Kraft Heinz: Reiterating The Case For A Dividend Cut

by The Compound Investor

Food stocks such as Kraft Heinz (KHC) have had a tough time of it in recent months. There is a bunch of negative sentiment in the sector, much 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 products 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 result is that demand for the Kraft Heinz products has dropped, possibly permanently.

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 will buy it at twice the price of generic brands.

More Issues

The above notwithstanding, 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 are looking at an earnings yield of around 6.5%. If you think that looks attractive for a high quality consumer defensive stock, then I’m tempted to agree. I mean, you don’t need all that much growth to make a 6.5% 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. I note that organic sales and EBITDA both fell in the first quarter of the year. The second point worth remembering is that Kraft sports a fairly serious amount of debt. The figure stood at about $30b net of cash & cash equivalents at the end of 1Q18. One consequence of this is that the stock’s debt adjusted valuation is higher than the headline number otherwise suggests.

The Case For A Cut

Here’s why I’d like to see a dividend cut here. Currently, the annual interest bill on that debt mountain is running at about $1.2b. That’s equivalent to about one dollar 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. Although 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 $3.1b that Kraft spends on annual dividends went towards debt reduction, then it could easily halve the debt load within a few years. If we assume that the interest bill fell in tandem, then we are looking at an extra $600m per year to Kraft’s profit. Let’s say the company achieved this over a five-year period – theoretically possible given its current earnings power implies over $20b in net profit over that timeframe. That is the same as boosting earnings per share by 2.5% per annum over 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 stock doesn’t look so bad right now at around $58 per share. If the company earns $3.75 per share this year then, as mentioned above, we are looking at an earnings yield of around 6.5%. Can the company scratch out an extra 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.

Note

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