Kraft Heinz (KHC) stock has put in a pretty dismal performance over the last twelve months. While the Dow Jones Industrial Average has gained around 24% since this point last year, Kraft stock has actually lost the same amount in that time. Even throwing in the cash received from dividends can’t cover up how bad the past year has been for stockholders.
For those of you who have followed 3G Capital over the years, you will probably know the basic playbook here. They are well-known for debt-laden mergers and acquisitions of businesses that display significant overlap. The merger of Kraft and Heinz back in 2015 represents a pretty good example, on paper at least.
Imagine these deals as a Venn diagram where the middle bit represents all the synergies and cost cutting available to the newly combined business. The upside to this strategy is fairly obvious – when it works you see high rates of earnings growth without doing the hard part of growing 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 gross profitability. Margins are the highest in the food sector, even compared to other quality names like 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 Kraft Heinz stock over the past few years. I mean, we were looking at a valuation of 25x earnings when the stock traded in the $90 region. It is hard to generate good medium-term returns with that kind of headwind, even with a perfect execution of the 3G playbook
The second is the balance sheet situation. Kraft’s net debt position sits at around $30b right now, equivalent to around 4x annual EBITDA. Normalized free cash flow currently clocks in at around $4b, while the annual dividend takes up 75% of that. Now, the great thing about owning brands such as Heinz Tomato Ketchup is that the cash flow is reliable. It would only take a few years to make a serious dent in the debt pile assuming the company earmarked all free cash flow for that purpose.
The income investors will probably already have switched off at this point. That said, I think there are good reasons to accept the short-term pain of a dividend cut here. The most obvious one is the growth issue. Given the stock still trades at 17x earnings, which looks reasonable but is actually still expensive once you include net debt, I would say that growing profit is quite important right now in terms of shareholder returns.
As far as I can see, Kraft has two ways to deliver this. The first is by going down the traditional route of investing in its brands, 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. Most obviously it will reduce the annual interest bill currently eating into net profit. That is currently worth around $1.2b per year, which is cash that could be spent on the company’s brands, thereby helping to grow the top line. Failing that, it simply flows down to the company’s pre-tax profit line.
Alternatively, fixing the balance sheet would put the company’s financial health back into good shape should it go down the route of another 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.
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