Kraft Heinz: Digesting 3Q19 Results

by The Compound Investor

Kraft Heinz (KHC) shareholders have been put through the wringer over the past few years. The stock has been an absolute disaster zone in terms of wealth destruction, and underlying business results have been desperately poor. Just to compound matters, the company slashed its quarterly dividend by some 36% in order to shore up the balance sheet. That is the backdrop against which the company recently released third quarter financial results. While not exactly stellar, the good news for long-suffering stockholders is that there are some tentative signs that things may be settling down.

Kraft sold $6.08b worth of goods last quarter, down around 5% on 3Q18. That looks pretty dire at first glance, though the company is slightly smaller nowadays and has also had to grapple with the effects of a stronger US dollar. Sales dropped 1.1% after stripping out the effects of divestments and foreign currency movements. Turning to profit, adjusted earnings per share came in at $0.69. Wall Street analysts were so pessimistic that this actually represented a pretty big beat compared to estimates of $0.54 per share.

Some other points to consider. First, volumes continue to decline. Kraft sold fewer products last quarter compared to the equivalent period last year. Volume fell 3.2% in the United States, while elsewhere in the world the situation looked fairly static. That trend was marginally offset by the company raising its prices. Second, management sees 4Q19 being roughly similar to the third quarter in terms of financial performance. While the third quarter wasn’t exactly brilliant, the numbers are not totally disastrous either. Another quarter in the same vein would be a small sign that business is starting to stabilize.

Debt, Further Dividend Cuts

The health of Kraft’s balance sheet has been in focus for some time now. The profit collapse that investors witnessed here has been bad enough in its own right, but $30b worth of net debt makes it a lot worse. The 36% dividend cut announced earlier this year was therefore a no brainer. I mean, at $2.50 per share it was costing Kraft pretty much the entirety of net profit.

The current payout amounts to around $1.60 per share on an annualized basis. Needless to say that appears much more manageable, though a lot of analysts and ratings agencies think the cuts need to go further. When questioned on the prospect the new CEO had this to say:

But now we are going to a very deep strategic review of the business, understanding how we’re going to see the future performance of the company. And in this analysis, in this review, a capital structure is going to be a very important chapter.

That sounds like it could be on the cards to me. The good news is that debt is indeed slowly making its way down. I have net debt at around $28.3b as of the end of last quarter, equivalent to around 4.5x annual adjusted EBITDA. Net debt clocked in at around the $31b mark at this point last year, just by way of comparison.

Given Kraft raised around $1.2b by selling its Canadian cheese business, not all of that reduction is a result of surplus free cash flow. The company probably pumps out circa $1.25b on an annual basis after subtracting its dividend bill. Slashing dividends to zero would free up close to $2b more each year. Time will tell if this is necessary, but don’t be surprised if another cut is announced next year. Right now a healthy balance sheet and operational stability take priority over cash distributions to stockholders.

Valuation

It is a measure of how low expectations were that Kraft stock jumped after the earnings figure hit the newswires. I mean, the shares stood at around the $28.50 mark before the announcement on Thursday morning. They were changing hands for around $32.60 each by Friday’s close. Now, the company has generated underlying EPS of $2.13 so far this year. With one quarter left to go in 2019, we could reasonably put annualized EPS somewhere in the $2.85 region. On that basis, Kraft stock currently trades at around 11x forward earnings estimates. Call that an earnings yield of 9%. Granted, the company is not completely out of the woods just yet, but with signs that the business is beginning to settle down I continue to think it represents decent long-term value.

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