Shares of Hellmann’s mayonnaise owner Unilever and Frank’s RedHot sauce maker McCormick fell on Tuesday following the announcement over concerns about the transaction’s structure, long path to closing and antitrust risks.

The top U.S. spice maker, home to more than 30 household brands, is playing the long game, some analysts said.

While many food companies are scrambling to reformulate products and resize portions as the surging popularity of GLP-1 weight-loss drugs reshapes eating habits, McCormick argues that flavor will remain essential even as calorie counts fall.

“We will continue to flavor calories while others compete for them,” McCormick CEO Brendan Foley, a packaged-food industry veteran, said on a call with investors on Tuesday.

“As consumers increasingly focus on cooking at home, adding more protein and produce, and pursuing healthier lifestyles, flavor plays a critical role in elevating those choices,” Foley said.

The GLP-1 bet

The surge in weight-loss drug use has consumers craving more flavor ‌in their food, leading to condiment and spice makers benefiting and attracting more interest in the M&A marketplace, dealmakers have said.

“Consumers shifting away from fatty, greasy, or overly sweet foods … creates a massive opportunity for flavor enhancers (spices and hot sauces) that provide sensory satisfaction without adding calories,” said Timothy Malefyt, professor of marketing at the Gabelli School of Business at Fordham University.

The deal will also help the U.S. company tap into Knorr stock cubes maker Unilever’s global scale and expertise, executives said on Tuesday’s investor call. Unilever executives highlighted its popular flavors such as Asian and Chinese.

“McCormick with this could be well-positioned to create the right nutritional functional benefit in food that is lacking in America right now,” said Mike Anstey, founder of Pilot Lite, a global CPG (consumer packaged goods) commercialization partner.

It would also open up key emerging markets such as Brazil, China and countries across Europe, the Middle East and Africa (EMEA).

“(The deal) represents a step-change in scale, broadening MKC’s exposure to faster-growing emerging markets and expanding opportunities for its foodservice platform,” Jefferies analyst Scott Marks said in a note.

Unkind market conditions

McCormick is seeking new markets and flavors against the backdrop of a tough U.S. market, where consumers are eating healthier and also looking for cheaper pantry alternatives and smaller pack sizes to stretch budgets hit by inflation.

“We’re certainly aware of the near-term pressures facing not just the food industry but broadly … the conflict in the Middle East and the broader CPG space. However, we continue to believe in just the long-term fundamentals that really underpin the confidence in this combination,” McCormick’s Foley said.

The company’s total volume growth has slowed over the last year, and was down 0.7 per cent in the most recently reported quarter, falling across both its consumer brands and flavor solutions segments.

“Despite the combination’s strategic merits, we think this may be a ploy to incite growth in an industry where gains have stagnated,” said Erin Lash, analyst at Morningstar Research.

Rival Kraft Heinz, which media reports said had explored a bid for Unilever’s food business, underscored the tougher U.S. market when it paused plans for a split.

“Investors should look at this transaction more optimistically than broken deals like Kraft Heinz because it creates value through greater depth in a single category, flavorings, rather than diversification,” said TD Cowen analyst Robert Moskow in a note.

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Such a move would mark an acceleration of efforts to reshape Unilever. More than one Unilever CEO has tried to refocus the company’s portfolio by expanding in personal care and beauty, and selling some food brands.

The food business came under the spotlight again when the Financial Times reported that Unilever might spin it off, and had held merger talks with Kraft Heinz, which ended.

Unilever’s shares, which were higher in early trade on Friday, had fallen to their lowest since July last year as investors and analysts worried that CEO Fernando Fernandez could be distracted from the day-to-day running of Unilever by the potential separation. And they questioned ‌the benefits of such an action so soon after Unilever’s protracted ice cream unit split.

How much is Unilever’s food business worth?

Unilever’s packaged food business accounts for more than a quarter of group sales, but faces pressures from a shift away from ultra‑processed products, competition from private label brands, and softer demand as the rise of weight‑loss drugs changes consumer buying habits.

