Food stocks such as Kraft Heinz have had a tough time of it in recent months. There is a bunch of negative sentiment in the sector, most of which boils down to three main issues. The first is that consumers, particularly younger ones, are increasingly turning away from processed foods. The second is that supermarkets are laying on increased competition in the form of store owned brands. These products, which have deceptively similar branding, are often half the price of those produced by the big food companies.
The third point is a more general one concerning the stickiness of certain consumer products. Cigarettes would be a good example of something that are extremely sticky because there are huge barriers to entry in terms of both regulation and brand loyalty. Beverages are another good one. Folks who want to buy a Coca-Cola, Pepsi or Dr Pepper do not swap out just because a generic cola brand is a lot cheaper. In that sense packaged food items probably don’t measure up quite as strongly, though there are notable exceptions. In any case the net resuslt is that demand for the Kraft Heinz products has dropped, possibly permanently.
At the moment this probably reads like the introduction to a hit piece on the company’s business and stock. Actually I think Kraft Heinz has some terrific brands. Heinz Tomato Ketchup seems to me to be the jewel in the crown, and one of the ‘notable exceptions’ mentioned above. Barring some kind of extinction level event it will still be flying off supermarket shelves within the lifetimes of folks reading this article; customers will still buy it, and they’ll buy it at twice the price of generic brands.
That said Kraft’s stock price has taken a hammering over the past year so. It is down nearly 40% on where it was at this point in 2017, and has even managed to shed about 15% since I last covered it in March. Currently we’re looking at an earnings yield (i.e. the inverse of the price-to-earnings ratio) of around 6.5%. If you think that looks attractive for a high quality consumer defensive stock then I’m tempted to agree; after all you don’t need all that much growth to make a 6.65% base look attractive in the long-run. Kraft also pumps out gobs of cash each year due to its relatively low capital expenditure requirements.
There are, however, a couple of extra points to bear in mind. The first is that the company obviously has a bit of a growth problem. In the first quarter of this year (Q1 2018) organic sales and EBITDA both fell. The second point worth remembering is that Kraft sports a fairly serious amount of debt. At the end of Q1 2018 the figure stood at about $30 billion net of cash & cash equivalents. One of the consequences is that the debt adjusted valuation is higher than the headline numbers might otherwise suggest.
Here’s why I’d like to see a dividend cut. Currently the annual interest bill on that debt mountain is running at about $1.2 billion. That’s equivalent to about $1 per Kraft Heinz share. The company is expected to earn around $3.75 per share this year while the cash dividend is running at around $2.50 per share on an annualized basis. Though this isn’t particularly problematic, there is still a relatively large chunk of cash going to bondholders each year.
What if that money went toward shareholders instead? If, hypothetically speaking, the $3.10 billion that Kraft spends on annual dividends went towards debt reduction, then it could easily halve the debt load within a few years. If we then assume that the interest bill fell in tandem, we’re looking at around an extra $600 million per year to Kraft’s bottom line. Let’s say Kraft achieved this over a five year period – theoretically possible given its current earnings power implies over $20 billion in net profits over such a time frame. On its own that is the same as boosting earnings per share by 2.5% per annum for those five years.
This is low hanging fruit in that requires no extra work on the company’s behalf. That extra cash could then either be sent to shareholders (e.g. as dividends), or used to enhance earnings further (e.g. share buybacks, more debt reduction, financing an acquisition, investing in current brands, and so on). In any case Kraft shares don’t look so bad right now at around $58. If the company earns $3.75 this year then, as mentioned above, we’re looking at an earnings yield of around 6.5%. Can the company scratch out an extra 3.5% over the long run to make it a very respectable conservative investment? It doesn’t seem a particularly big ask, and reducing the debt would be a good place to start.