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duce.in Uncertain Times

CASE 12 H. J. Heinz: Estimating the Cost ofroCapital
rep
o n o t
e o n ,d
lysuccess.
lu s
rsonaHenry
To do a common thing uncommonly well brings
PeFounder John Heinz3-03-27
202
—H. J. Heinz

i z i rg American Consumer Products division, Solomon

nits.oNorth
u n
As a financial analyst at the H. J. Heinz Company (Heinz) in
51@investment proposals involving a wide range of food products. Most
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Sheppard, together with his co-workers,
discussions in his office focused on the potential performance of new products and reasonableness of cash flow
projections. But as the company finished its 2010 fiscal year at the end of April—with financial markets still in turmoil
from the onset of the recession that started at the end of 2007—the central topic of discussion was the company’s
weighted average cost of capital (WACC).

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At the time, there were three reasons the cost of capital was a subject of controversy. First, Heinz’s stock price had
t r ep
o n l y,d o no
just finished a two-year roller coaster ride: Its fiscal year-end stock price dropped from $47 in 2008 to $34 in 2009,

al us e
then rose back to $47 in 2010, and a vigorous debate ensued as to whether the weights in a cost of capital calculation
n
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202 3
should be updated to reflect these changes as they occurred. Second, interest rates remained quite low—unusually so

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for longer-term bond rates; there was concern that updating the cost of capitalrgto reflect these new rates would lower
un Third, there was a strong sense that, as a result of
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the cost of capital and therefore bias in favor of accepting projects.
the recent financial meltdown, the appetite for risk in the market had changed, but there was no consensus as to whether
this should affect the cost of capital of the company and, if so, how.
When Sheppard arrived at work on the first of May, he found himself at the very center of that debate. Moments
after his arrival, Sheppard’s immediate supervisor asked him to provide a recommendation for a WACC to be used by

ro d u e.
the North American Consumer Products division. Recognizing its importance to capital budgeting decisions in the firm,
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he vowed to do an “uncommonly good” job with this analysis, gathered the most recent data readily available, and
began to grind the numbers. o n l y
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Page 190

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Heinz and the Food Industry 2 3 - 0 3
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In 1869, Henry John Heinz launched a food company by making horseradish from his mother’s recipe. As the story
n
51@u21 styles of shoes, which he thought was clever.
580advertising
goes, Heinz was traveling on a train when he saw a sign
Since 57 was his lucky number, the entrepreneur began using the slogan “57 Varieties” in his advertising. By 2010, the
company he eventually founded had become a food giant, with $10 billion in revenues and 29,600 employees around
the globe.
Heinz manufactured products in three categories: Ketchup and Sauces, Meals and Snacks, and Infant Nutrition.
r o d u c e.
n ot reone p
Heinz’s strategy was to be a leader in each product segment and develop a portfolio of iconic brands. The firm

o n d o
estimated that 150 of the company’s brands held ,either
l y the number or number two position in their respective target
markets.1 The famous Heinza
o n l usewith sales of $1.5 2
Ketchup, billion a year or 650 million bottles sold, was still the
undisputed world rs
Peleader. Other well-known0brands
2 3 - 0 3- 7Weight Watchers (a leader in dietary products), Heinz
included
2
i n . org2 the “biggest bean-eating nation in the world”),
Beans (in 2010, the brand sold over 1.5 million cans a day in Britain,
n i z
051@ uItalian market). Well-known brands remained the core of the
5 8
and Plasmon (the gold standard of infant food in the
business with the top 15 brands accounting for about 70% of revenues, and each generating over $100 million in sales.
Heinz was a global powerhouse. It operated in more than 200 countries. The company was organized into business
segments based primarily on region: North American Consumer Products, U.S. Foodservice, Europe, Asia Pacific, and
Rest of World. About 60% of revenues were from outside the United States and the North American Consumer

ro d u c e.
Products and Europe segments were of comparable size. Increasingly, the company was focusing on emerging markets,

o re
which had generated 30% of recent growth and comprised 15% of totaltsales.
n p
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oninlythe United States included Kraft Foods, the largest U.S.-based
a l u e
The most prominent global food companies based
s
P
food and beverage company; son Soup Company, 3
erCampbell the iconic-2
- 0 3 7 food maker; and Del Monte Foods, one of
canned
2 food and pet products focused on the U.S. market (and a
20branded
largest producers and distributers of premium-quality
former Heinz subsidiary). Heinz also competed with a number n
u zi
ofiother .orgplayers such as Nestlé, the world leader
nglobal
5805
in sales, and Unilever, the British-Dutch consumer 1@
goods conglomerate.

Recent Performance
With the continued uncertainty regarding any economic recovery and deep concerns about job growth over the previous
two years, consumers had begun to focus on value in their purchases and to eat more frequently at home. This proved a

e p ro d uce.
benefit for those companies providing food products and motivated many top food producers and distributors to focus
on core brands. As a result, Heinz had done well in both 2009 and 2010,
, d owith ot r sales growth and profits above
npositive
s e othanl y
n those in 2009. These results were
s o n a l
the 2008 level both years, although 2010 profits were u lower
7 Page 191
particularly striking since a surgeP e r
in the price of corn syrup and an3 - 2
-03 in the cost of packaging had
2 0 2 increase
n i zi n . orgin Asia, had also positively
necessitated price increases for most of its products. Overseas sales growth, particularly
affected the company’s operations. Exhibit 12.1 and Exhibit512.2
0 1@ u financial results for the years 2008, 2009,
present
and 2010.
5 8

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EXHIBIT 12.1 | Income Statement (numbers in thousands except per-share amounts; fiscal year ends in April)
i
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Data source: H. J. Heinz SEC filings, 2008–10.

