the merger happened, in the best case the combined company would have cut costs in marketing, manufacturing and distribution, and Kraft Heinz could have used the channels Unilever has already built to win more packaged-food share in emerging markets. But because the two companies sell in such different places, the savings from combining them would not have been especially large.

Besides, even companies with bigger packaged-food businesses than Kraft Heinz — Nestlé and Unilever among them — are now stuck with weak global sales growth and limited room to raise profits. Nestlé, the world's largest packaged-food company, has to deal with deflation in Europe, falling sales in China, and inflation in Brazil and Russia. Last week, its new CEO, Mark Schneider, said the company expects organic growth this year — growth from existing operations, not from acquisitions or asset revaluations — of just 2-4%, down from the 5-6% it had forecast for more than a decade, even as it works to turn itself into a healthy-living services company.

3G Capital, which holds 24% of Kraft Heinz, has always been good at cutting costs and lifting margins. Kraft Heinz's share price has climbed on rising profit, not on selling more product: fourth-quarter results released last week showed sales down 3.7% year on year.

Even with Unilever in hand, Kraft Heinz would have faced the same slow or shrinking sales and the same profit problem as everyone else. The question then would probably have become which markets mattered most, and which one to start cutting first.

The two companies' product businesses are very different too

By market share, Unilever and Kraft Heinz are the world's fourth- and fifth-largest packaged-food companies. But Kraft Heinz sells nothing but food, while Unilever is far more mixed: in its 2016 annual report, the biggest contributor is personal care, not food.

That was one reason Unilever CEO Paul Polman opposed the merger once Kraft Heinz made its move. He warned board members and investors that Kraft Heinz had no relevant experience in personal care or home care.

Since taking the job in 2009, Polman has built up that side of the business and pushed toward higher-margin products, putting more money into them and tying product developers more closely to suppliers. Premium shampoos and creams, he has said, carry margins 8% higher than mainstream ones.

Even within packaged food, the two companies perform very differently.

Under British rules, once Kraft Heinz publicly withdrew its proposal it cannot bid for all of Unilever again for six months. But precisely because the two businesses differ, and because Unilever is reshaping its own, many now expect Kraft Heinz to go after Unilever's food business instead, to add scale — and perhaps its tea and refreshment business too, the lines that look most like snacks. That would also let Unilever concentrate on personal and home care.

Citi's research team has said some form of deal between the two remains possible: one covering the food and refreshment business rather than the whole group, for instance, "making this unexpected episode a potential opportunity for Unilever to restructure its portfolio."

In recent years, Unilever has in fact bought more aggressively in personal and home care

What has Unilever acquired lately?

(Compiled from public reports)

2014.12.02

Talenti Gelato & Sorbetto, a premium Italian gelato brand

Price: undisclosed

2015.05.01

Camay & Zest, soap brands

Price: undisclosed

2015.05.01

REN, a premium personal care brand

Price: undisclosed

2015.08.03

Dermalogica, a premium personal care brand

Price: undisclosed

2015.08.06

Kate Somerville, a premium personal care brand

Price: undisclosed

2015.09.01

Murad, a medical-grade skincare brand

Price: undisclosed

2015.10.01

GROM, a premium Italian gelato brand

Price: undisclosed

2016.08.10

Dollar Shave Club, a razor subscription service

Price: $1 billion

2016.10.20

Seventh Generation, household cleaning products sold as green and healthy

Price: $600-700 million

2017.02.01

Living Proof, a premium hair care brand

Price: undisclosed

Eight of Unilever's last 10 acquisitions were in personal and home care, which tells you how much weight the company puts there. The timeline also shows where it is heading: premium, natural, aimed at young consumers.

The most watched of these deals — the only one with a disclosed price, and the largest — was the razor subscription company Dollar Shave Club (DSC).

The startup, which raised $163 million from venture investors in all, runs a simple business. DSC sells shaving products: pay a membership fee and a handle and blades arrive in the mail each month. The site offers three blades, at $1, $6 and $9 a month. It also sells shaving, cleansing, styling and sun products, none above $10, covering nearly everything a man might put on his face.

Buying things by the month is nothing new to American consumers. Compared with traditional retail, the model suits millennials, who care about the product more than the brand. Since it started, DSC has worked at staying in direct touch with its users: every shipment comes with a "Bathroom Minutes" insert that passes on personal care knowledge in a light tone.

