Bottled Up Profits aren't flowing like they used to at packaged-goods companies. Can green ketchup and Tuna in a Pouch save Heinz?
By Julie Creswell

(FORTUNE Magazine) – It's a muggy, overcast August afternoon in Pittsburgh, and inside H.J. Heinz headquarters the ten members of Project Snackarama are talking about pet treats. Thick stapled handouts filled with flow charts and spreadsheets are passed around. Prototypes are examined. Should the group's next product be a cat or a dog treat? Should it go under the Meaty Bone or Pup-Peroni brand? Some see an opening in the market for a functional treat, one that cleans teeth or makes coats shine. Others want a more complicated treat that looks like something humans, not dogs, might eat. That worries the guy from research and development. How will he produce it? As ideas are debated, the room is filled with jokes, laughter--and tension.

Nobody feels it more than Jeff Watters. About a month earlier, Watters, 34, left his job at Clorox in Oakland, packed up his wife, young daughter, and English bulldog, and took a position as head of new ventures for Heinz's pet treats unit in Pittsburgh. His mandate was to come out with a blockbuster product. The punch line: It needs to be in stores by next spring.

Developing new products can take years, but Watters doesn't have that luxury. Heinz, home to such well-known brands as StarKist tuna, Ore-Ida French fries, Heinz ketchup and 57 Sauce, and 9-Lives cat food, posted a 5% rise in net income last year on a paltry 1% increase in sales. Its stock is flat this year but down 36% from its late-1998 high. Heinz needs a hit from its high-margin pet treats group--and soon. Heading into the meeting, I ask Watters whether one of the treats on the table in the corner of the room will actually go from the idea stage to a developed product on store shelves in less than nine months. "One of these products had better make it," he says, laughing nervously. "Otherwise, I'm out of a job." His boss, Todd Lachman, the managing director of Heinz's pet treats unit, laughs too. And nods.

It didn't used to be this tough. For years the packaged-goods industry was a cornerstone of America. Mothers served Campbell's soup and did laundry with Procter & Gamble's Tide detergent. Coke and Pepsi were the only contenders in the drink wars. Charlie the Tuna, Morris the Cat, and the Pillsbury Doughboy were national--heck, international--icons. And while there was the occasional hiccup, the industry was among the steadiest and strongest. Between 1981 and 1991, Heinz returned 28% annually, double Standard & Poor's 14% average annual return.

But by the fall of 1998 signs began emerging that something was amiss. Consumer staples companies like Kellogg, Gillette, and Coca-Cola warned that they were going to miss Wall Street's earnings projections. The warnings persisted throughout last year, becoming increasingly dire.

Then in June of this year, Procter & Gamble told analysts its fiscal fourth-quarter earnings increase wasn't going to be in the expected 15% to 17% range. In fact, it wouldn't even be close. P&G would report no earnings increase for the quarter and a paltry 4% rise for the year. P&G's stock, already stung by earlier warnings, had been cut in half, to $55, by midyear, and after a mere 17-month reign, CEO Durk Jager was out. "When P&G fell down this year, that signaled to many that the winds in the face of consumer companies were growing strong," says John McMillin, an analyst at Prudential who has followed companies like Campbell and Heinz for 19 years. "But the wind has been in the face of consumer companies for almost a decade. Procter was simply the strongest tree and took the longest to break."

The past is finally catching up with the packaged-goods industry. Years of management denial, lackadaisical innovation, inventory shoved down grocery store pipelines, and general earnings tweakings can no longer hide the industry's big problem: It's not growing.

There are, of course, exceptions. Certain segments of the packaged-goods industry continue to show strong growth, including high-end pet food and treats, candy and confectioneries, and personal-care items (like Estee Lauder's Creme de la Mer, at $85 for a one-ounce jar) that cater to consumers with more discretionary income.

But for most packaged-goods companies, the glory days may very well be behind them. Gillette grew earnings at an average rate of 18% between 1990 and 1995, then watched its growth rate plunge to 5% over the next five years. Likewise, Kellogg's average EPS growth fell from 13% to zero over the past five years.

In response to the slowing revenue trends, Wall Street analysts have slashed five-year earnings growth targets for the industry to between 8% and 11%. But with actual volume growth projected around 5% or less and little room for companies to raise prices, those estimates are likely too optimistic. "There are just not a lot of signs out there of a turnaround," cautions Burt Flickinger III, a former P&Ger who is now a managing director of consulting firm Reach Marketing in Westport, Conn. "Unless you're a company like Nestle, Mars, or Ralston and you're blessed with categories with very strong growth trends, the company is in trouble."

Gregg Newcombe hopes to turn the tide at Heinz. Striding quickly across a parking lot in a Pittsburgh suburb, his eyes shielded from the sun's glare, Newcombe approaches the packaged-goods industry's battlefield: a Giant Eagle grocery store.

Newcombe joined Heinz six months ago also from Clorox, where he headed up sales for its Brita division. At Heinz, Newcombe is helping to restructure the company's sales force. Heinz has created teams devoted to each of the seven retailers--including Wal-Mart, Albertson's, and Safeway--that make up half of its volume sales. The goal is not only to get Heinz products on the shelves faster but to get them placed more prominently than the competition.