Home to Knorr bouillon powders and Hellmann’s condiments, the division’s underlying operating margin – which excludes the impact of foreign currency exchange rates – was 22.6 per cent of revenue, outstripping the group’s 20 per cent margin last year.

The food business, which also makes Marmite spreads, reported an operating profit of 2.9 billion euros (C$4.6 billion) last year, giving it an enterprise value of roughly 30 billion euros (C$47.6 billion), according to Barclays estimates.

Slower to grow compared with the rest

The business, Unilever’s second largest by sales after personal care, grew at 2.5 per cent last year, more slowly than the rest of the group and well below the company’s own mid-term goal.

Underlying sales growth at Unilever’s foods division has lagged that of other units since the COVID-19 pandemic highs, repeatedly falling short of the company’s annual goal of sales growth of between four and six per cent.

Analysts and investors question the long-term prospects of the packaged food industry when politicians, including U.S. Health Secretary Robert F. Kennedy Jr, have highlighted the potential health risks of processed foods.

Developed markets have reached saturation

Part of the problem is that the business is operating in two contexts: developed and emerging markets. Unilever’s food business is growing more slowly in North America and Europe than in countries such as India and parts of Latin America, where the group has a stronghold in food and private label products are less sophisticated, meaning they offer less competition.

“There is more growth in emerging markets, which accounts for 55 per cent of food for Unilever, but it’s still not enough to make up for Europe and the U.S. where the market is saturated,” Barclays analyst Warren Ackerman said.

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Products sold by companies including Nestle, Pepsico and Unilever were assessed as part of a global index published by the Access to Nutrition Initiative (ATNI), its first since 2021.

The non-profit group found that across 30 companies, the products sold in low-income countries scored lower on a star rating system developed in Australia and New Zealand than those sold in high-income countries.

In the Health Star Rating system, products are ranked out of 5 on their healthiness, with 5 the best, and a score above 3.5 considered to be a healthier choice.

In low-income countries, the multinationals’ portfolios rated 1.8 on the system. In high-income countries, where more products were tested, they were 2.3.

“It’s a very clear picture that what these companies are selling in the poorest countries in the world, where they are more and more active, are not their healthier products,” said Mark Wijne, research director at ATNI, in an interview with Reuters.

“It’s a wake-up call for governments in these countries to be vigilant,” he added.

It is the first time the index has split the assessment into low and high-income countries.

ATNI said the index was important as packaged foods are increasingly playing a part in the obesity crisis that is now a global phenomenon. More than one billion people worldwide are living with obesity, according to the World Health Organization. The World Bank estimates that 70 per cent of people who are overweight or obese live in low-and-middle-income countries.

“We have committed to grow our sales of more nutritious foods, as well as guiding people towards more balanced diets,” a Nestle spokesperson said by email, adding that Nestle also fortifies products to help close nutrient gaps in developing countries.

A PepsiCo spokesperson declined to comment. The company last year set new goals to lower sodium in its potato chips and add ingredients like whole grains into its foods.

“We acknowledge that there is always more to do, both at a business and industry level,” said Isabelle Esser, chief research, quality and food safety officer at Danone, which was the best performer in the index.

— Additional reporting by Jessica DiNapoli and Richa Naidu

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The report by the Farm Animal Investment Risk and Return (FAIRR) coalition showed 25 major retailers and manufacturers were developing strategies for sustainable protein products, recognising the risk of a strategy reliant on animal protein.

“Many have now begun a journey to diversify the protein products away from being predominantly animal-based, and towards low carbon and less resource intensive sources that are plant-based,” said Jeremy Coller, founder of FAIRR, which includes institutions such as UBS and Schroders .

Unilever, Tesco and Nestle were awarded top rankings for their work in understanding the impact and reducing risks associated with intensive animal agriculture, such as the emission of greenhouse gas.

