Early Thursday morning, The Wall Street Journal and the Pittsburgh Post Gazette, among many others, reported that H.J. Heinz Co. said it agreed to be acquired by Berkshire Hathaway Inc. and private-equity firm 3G Capital for more than $23 billion. Under the terms of the deal, which has been unanimously approved by Heinz's board, shareholders will receive $72.50 in cash for each share, a 20% premium to Wednesday's close. As expected, Heinz Chief Executive William Johnson affirmed, "The Heinz brand is one of the most respected brands in the global food industry and this historic transaction provides tremendous value to Heinz shareholders."

Deconstructing the deal from a reputational value perspective, Berkshire Hathaway is paying a 20% equity price premium to acquire a company with the highest reputational value premium in its sector, as shown in the reputational value metrics charts from Steel City Re. As discussed in Reputation, Stock Price, and You (Apress, 2012), the potential equity value implied by the reputational value premium was there for the taking;  equity investors -- Warren Buffet, excluded -- just weren't seeing it. That value arbitrage, to give a name to Buffet's investment strategy, is what the RepuStars Algorithm attempts to expose through the RepuStars Variety Corporate Reputation Composite Equity Index (Ticker: REPUVAR).

Side Bar: Berkshire Hathaway and 3G Capital have pledged to maintain Pittsburgh as Heinz's global headquarters. The word "Variety" in the full name of the RepuStars Index comes from Heinz's tag line, 57 Varieties, for the reason that RepuStars comprises a portfolio of up to 57 names. RepuStars Variety returns are reported each week on this blog. Steel City Re, which calculates the measures of reputational value and volatility, is also headquartered in Pittsburgh.

Returning to the measures, as of last Thursday when these were last calculated, Heinz's CRR, a measure of relative reputational ranking, was in the 96th percentile. Return on equity was in the 56th percentile, and RVM volatility, a non-financial measure of reputational value volatility, was in the lowest decile for most of the year spiking only recently to the 68th percentile. Return on equity has been keeping with the median for the sector. Last, prospects for future change, as reflected in the CRR vector and the related indication of stability at the 86th percentile, suggested little expectation of change. In other words, each of the various stakeholder groups, holding expectations appropriate to their experiences with the company, thought that they were valuing the company properly. Those views were not aligned -- but which group was off the mark?

Buffet's actions today, affirming the logic of RepuStars, suggest that equity investors were missing the boat.

There is good news in the airlines industry. Notwithstanding safety issues on the hardware side of the business at Boeing, the service side is getting some recognition for improved quality. As Huygens points out from time to time, its great to have a superior reputation and capture the economic premium. But if equity investors have already factored all that into the stock price, there is little upside potential. The big returns come from companies with poor reputations and little reputational value premium who surprise everyone with better (fill in the blank.) In the airline business, there is only one variable measure: service quality.

Compare USAirways (NYSE:LCC) and Delta (NYSE:DAL) as reflected in the Steel City Re reputational value metrics. Over the past year, USAir's CRR, its relative rank or reputation premium, grew; equity prices grew to match - with a 70% ROE. Going forward, and based on both the CRR velocity and RVM volatility, it looks like Delta will make the next hop upward. Soon.

Everybody has problems. Boeing has an airplane problem. Tesco has a hamburger problem. And YUM! has a chicken problem. Three different commercial sectors each with quality problems, often leading to safety issues, with one common element. All of the problems originated within the companies' supply chains, comprise failures in operational oversight and control, and have the potential for blossoming into full-on reputational crises.

Reputational crises are expensive. Customers slow down their purchase frequency and extend the their purchase decision cycle, to say nothing of their resistance to premium pricing. But the pain goes further. Vendors offer less favorable terms; creditors raise the cost of capital, employee turnover is but one indicator of morale problems that start brewing, NGOs take interest, and regulators start paying more attention. And of course, equity investors, who have the shortest fuse, sell. That is why Huygens prefers to call them, "reputational value crises."

CNBC reported yesterday that Yum Brands, the parent of restaurant chains Taco Bell, KFC, and Pizza Hut, reported surprise weakness in China. "This skews to the worst case for the company," said David Palmer, managing director and senior food & restaurant analyst at UBS, who covers the company. China represents almost half of the business, in profit terms, for the company, he said in an interview on CNBC's "Squawk on the Street."

Forbes reported, "At YUM’s analyst day on December 6, 2012, we asked CEO David C. Novak what his “defense” was to media exposes that one of KFC China’s suppliers had pumped its chicken full of chemicals to expedite their growth. The story prompted a furious social media reaction. His answer was “No worries. It will blow over.” When asked how, he shrugged: “It always has.”