But as Newcombe makes his way into Giant Eagle's produce department, he stops short. He sees something he doesn't like. Two weeks earlier Heinz began shipping its Fruit & Vegetable Wash. But Newcombe is staring at a display of Fit--Procter & Gamble's wash. He likes where it's located on the floor. "I want to be here," he says, using his hands to outline where a Heinz stand should be. Moments later, as Newcombe moves deeper into the produce department, he comes across Heinz's product. He likes its price point ($3.19 vs. $4.99 for Fit), but he doesn't like the green metal rack the product is sitting on. He wishes out loud that a few bottles were strewn along a display of pears and bananas. Sighing, he heads toward another aisle.

As recently as a year ago, it would have taken weeks, even months, for a new Heinz product to hit store shelves after it was shipped. But Heinz and other consumer packaged-goods companies can no longer be that passive. Double-digit earnings growth throughout the '70s and '80s had been easy--simply raise prices. That didn't work in the low-inflation environment of the 1990s. After years of semiannual price increases, cereal makers like Kellogg and General Mills launched a price war to gain market share in the mid-1990s. This month Procter & Gamble plans to raise prices on its dry detergents by 5%--the first price increase in ten years.

Consolidation in the grocery store business and the rise of national retailers like Wal-Mart provide part of the explanation for the pricing environment. Since 1995, the market share of the five largest grocery chains has climbed from 25% to 40%. Manufacturers who once could push their products onto the shelves of regional stores with ease now face national chains with more buying power. And in the mid-1990s retailers began to grow their own private-label businesses. For manufacturers like Heinz, that meant not only were they competing for shelf space but their margins were also being squeezed as private-label products set price ceilings.

Price restrictions might have been surmountable if the industry had taken advantage of broad demographic changes. While the growth rate for whites in the U.S. slowed between 1980 and the late 1990s, the black and Hispanic segments of the population each surged more than 30%. But, says Ryan Mathews, a strategist at Westport, Conn., consulting firm FirstMatter, "the consumer packaging companies continued to put out products with little angelic Aryan babies on them and then couldn't figure out why they weren't selling to the different populations. That's not the way to ingratiate yourself to a diverse population."

America's social fabric was also changing. Between 1970 and 1990 there was a 33% increase in the number of women in the work force. The era of the sit-down pot-roast-and-potatoes family dinner had ended. People began eating out more often. And when they did eat at home, the emphasis was on easy-to-prepare meals. "My father had a bowl of oatmeal every day and spaghetti every Wednesday," says David Nelson, a food analyst at Credit Suisse First Boston. "But my world isn't like that."

For most of the past two decades, as the industry was going through a period of prosperity and change, Heinz had at its helm one of the most charming and charismatic CEOs in America. A former rugby star who owned newspapers in his native Ireland, Tony O'Reilly threw lavish parties for customers each year at his 18th-century mansion in County Kildare. Like many other packaged-goods companies, Heinz and its eight North American units were set up as separate fiefdoms. The units and their managements were often pitted against one another. And when the pricing environment weakened in the 1990s, O'Reilly, along with other packaged-goods CEOs, saw an easy way to achieve earnings growth: Cut costs.

Certainly there were efficiencies to be gleaned. But some managers sliced deeply. "Everyone became short-term focused" throughout the industry, says consultant Flickinger. "They were saying, 'I'll cut the ad budget, cut the research budget, get short-term profitability, and I'll get promoted and pass along all of these problems to my successor.' " That's pretty much what happened at Heinz. Marketing and sales expenses were sharply reduced, as were research and development costs. Earnings and revenues became increasingly erratic.

Infatuation with O'Reilly was also beginning to fade. Heinz's performance was slipping, and a 1992 FORTUNE story asserted even then that O'Reilly had overdone the cost cutting. The year before, O'Reilly had raised eyebrows when he exercised stock options valued at $71.5 million. (When he retires as chairman this fall, he will remain Heinz's largest individual shareholder.)

O'Reilly's successor was his polar opposite, a straightforward manager with a quick sense of humor who peppers his conversations with inspirational, gimme-the-ball sports talk. The son of legendary football player and former Cincinnati Bengals coach Tiger Johnson, Bill Johnson was 49 when he was tapped to lead the company in 1998, becoming the sixth CEO in Heinz's 131-year history.

Johnson, who had been at Heinz for 16 years, was one of a crop of new CEOs at the large consumer staples companies. Malcolm Jozoff was tapped to be Dial's CEO in 1996; Dale Morrison replaced longtime Campbell Soup CEO David Johnson in 1997; and Jager took over P&G in 1999. But these young, ambitious CEOs were all dealt losing hands. Heinz's revenue growth had slowed to an average of 6% between 1990 and 1995, P&G's was 7%, and Campbell's was a paltry 4%. To make matters worse, the tech and Internet industries were stealing not only the attention of investors but also many of the best and brightest executives.