They were also among the firms that had strong sustainable sourcing programmes and had targets to reduce emissions, said Aarti Ramachandran, FAIRR’s head of research and engagement.

The report, titled “Appetite for Disruption”, found 87 per cent of retailers were increasing their own-brand plant-based products, while 64 per cent of the 25 firms that FAIRR engaged with had referred to “vegan” and “plant-based” in their annual reports.

The alternative protein market has taken off in part due to the inclusion of such products at global restaurant chains such as Burger King and McDonalds Corp, as well as the blockbuster listing of Beyond Meat Inc.

The alternative protein market is now valued at $19.5 billion and is expected to capture 10 per cent of global meat market, the report said, citing research from Barclays and JPMorgan. The market is expected to reach $100 billion in value in 15 years.

Amazon and Costco fared lower in the rankings and were described as “reactive” in part because of their limited work in sustainable sourcing of animal protein.

While manufacturers were expanding alternative protein portfolios, 56 per cent of those companies were responding to consumer demand rather than taking a more proactive approach.

“We can’t tackle climate change … unless food companies more rapidly diversify their protein portfolios away from animal agriculture,” Coller said.

Only four companies had undertaken a risk assessment to stress test the resilience of their protein supply chain, FAIRR’s report said.

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The business includes the brands Stork and Flora, the latter of which is sold under the name Becel in Canada and several European countries, and as Promise in the U.S.

The sale of the business officially kicked off in late September, with Unilever’s banks sending out confidential information to a series of heavyweight buyout funds which have been working on this deal since the start of the summer, the sources said.

The auction has been dominated by private equity firms which have been lured by the unit’s strong profit margins. But the valuation might prove difficult, as Western consumers cut back on bread and margarine, the sources said.

International investors have teamed up in three rival consortiums consisting of Bain Capital and Clayton Dubilier + Rice (CD+R) as part of one group, Blackstone and CVC Capital Partners as part of a rival group, and KKR joining forces with Singapore’s sovereign wealth fund GIC.

U.S. investment fund Apollo was instead looking to bid alone, the sources said.

Industry players including U.S. agricultural trader Archer Daniels Midland have decided against bidding, the sources added.

Blackstone, CD+R, Bain, CVC, KKR and Apollo declined to comment, while Unilever and GIC were not immediately available for comment.

The sale, which is led by Morgan Stanley and Goldman Sachs, could fetch as much as six billion pounds (C$9.9 billion/US$7.8 billion) and was expected to wrap up toward the end of 2017, the sources said.

In its bid to exit from the shrinking margarine business, Unilever agreed last month to exchange its spreads unit in South Africa for Remgro’s 26 per cent stake in Unilever’s South African subsidiary, a deal worth US$900 million.

The consumer giant has been working hard to boost its margins and performance after rebuffing a surprise US$143 billion takeover bid from Kraft Heinz this year.

Unilever’s underlying operating margin improved 180 basis points to 17.8 per cent in the last six months, helped by an acceleration of cost-savings programmes, and a 130-basis point drop in brand and marketing spending.

On Sept. 25, Unilever made a 2.27 billion-euro (C$3.3 billion) swoop on fast-growing cosmetics company Carver Korea in a bid to build a global beauty business.

— Reporting for Reuters by Pamela Barbaglia, Dasha Afanasieva and Clara Denina.

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Kraft had made a surprise offer for Unilever to build a global consumer goods behemoth — an offer flatly rejected on Friday by London- and Rotterdam-based Unilever, whose food brands in Canada include Becel margarine, Ben and Jerry’s ice cream, Knorr soups, Lipton tea and Hellmann’s mayonnaise.

Kraft withdrew its offer because it felt it was too difficult to negotiate a deal following the public disclosure of its bid so soon after its approach to Unilever, according to people familiar with the matter who requested anonymity to discuss confidential deliberations.

