Kraft Heinz recently took a charge-off that shocked investors and led to a share price decline. At about the same time, WPP took a charge-off that reassured investors and led to a share price rise. What's going on here?
The advertising and financial community was shocked by Kraft Heinz's (KHC's) recent $15.4 billion charge-off -- $7.1 billion for goodwill and $8.3 billion for other assets in 2018, coming as it did only four years after the merger of these two food giants. The market punished Kraft Heinz with a 25% drop in its share price. This was hardly the Madison Avenue Makeover hoped for by Kraft and Heinz investors, including Warren Buffett and 3G Capital.
Quite different was the £302 million charge-off ($400 million) by WPP for its three-year restructuring and transformation plan. The charge-off will give WPP the accounting flexibility to restructure, reduce its complexity and reinvest in creativity, tech and talent through 2021. The stock market's reaction? A 7% increase in WPP's share price -- Madison Avenue Makeover in action.
All write-offs, "reserves," write-downs or charge-offs have something in common: they reduce shareholder equity. That's just as true for Kraft Heinz as it is for WPP. A charge-off says, "value that we once booked in our equity account now has no value and is being removed immediately."
Unrealistic KHC Expectations
KHC booked high values of goodwill and other assets in the KHC equity account when Kraft and Heinz merged in 2015. Management expected to realize synergies from higher international growth and cost economies of scale. In the four years since the merger, though, management has failed to realize these synergies. With the benefit of hindsight, we can see that they seriously overvalued Kraft Heinz when putting the two companies together. The $15.4 billion charge-off took 23% out of the 2017 KHC equity value.
"Here's what happens when 3G buys your company," announced a Fortune article at the time of the merger in 2015, highlighting the extreme downsizings and cost eliminations that could be anticipated at KHC -- the "3G Way." The marketing community jumped on the 2018 KHC write-downs, seeing in them proof that the 3G Way does not add value and cripples existing brands.
For WPP, the 2018 charge-off of £302 million ($400 million) was a different story. The charge-off created a "reserve" that Mark Read can dip into for cost investments through 2021 that will not have an impact on WPP's future profits. Read already wrote off the costs in the "big bath" 2018 charge-off, even though in reality it was only a tiny-sized bath -- it affected only 3% of WPP's 2017 equity value.
In effect, WPP was charging off some of the "excess profits" generated during past years, when WPP agencies aggressively downsized and cut costs to generate large and growing profit margins for the holding company. WPP now has to claw back some of those cost reductions to invest for the future.
The magnitude of "excess cost reduction" in the past exceeds the £302 million reserve, I believe. Mark Read may find that he needs to take additional charge-downs in the future to invest at the required rate. I suspect that a £1 billion investment might be required -- but this is still only 10% of WPP's equity.
Read's accounting conservatism in 2018 was certainly understandable. This was WPP's first charge-off for future investment and Read could not have known what the market's reaction might have been. As it turned out, he was given a strong vote of confidence by investors.
In this respect, the WPP's charge-off is entirely different from that of Kraft Heinz. WPP said, "We have to make some strategic investments in the future to get us where we need to go." The market agreed.
Kraft Heinz's statement was less inspiring. "Whoops! We really f**ked up!" Investors must now wait for a new turnaround plan from the tarnished KHC management team.
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