When it was acquired, DSC had 3.2 million paying users, and in 2015 its sales topped $150 million. The deal strengthened Unilever's shaving business and handed it the data the startup had gathered on young users — something to consult when selling Unilever's other products.

Unilever's strategy now is to spend about €2 billion a year on acquisitions (roughly 14.52 billion yuan). It has also set up incubators in offices around the world to draw startups in; the one in Singapore can already hold 50 of them.

Unilever is not alone. Old giants including L'Oréal and Kellogg's are doing the same thing. It is an investment in the future, and also a worry about losing that future market. Either way, Unilever looks confident about its own.

3G cares about short-term profit and loves nothing more than cutting — which Unilever sees as the opposite of sustainability

If 3G Capital buys your company, prepare for worse working conditions, or for losing your job.

3G Capital, a private equity firm on good terms with Warren Buffett, is Brazilian, and is known as "the Goldman Sachs of Brazil." Three tireless Brazilian venture investors founded it; the leading one, Jorge Paulo Lemann, is now worth more than $25 billion.

3G has worked across banking, retail and consumer goods. In 2010 it turned to restaurants. Its signature deal was taking Burger King private for $4 billion, quadrupling the core business in two years and listing it again.

In 2014, 3G led the C$12.5 billion merger of Canada's largest coffee-and-fast-food chain, Tim Hortons, with Burger King. In 2015 it worked with Buffett's Berkshire Hathaway to push Heinz and Kraft together.

3G knows how to cut costs and produce profit. But because it "focuses on short-term profitability and cash flow", the companies it buys may suffer over the long run. Two years after 3G bought Heinz, 65% of its product categories had lost market share.

Jobs are at stake too, so governments do not always welcome 3G's purchases. Kraft once promised to keep Cadbury's British factories open after buying the company, then broke the promise almost at once — which is why its approach to Unilever drew attention from the British and Dutch governments.

3G's way of doing things also clashes with Unilever's culture. If you have been paying attention, you will have noticed that Unilever has spent years talking about protecting the environment, social responsibility and employee welfare — above all, sustainability.

That was Paul Polman's other reason for opposing the merger: he believed a 3G takeover would damage the Unilever brand. According to the Wall Street Journal, Unilever's management was "surprised" to receive the proposal, and saw it as speculation with money.

After Polman took over, Unilever stopped giving investors quarterly earnings guidance; what he stressed was the company's long-term development: "This is a long-term, value-creating model which is equitable, which is shared, which is sustainable. If you buy into this model of sustainability, come and invest with us. If you don't buy into this, I respect you as an individual, but don't put your money in our company."

And yet, to raise profit, Polman has begun using the zero-based budgeting that 3G favors — justifying every expense from scratch rather than from last year's budget — to cut operating costs. Through zero-based budgeting and a simpler company structure, Unilever plans to save €1 billion (about 7.226 billion yuan) by 2019.

In fact, Kraft Heinz's proposal failed in large part because Polman fought back. According to the Financial Times, last month, as soon as Polman realized Kraft Heinz might come for Unilever, he brought in bankers and lawyers and put together a team to handle it. In the first public statement, and in the emails he later sent to 3G Capital and Buffett, Polman made his hostility plain — and Kraft Heinz finally withdrew.

Still, consumer goods companies have all been working hard to remake themselves. Last November, Procter & Gamble sold 41 brands to Coty for $11.4 billion, and plans to cut $10 billion in costs over the next five years. Unilever faces growth pressure too, and means to lift its operating margin from 0.2-0.4% to 0.4-0.8%.

History suggests that huge mergers come easily in bad times. 2015 could almost be called a merger year: AB InBev bought SABMiller for $107 billion, Pfizer bought Allergan for $160 billion, Marriott bought Starwood for $16 billion, and so on. Mergers tend to bring the combined company lower costs and a bigger share of the market — exactly what companies need when the economy weakens and buyers spend less.

So Kraft Heinz's proposal for Unilever was not really a big event in consumer goods. It was a new round in a game capitalists play. Unilever has said no for now, but it is hard to call the matter closed. Since the rejection, 3G — holding $15 billion — has said publicly that it is hunting for its next prey.

Often it is not only about money. In the end, though, money usually settles it.

Once Kraft Heinz withdrew, Unilever's market value, which at the peak had swollen by more than $15 billion, slid straight back down — and finished nearly $10 billion lower than where it started.

See?

Charts: Wu Lingwei

Cover image from: Tax Credits, 401kcalculator, Unilever, Flickr