Kraft had not expected to encounter the resistance it received from Unilever, one of the people said. Some key concerns raised during talks included potential U.K. government scrutiny, as well as differences between the companies’ cultures and business models, the person added.

“Kraft Heinz’s interest was made public at an extremely early stage,” Kraft Heinz spokesman Michael Mullen said in a statement. “Our intention was to proceed on a friendly basis, but it was made clear Unilever did not wish to pursue a transaction. It is best to step away early so both companies can focus on their own independent plans to generate value.”

Kraft was forced to publicly disclose its offer on Friday to comply with Britain’s takeover regulations, after rumours of its approach to Unilever circulated among stock traders.

Under U.K. takeover rules, Kraft’s public withdrawal of its offer precludes it from reviving takeover talks with Unilever for six months.

A combination would be the third-biggest takeover in history and the largest acquisition of a U.K.-based company, according to Thomson Reuters data. The combined entity would have US$82 billion in sales.

The premature exposure of Kraft’s bid left the aggressive acquisition machine scrambling to craft an appetizing message for shareholders, the press, Unilever’s rank and file, and British and Dutch leaders.

Prime Minister Theresa May ordered top officials to investigate if the proposed deal posed potential threats to British economic interests, the Financial Times reported.

May has been adamant the government should be more active in vetting proposed foreign acquisitions of U.K. companies. She had previously singled out Kraft’s 2010 acquisition of another British household name, Cadbury, as an example of a deal that should have been blocked.

A deal for Unilever would have marked the next instalment of Brazilian private equity firm 3G Capital Management’s longstanding strategy of buying food companies and slashing costs.

In 2013, 3G teamed up with billionaire investor Warren Buffett to acquire Heinz and then purchased Kraft two years later. It is now the second-largest shareholder in Kraft, behind Buffett’s Berkshire Hathaway.

Unilever feared that a merger with Kraft, under 3G Capital’s relentless cost-cutting, risked eroding the value of its brands and could impede its expansion in emerging markets, which requires more investment, according to people familiar with the company’s thinking.

Unilever also saw its household products and consumer care divisions as too distinct from Kraft’s food business, the people added.

3G made its name in corporate America by orchestrating large debt-laden acquisitions and then slashing costs dramatically to juice profits. Using a strategy called zero-based budgeting, its managers must justify all expenses, from pencils to forklifts.

Kraft still hungry?

The breakdown in deal talks sparked speculation among analysts and investors about whether Kraft might attempt to purchase another large consumer goods company as a backup plan.

“We believe this announcement serves as a reminder — if needed — of (Kraft’s) interest, capacity, and commitment to pursuing large-scale M+A in a potentially near-term time horizon,” said Barclays analyst Andrew Lazar in a note.

Its bid for Unilever, where more than 60 per cent of sales come from home and personal care products, signals a willingness to make big buys outside of its historic area of focus — food — said Sanford Bernstein analyst Ali Dibadj.

He cited Colgate-Palmolive as one potential target, noting that its stock popped four per cent Friday on news that Kraft was eyeing Unilever.

However, the breakdown of the Unilever talks means that some food companies that have long been speculated as potential targets for Kraft, such as Mondelez, are still very much on the table, said an industry banker, who declined to be named because he was not authorized to speak to the press.

Low interest rates and cheap debt have fuelled big cross-border deals, marking the busiest start to the year for M+A activity on record. The bid also reflected a broader interest in UK companies as acquisition targets, in part due to the British pound, which has been under pressure since Britain announced plans to withdraw from the European Union.

Labour union representatives expressed relief that the deal talks broke down, citing concern about its potential effect on jobs and consumers.

“How many scares must the government put U.K. workers through before they actually do as they have promised, which is to make the takeover process socially responsible?” said Len McCluskey, general secretary at Unite, Britain’s largest union.

— Carl O’Donnell reports on mergers and acquisitions for Reuters from New York. Reporting for Reuters by Ismail Shakil in Bangalore, Pamela Barbaglia in London and Lauren Hirsch and Greg Roumeliotis in New York.