Johnson was eager to make his mark at Heinz, but he offers a frank assessment of his starting point. "We weren't supporting our brands, and we weren't being innovative at all," he says. "We were not unique in that regard. In terms of cost cutting, the mistake for the industry, in retrospect, is that it did not take the cost out of the system; it took the cost out of the product. [It] cheapened and took some of the cachet out of the product."

Change was desperately needed, but some CEOs, like Jager, moved too drastically and too quickly. Others, like Morrison, moved too cautiously and too slowly. The result for both managers was the same: a short tenure.

At Heinz, many of the old-guard managers were ready to retire, giving Johnson an opportunity to bring in new blood. One of the first he hired was Joe Jimenez from ConAgra to be the president and CEO of Heinz North America. The sales force was restructured to focus on and deal directly with Heinz's most important customers. Another restructuring brought all the units--the fiefdoms of the O'Reilly era--to Pittsburgh, where they now share back-office activities.

Johnson's hands-on, sleeves-rolled-up management style is starkly different from O'Reilly's hands-off, golden-cufflink manner. Johnson is known for his "candy tours," dropping in unannounced on an employee with a bag of M&Ms and asking what's really going on. To attract and retain employees, Johnson beefed up pay packages and added performance-based bonuses and incentives. Last year the company had its first General Electric-inspired leadership conference for 100 midlevel employees in Miami.

All good ways to enliven a weary work force. But Johnson has to do much better. He must quickly improve the company's long-term growth prospects, or he risks joining the ranks of Jager and Morrison. (This year, for the first time since 1996, no stock options were rewarded to the company's top executives, which made Johnson's pay package of $3.1 million about half the previous year's.)

There are only two ways Johnson can boost growth: consolidate or innovate. The number of mergers and acquisitions in the food industry has risen sharply this year. This summer three large deals were announced, including the $20.3 billion acquisition of Bestfoods by Britain's Unilever. Other deals are sure to follow. Kellogg and Quaker Oats, as well as Colgate-Palmolive and Clorox, are reported to have had talks, while P&G has been linked to Gillette and has discussed merging with both American Home Products and Warner-Lambert.

The ideal merger for Heinz is one that increases its presence in Europe and adds new, higher-growth categories to its portfolio. Heinz was an eyelash away from such a deal last year before Bestfoods abruptly walked away. Some analysts suggest Johnson didn't want to be No. 2 to Bestfoods' CEO. "Marriage would help this company, and the prettiest girl, Bestfoods, left the room," says Prudential's McMillin. "Johnson should have made that deal happen."

Johnson won't discuss any merger talks and insists Heinz doesn't need a partner. But industry sources say Heinz is eyeing a number of acquisition targets, including, surprisingly, troubled Campbell and Kellogg. The sources say these mergers might make sense for Heinz because the brands have been undersupported, and in the case of Campbell, the two companies could merge their soup businesses. (Heinz is the largest manufacturer of private-label soup.)

Still, without a major deal in sight, Heinz is hoping to find its salvation through innovation. But there's innovation, and then there's innovation. "When it comes to industry innovation, most of the new stuff is extension or me-too stuff," scoffs Jeff Bronchick, chief investment officer for L.A.-based investment advisor Reed Conner & Birdwell. "Look at New Dial. More lather--come on!" Bernd Schmitt, who heads up the Center on Global Brand Leadership at the Columbia Business School, says true innovation, particularly for the food industry, can be extremely difficult: "Unless there are entirely new food products coming out through advances in biotechnology, there are limitations. Innovation can come in the surrounding things, like the packaging, and the selling and marketing of the item."

After a long dry spell, Heinz is sending up a number of new products this year and early next. One of the most anticipated, which launches next month, is green ketchup in an EZ Squirt bottle. The psychology behind the product is simple: Eating habits are developed at young ages. Heinz hopes children will be drawn to the ketchup because of its snazzy bright-green color (expect to see other bright hues down the line) and because the thin stream lets children play Jackson Pollack on their hamburgers and hot dogs.

Still, for green ketchup to be a success, consumers have to buy more than one ketchup at a time (a normal red ketchup for the adults and the green stuff for the kids). Heinz may have a better shot at getting volumes and revenues up with its StarKist Tuna in a Pouch, the biggest innovation in tuna packaging since canned tuna was introduced 80 years ago. Heinz has vacuum-sealed the tuna in a foil pouch so that it's more convenient--no can to open--and more firm and flaky, with little oil or water to turn the tuna mushy. (FORTUNE tried it. It is better.)

But StarKist, which generates about 12% of Heinz's sales, suffered last year from management departures, accounting irregularities that led to a $20 million charge, and low tuna prices. That means Heinz is betting a lot on a unit that's had its share of problems. Still, in its desire to drive up tuna sales, Heinz pulled Charlie the Tuna out of a ten-year retirement late last year. The talking tuna will be featured prominently in a splashy ad campaign for Tuna in a Pouch that kicks off in October. This time around, though, the last thing Heinz wants to hear is, "Sorry, Charlie."