Kraft Heinz: Getting Cheap

by The Compound Investor

Tracking the fortunes of Kraft Heinz (KHC) reminds me of a well-known article penned by Warren Buffett for Forbes. The title – You Pay A Very High Price In The Stock Market For A Cheery Consensus – seems pretty apt given what we know about blue chip stocks. I mean, it is rare for very good businesses to get cheap for no apparent reason absent wider market trends.

In the case of Kraft Heinz, we have something that seems to tick those boxes right now. Firstly, it retains a solid underlying business from selling brands like Heinz Ketchup and Velveeta. That business generated $15.78 per share in revenue over the first nine months of 2018, $2.67 of which flowed straight to the bottom line as post-tax profit. Those figures clocked in at $15.65 and $2.65 respectively in the equivalent period last year. Despite its problems the company remains a fairly stable money spinner.

Problems

Speaking of problems, yes the company has its fair share. A lot folks worry about the rise of store-owned brands and the impact this will have on certain Kraft-branded products. The upshot of that trend is that growth figures are sluggish to say the least. In the United States for example, which accounts for around 70% of Kraft’s revenue, sales were down 1.2% in the first nine months of the 2018.

On the plus side, the stock is starting to look pretty darn cheap. The shares currently change hands for around $51.50 apiece having lost around 35% of their market value over the past year. Note that this is on the back of 2017 reported adjusted EPS of $3.55. Let’s call that a PE ratio of 14.5 based on prior-year profits, equivalent to an earnings yield of around 6.9%. The current dividend yield tops 5%.

The catch, insofar as there is one, is the state of the balance sheet and the aforementioned growth situation. Kraft Heinz currently sports a net debt position of around $30b. Annual interest on that runs at approximately $1.2b, equal to around 20% of operating profit. If you look at things in a debt-adjusted way, the valuation suddenly doesn’t appear so modest.

Outlook

Now, the good thing about not having a cheery consensus is that market expectations are markedly more realistic. To understand what I mean by that then just run though the numbers as they apply here. As mentioned above, the stock price is currently around the $51.50 mark, while the company will likely earn net profit of around $3.60 per share this year.

Imagine a scenario in which the company grows that profit at a 4.5% per annum clip over the next decade. That would only be a percentage point or so ahead of the average historical rate of inflation. By 2028, that level of performance would imply EPS of circa $5.60 per annum. If we apply the current 14.5x earnings multiple to that, then we get a share price of over $80 a decade from now.

On top of that, it is also likely we will see a tidy pile of cash dividends accumulate here. The annual payout is currently worth $2.50 per share, and let’s assume that figure rises in tandem with our earnings projection. On that basis, total cumulative dividend cash would equal around $32 per share after a decade. Quick math suggests we could be realistically looking at a total return of somewhere in the $115 per share region, or average annual returns of around 8.5%. Note that figure assumes dividend cash just accumulates some place earning 0%. The projection would be higher if it were put toward some productive investment.

Okay, what about the real risk of a dividend cut? Well, the flip side to a cut is that the extra cash would pay down debt and boost EPS. Either way, I don’t think it impacts the total return assumption too much, so the risk-return tradeoff looks pretty good. Sure, the company has its issues to face going forward, but it still earns a ton of cash every year off the back of some very stable brands. Pick any timeline you want and you will still find Heinz Ketchup flying off supermarket shelves at the end of it. Plus, there’s a reason we are looking at Kraft stock at 14.5x earnings rather than 20x earnings. As Buffett said, you pay a higher price in the stock market for a cheery consensus.

Note

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