EXHIBIT 12.2 | Balance Sheet (numbers in thousands except per-share amounts; fiscal year ends in April)

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Data source: H. J. Heinz SEC filings, 2008–10.

The relation between food company stock prices and the economy was complicated. In general, the performance of
a food products company was not extremely sensitive to market conditions and might even benefit from market
uncertainty. This was clear to Heinz CFO Art Winkelblack, who in early 2009 had remarked, “I’m sure glad we’re
selling food and not washing machines or cars. People are coming home to Heinz.”3 Still an exceptionally prolonged

ro d u ce.
struggle or another extreme market decline could drive more consumers to the private-label brands that represented a
p
d o n t relikely in mid-2010, it was clear the
oless
e y ,
step down from the Heinz brands. While a double-dip recession seemed
oonnlmargins.
a l u
economy continued to struggle, and this put s
pressure
n been initially unaffected3by-2adverse
While the stock priceP rsohad
foreHeinz 3 -0 7 changes in the economy and did not
2 0 2
decline with the market, starting in the third quarter of 2008, Heinz’s stock price began tracking the market’s movement
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quite closely. Figure 12.1 plots the Heinz stock price against the S&P Index (normalized to match Heinz’s stock price at
n
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580price
the start of the 2005 fiscal year). The low stock the start of 2009 had been characterized by some as an over-
reaction and, even with the subsequent recovery, it was considered undervalued by some.4 Page 192

FIGURE 12.1 | Heinz stock price and normalized S&P 500 Index.

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Data sources: S&P 500 and Yahoo! Finance.

Cost of Capital Considerations

p ro d u ce.
o n re that the recent downturn had been largely
otGiven
Recessions certainly could wreak havoc on financial
y , d markets.
onlit was not surprising that the interest rate picture at the time was unusual.
l u s
precipitated by turmoil in theacapital e
on
Persinformation
markets,
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Exhibit 12.3 presents
2 0 2 3
on interest rate yields. As of April 2010, short-term government rates and even
commercial paper for those companies that could issue it were.at
i z i n rg low levels. Even long-term rates, which
ostrikingly
u n
5 8 051@standards. Credit spreads, which had drifted upwards during 2008 and
were typically less volatile, were low by historic
jumped upwards during 2009, had settled down but were still somewhat high by historic standards. Interestingly, the
low level of long-term rates had more than offset the rise in credit spreads, and borrowers with access to debt markets
had low borrowing costs.

EXHIBIT 12.3 | Capital Market Data (yields and prices as of the last trading day in April of the year indicated)

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Note that bond data were slightly modified for teaching purposes.

not r e p
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Data sources: Federal Reserve, Value Line, Morningstar, and case writer estimates.
1The

o n l y,
20-year yield is used for 2003–05, when the 30-year was not issued.

s o n a use(also shown in Exhibit712.3 ). He easily obtained historic

lHeinz
Sheppard gathered some market Pe r
data related to
3 -0 3-2
0 2
2 beta using the previous five years of data at about
stock price data. Most sources he accessed estimated the company’s

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0.65.5 Sheppard obtained prices for two bonds he considered representative of the company’s outstanding borrowings:
@u the commercial paper market in the past, but
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a note due in 2032 and a note due in 2012. Heinz had regularly
that market had recently dried up. Fortunately, the company had other sources for short-term borrowing and Sheppard
estimated these funds cost about 1.20%.
What most surprised Sheppard was the diversity of opinions he obtained regarding the market risk premium.

o duc e.
Integral to calculating the required return on a company’s equity using the capital asset pricing model, this rate
r
r ep
ly, d o not
reflected the incremental return an investor required for investing in a broad market index of stocks rather than a
o n
al u s e
riskless bond. When measured over long periods of time, the average premium had been about 7.5%.6 But when
Person 0 2 3 - 0 3-27
measured over shorter time periods, the premium varied greatly; recently the premium had been closer to 6.0% and by
2were the results of a survey
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some measures even lower. Most striking
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even lower premium in the near future—close @
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to 5.0%.
5 8
2010 only made sense if a much higher premium—something close to 8%—were assumed.
As Sheppard prepared for his cost of capital analysis and recommendation, he obtained recent representative data
for Heinz’s three major U.S. competitors (Exhibit 12.4). This information would allow Sheppard to generate cost-of-
capital estimates for these competitors as well as for Heinz. Arguably, if market conditions for Heinz were unusual at

ce.
the time, the results for competitors could be more representative for other companies in the industry. At the very least,
p ro d u
o not re
Sheppard knew he would be more comfortable with his recommendation if it were aligned with what he believed was

u se nly, d
appropriate for the company’s major competitors.
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EXHIBIT 12.4 | Comparable
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Data sources: Value Line; H. J. Heinz SEC filings, 2008–10; case writer estimates; Morningstar.

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