Shares in food giant Kraft Heinz have put in a pretty dismal performance over the last twelve months or so. While the Dow Jones Industrial Average has put on around 24% since this time in 2017, Kraft stock has actually lost the same amount over that period. Even chucking in the dividends dished out over the period can’t cover up how bad the past year has been on the shareholder returns front.
Now, for those of you who have followed 3G Capital over the years you’ll probably be aware of the basic strategy they apply to management. Essentially you see these huge debt funded takeovers of similar businesses that have large overlap potential; Kraft and Heinz being a perfect example. Imagine these deals as a Venn diagram where the middle bit represents all the synergies that can be exploited plus the costs that can be driven out of the new combined business. The upside of this strategy is fairly obvious: when it works well you get large earnings growth without doing the hard part of trying to grow underlying revenue. The increase in earnings is then used to rapidly pay down debt before the process repeats itself with another acquisition. For proof of success check out the shareholder returns from a ten year investment in Anheuser-Busch stock.
In the case of Kraft this strategy has certainly worked in boosting profitability: margins are the highest in the food sector, even compared to other quality names such as Nestle. That said there are two big issues that have limited the success in terms of shareholder returns. The first is the crazy valuation ascribed to the stock over the past few years. Back when the shares were trading in the $90 region we were looking at a valuation of something like 25x earnings. Even with a perfect execution of the 3G playbook it is very hard to generate good medium-term returns with that kind of headwind.
The second is the balance sheet situation. As it stands Kraft’s net debt position sits at around $30 billion, which is equivalent to somewhere in the region of 4x annual earnings before interest, depreciation and amortization (EBITDA). Normalized free cash flow is currently in the $4.00-$4.50 billion range, while annual cash dividends take up around $2.90-$3.00 billion of that. Now the great thing about owning brands such as Heinz Tomato Ketchup, Velveeta and Philadelphia is that the cash flow is fairly reliable. If we therefore assume that Kraft’s $4 billion free cash flow is sustainable then it could realistically reduce the net debt to EBITDA quite rapidly if the dividend was slashed.
At this point the income investors will probably have switched off, however I think there are good reasons to accept the short term pain of a dividend cut in order to slash debt. The most obvious one is the growth issue. Given the shares are still trading at 17x earnings, which looks quite reasonable but is actually still expensive once you include net debt (see chart below), I’d say growing profits is important in terms of shareholder returns. As far as I can see Kraft Heinz has two ways to deliver this. The first is by going down the traditional route of investing in its brands, perhaps targeting emerging markets, along with productivity increases. The second is to continue the strategy of leveraged acquisitions followed by aggressive cost cutting.
Quickly reducing debt could help on both counts. Firstly, and most obviously, it will reduce the annual interest bill which is eating into net profit. Currently that equates to around $1.2 billion, or $1 per share each year. That would free up cash which could then be reinvested into the brands – helping to grow the top-line – or else would flow straight down to the company’s bottom line. Alternatively it would put the company’s financial health back into a good starting shape should it go down the route of pursuing another big ticket acquisition. Given that Kraft’s high quality cashflow means it could achieve this quite quickly, I’d say it would be worth doing as an easy way to boost profits and help justify the current valuation.