Turning to a measure of reputational value, the Steel City Re reputational value metrics, the measures for YUM! in contrast to McDonald's, the sector reputational leader, are informative. The problem, it seems, hasn't blown over. The company's reputation ranking is sinking steadily and the forecast last week as shown below, before this week's news, was for further deterioration. The steadiness of the deterioration was suggested by the RVM volatility measures and the median forecast stability numbers. RVM, as Huygens' followers know, is a non-financial measure of reputational value.

YUM!'s loss would reasonably be expected to by McDonald's gain. MCD, with a CRR, a measure of relative reputational ranking, buried at 1.0 for the sector, could only gain in RVM.  MCD's RVM volatility suggests this is the case, and not surprisingly, its ROE has been climbing as YUM!'s has been sinking. 

The moral: supply chains are great sources of cost savings, value, operational risk, and reputational value risk. Their operations need to be overseen and controlled no less so than organic operations. And if the excuse is that the whole point of outsourcing was to reduce the costs associated with organic controls and oversight, well, then, add that sentence to the ever-growing collection of things that seemed like a good idea at the time.

"They’ve found horse meat in Tesco burgers? It’s an unbridled disaster." Through internet-wide humor, at the very least, Tesco is being reminded that supply chains can be a major source of quality risk. As the FT reports:

Having inquired into the provenance of beefburgers that contained horsemeat, it has dumped Silvercrest, its supplier of frozen burgers, essentially for deviating from the list of Tesco-approved meat suppliers. “The breach of trust is simply too great,” said Tim Smith, the UK retailer’s technical director, in a statement. (The owner and founder of Silvercrest’s parent told the FT earlier this month it had been “let down” by its own suppliers.)

Humor aside, stakeholders do not appear to be materially shaken by this turn of events -- a supply chain quality control (operational) failure -- with respect to Tesco's reputational value.

The Steel City Re Reputational Value Metrics, explained in greater detail in the 2012 book, Reputation, Stock Price and You, show no difference in RVM volatility between historic and current periods. RVM is a non-financial measure of reputational value and is holding steady in the 70th percentile. The company's CRR, a measure of reputational ranking, is at the 26th percentile. Its economic returns are median, and its reputational forecast suggest slightly below median stability with directionality indicators being positive.

The data suggest that stakeholders, having already ranked the company at the lowest quartile, were less shocked by Tesco's discovery of horse meat than they were pleasantly surprised by the company's swift response. First, severe action against a supplier to punish it for its failure and second, a commitment to  test the DNA of meat going forward to mitigate future potential problems. These comprise textbook reputational value crisis management practices. [A textbook response, it should be noted, is not PR; but rather substantive operational fixes. Pass the hint to Boeing.]

For supply-chain watchers, note the references to "trust" and "being let down." Supply chains can not operate effectively absent trust nor can they operate only on the basis of trust. Tools that help companies verify that which is the basis for trust will become increasingly important. Stay tuned.

The intangible asset of interest is quality, and the problem  -- according to Blackrock (BLK) -- is that it's missing. Bloomberg reported yesterday that "Credit rating companies are distorting capital markets by assigning the same debt ranking to countries from Italy to Thailand and Kazakhstan, according to BlackRock Inc. (BLK), the world’s biggest money manager...For BlackRock, which oversees $3.7 trillion in assets, the measures are so untrustworthy that the firm is setting up its own system to gauge the risk of investing in government bonds."

The ratings agencies generate a product that customers do not value, or even trust. As we shared before, the regulators are upset that the product is distorting markets. The book Reputation, Stock Price and You: why the market rewards some companies and punishes others, explains how one of the cardinal signs of a reputational value crisis is when stakeholders turn on you. Watch this one closely.

Chanel used to say, ‘If a woman walks into a room and people say, “Oh, what a marvellous dress,” then she is badly dressed. If they say, “What a beautiful woman,” then she is well- dressed.’ S&P & Moody's similarly, provide the service of adorning countries with ratings that, in the ideal, make them attractive to investors. Look at the country, not the rating, they would say. Unfortunately, the ratings agencies lately have been attracting far too much attention to themselves.

Japan’s Financial Services Agency last week said it ordered S&P’s Japan unit to improve its system for verifying and updating ratings. In November, an Australian judge ruled S&P misled investors by giving its highest ratings to securities whose value plunged during the global financial crisis. Yesterday, Bloomberg reports that this year's ratings calls missed market movement more often than they concurred. "Yields on sovereign securities moved in the opposite direction from what ratings suggested in 53 percent of the 32 upgrades, downgrades and changes in credit outlook, according to data compiled by Bloomberg. That’s worse than the longer-term average of 47 percent, based on more than 300 changes since 1974. This year, investors ignored 56 percent of Moody’s rating and outlook changes and 50 percent of those by S&P." 