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3G made its name in corporate America by orchestrating large debt-laden acquisitions and then slashing costs dramatically to juice profits. Using a strategy called zero-based budgeting, its managers must justify all expenses, from pencils to forklifts.

Its investment approach has attracted backers ranging from billionaire investor Warren Buffett, who has helped bankroll all four major 3G deals, to celebrities such as supermodel Gisele Bundchen and tennis champion Roger Federer, who invested in 3G’s latest approximately $10 billion fund (all figures US$).

This relentless focus on costs, however, may end up making Kraft’s pursuit of Unilever more difficult. In rebuffing Kraft’s bid publicly on Friday, Unilever cited “strategic” in addition to financial reasons.

While sources told Reuters that Kraft believes that investing in innovation would be an important part of the combined company, analysts have begun to question whether 3G’s operational approach hinders Kraft’s ability to grow over the long term.

“We can understand how some investors could wonder if Kraft’s efficiency-centric model is as sustainable as many have believed,” Barclays analysts said earlier this month.

Kraft’s sales were down 3.8 per cent to $6.86 billion in the fourth quarter of 2016. Kraft has attributed the decline in sales to a pruning of its portfolio, as it weeds out non-profitable products. It sees tight operational management as perfectly compatible with sales growth.

London- and Rotterdam-based Unilever — whose food brands in Canada include Becel margarine, Ben and Jerry’s ice cream, Knorr soups, Lipton tea and Hellmann’s mayonnaise — defines itself as a business “making sustainable living commonplace.”

This means putting money with an eye beyond the immediate bottom line, such as products with low environmental impact and resources toward bringing safe water to under-served regions.

“(The rebuff of Kraft) makes us also wonder if Unilever’s focus on sustainability might make it very resistant to any further approach from Kraft,” said Royal Bank of Canada analyst David Palmer.

Adding to Kraft’s challenges, the U.S. consumer food company will need to either integrate or find other options for Unilever’s household and personal care (HPC) business, which makes products such as toothpaste, soaps and detergents.

“It seems plausible that the HPC piece of (Unilever) then becomes a merger partner for something 3G might do on its own in HP. In other words, this could be part one of a huge two-step process,” said Don Bilson, head of research at event-driven research firm Gordon Haskett.

Kraft, Unilever and 3G Capital declined to comment.

Management philosophy brewed at Anheuser Busch

Co-founded by Brazilian billionaire financier Jorge Paulo Lemann, 3G combined Kraft and H.J. Heinz Co in 2015 to create a company that now has a $112 billion market capitalization, and combined Burger King and Tim Hortons in 2014 in a $11 billion deal.

The 3G management philosophy was developed by Lemann and Brazilian investment bankers Marcel Herrmann Telles and Carlos Alberto Sicupira, and pioneered at Budweiser brewer Anheuser Busch InBev, the world’s biggest brewer, which they helped create through a series of big mergers.

Lemann, Telles and Alberto Sicupira made their mark at Banco Garantia, the investment bank they founded in Brazil in the 1970s. After selling it to Credit Suisse Group AG in 1998, they formed private equity firm 3G to invest in U.S. consumer names.

After 3G teamed up with billionaire Buffett to buy Heinz in 2013, they closed six factories and cut 7,000 jobs in 18 months. Operating margins jumped from 18 per cent to 26 per cent.

Lemann, Brazil’s richest man and a former tennis pro, once served on the board of Gillette, where he met Buffett, who has partnered with Lemann on Heinz and Kraft and has said he would like to do more deals.

While 3G is often seen as extreme — at Heinz they limited employee use of company printers to 200 pages per month, requiring double-sided printing — zero-based budgeting has been adopted elsewhere, such as at Oreo cookie maker Mondelez International.

— Reporting for Reuters by Michael Flaherty and Lauren Hirsch in New York.

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