In 1909 John Moody had a good story. Access to information was slow and expensive, and the cost of ignorance was evident in the losses of the 1907 market crash. Today, the rating agencies' story is being blamed, in part for the losses of the 2008 market crash. One would expect reputational value consequences, and yet...

The Steel City Re Reputational Value Metrics show that Moody's ranking is at the median and trending up, while its return on equity is already the top percentile among 15 financial publishing peers. Current volatility of RVM, a non-financial measure of reputational value, is very low. The vital signs present an odd mix of data. Is Moody's making up for lost ground, or have investors gone whacky? Things are not in balance raising the question: Will the the story morph into the fable, "The emperor's new clothes?"

Last Friday, J.C. Penny Co. Inc (JCP) reported a $123 million loss for the most recent quarter. CEO Ron Johnson describes the company as “the fastest-growing startup in retail history,” language that unfortunately brings to mind Kodak’s characterization of its innovation-led transformation over the past decade. It is a great mindset but spending, too, has to conform to an environment where the business model is still being perfected.

The company sees itself in transition: the boutique, jcp, emerging from the tired jcpenney. The new jcp is boasting higher productivity of $269 per square foot compared to $180 per square foot at jcpenny. Combined, however, the stores reported a 26.1% drop in same-store sales on reduced traffic of 12%. Internet sales fell by almost 40 per cent in the third quarter reported last week. At best, customers are not sure what to expect. At worst, they've stopped looking. Employees, and other stakeholders are confused, perhaps too, and that, by definition, is impacting the firm’s reputation.

Looking at Steel City Re’s Reputational Value Metrics, its been a wild ride for JCP's RVM. The metrics at left show that both the RVM and CRR measures are holding at nearly rock bottom, but that future stability is unlikely with a ranking among its 22 peers at 0.0 percentile. The volatility metrics, shown at right, report extreme movements with negative directionality. The only conclusion to draw is that stakeholders as a group are confused -- and that can't sit well with equity markets.

In late September, Huygens commented on how quickly the National Football League (NFL) resolved an emerging reputational value crisis. By invitation of CFO magazine's risk editor, Caroline McDonald, a follow up article was published Monday 15 October detailing the financial issues at stake as an operational failure began blossoming into a full-blown quality-linked reputational value crisis. Click here to link to CFO.com

Bloomberg has a thing for Standard & Poor's, the rating agency subsidiary of the McGraw Hill Company (MHP). Inspired by S&P's unilateral downgrade of US debt in August 2011, Bloomberg started asking questions and concluded that when it comes to sovereign debt, S&P is out of its league. (Moody's and Fitch still give the US their highest ratings.) Looking at the latest update yesterday (Detrixhe J, 8 Oct), the message from Bloomberg comes in three parts: S&P doesn't have the competency, their ratings upgrades/downgrades are no better than a coin toss, and if you will lose money if you believe them.

David Jacob, who was fired from S&P in December, said in a June interview that grading government bonds is outside ratings companies’ traditional areas of expertise because “you’re talking about politicians, you’re talking about legislators, you’re not talking about credit risk.”

Predicting the reaction to rating changes by S&P or Moody’s is little more than a toss up, with yields moving in the opposite direction than suggested 47 percent of the time, according to data compiled by Bloomberg in July. Yields were measured after a month relative to U.S. Treasury debt, the global benchmark.

Pacific Investment Management Co.’s Bill Gross,...who manages the $277.7 billion Total Return Fund, ... eliminated government-related debt from the Total Return Fund in February 2011 and said in March of that year that Treasuries needed to be “exorcised” from portfolios. The fund lost against 70 percent of its peers that year, prompting Gross to capitulate and buy U.S. government debt.

Bloomberg's comments comprise a Clausewitzian strike at S&P's reputation: a challenge to their product's quality. The First Amendment to the US Constitution grants S&P the freedom to opine on the credit ratings of any sovereign--a hollow right if no one cares to listen.

Meanwhile, over at S&P's competitor, Moody's things are looking up. The Reputational Value Metrics from Steel City Re show a stable reputation ranking (CRR) among its 15 peers in the Financial Services/Publishing sector. Reputation stability is the defining feature of Moody's (MCO) metrics with the resulting benefit that it is outperforming its peers and rewarding its equity investors.

When a labor dispute escalates into a reputational crisis, the calculus changes. Instead of owners making money with substitute labor while labor starves through attrition, owners face the risk of reputational value loss. For the NFL and its owners, measurable losses would include fans buying fewer tickets, and branded products; fans watching less broadcast programming; lost pricing premiums on tickets, branded products, and broadcast slot advertising; greater employee costs (turnover, litigation); greater supplier/vendor costs; greater credit costs; and possible loss of anti-trust immunity. The incentives to settle the matter quickly were transparent to all, and so they did. Did we mention that reputation has significant value?