A reader of this site recently asked what Warren Buffett and Bill Gates might see in Kraft Heinz (KHC). It’s a good question given the stock’s struggles: Kraft shares have dropped from above $90 per share in 2017 to $38.40 currently with only around $11.15 per share in cumulative dividend cash to cushion the blow. Buffett’s Berkshire remains a very large shareholder: despite its fall these past six years Berkshire’s 26.6% stake is worth around $12.5 billion. As for Mr Gates, Kraft Heinz stock recently popped up in the portfolio of the Bill & Melinda Gates Foundation Trust, albeit in very modest size.
Buffett has been candid on what he sees in Kraft Heinz, describing it as a “wonderful business” during a 2019 interview on CNBC:
“It’s a wonderful business…. You go up and down the list, there are very few businesses that earn $6 billion (pre-tax) on $7 billion in tangible assets.”Warren Buffett – 2019 CNBC interview with Becky Quick
Buffett then went on to describe the company’s woes, namely its high debt load, lack of retained earnings, struggling brands, growth projections that failed to materialize and the consequent dividend cut, to which I would add the de-rating of the stock’s valuation multiple from 25x earnings to 14x.
There is a very good case study to be had in this experience. When you hear Buffett extol the underlying profitability of selling Heinz Ketchup, Philadelphia and Oscar Mayer, you should place it in the context of the advantages this bestows on the ordinary stockholder. The best features of this type of business are (1) capital requirements are so low that management can ship out a large portion of profits to shareholders without impeding growth; (2) you know there is going to be a market for Heinz Ketchup or Doritos or Coca-Cola or whatever two to three decades down the line; and (3) the margins they generate have proven over time to be stable-to-growing. When you see a stock like PepsiCo trade at 25x earnings as if it is Google or Microsoft, these are three good reasons why.
At Kraft, the applicability of the above points have come into question because sales have stagnated while the company’s operating margin has declined from 30% to 23.5%. As a result, profit per share is now in the $2.70 area versus $3.50 back in the 2017 period.
First and foremost, if the prospect of growth no longer exists then the advantage of low reinvestment needs diminishes rapidly. Moreover, in the late 2010s Kraft booked multi-billion dollar impairment charges against a chunk of its brands in the processed cheese and meats segments. This represented an overt recognition of both lower overall category growth and a need to sacrifice pricing and boost investment in R&D and marketing in order to maintain volumes. Those store-owned brands that trade at a fraction of the cost yet have no discernible impact on consumer satisfaction hurt the likes of Kraft way more than Hershey, PepsiCo and Coca-Cola. The Condiments and Sauces segment, which contains the pearl that is Heinz Ketchup, has been much stronger, growing sales from $6.3 billion in 2016 to over $8.2 billion today, but with the caveat that it was only a quarter of the overall business back then.
The above is why investors are now only willing to pay 14x earnings to own Kraft Heinz stock versus 25x back in 2017. The one-two combination of lower EPS and earnings multiple compression is what has done the major damage to shareholders.
So, what might Buffett and the Bill & Melinda Gates Foundation see in Kraft stock? Despite its issues, Buffett said in 2019 that he would be “happy to be in Kraft Heinz five years from now or ten years from now”. Considering Berkshire has collected around $2 billion in dividend cash from Kraft since that interview I can see the logic. There will be another $525 million hitting their accounts this year. I mean, there are certainly worse mistakes to make in life. More importantly, his thoughts are separated between Kraft’s operating activities and the KHC ticker that trades on the NASDAQ. It is still a top business that converts over 13 cents of every dollar of sales into after-tax profit.
The Bill & Melinda Gates Foundation, on the other hand, picked up Kraft Heinz stock for just 14x annual profits. They are in a safer position whereby the business can afford to undershoot management targets of 6-8% long-term annual EPS growth while still producing fine investment returns. They get to collect a 4%-plus dividend right off the bat. Moreover, that 4% yield represents a payout ratio of around 60%. There is still around $1.3 billion in retained earnings being generated each year, the kicker being that net debt is now more like $19 billion versus over $30 billion a few years back. I would also add that Kraft has been slowly repositioning its portfolio toward the less-disadvantaged Condiments and Sauces segment, which is now over 30% of sales versus 24% in 2016.
All isn’t rosy with Kraft Heinz, but things get interesting when the quality differential between it and PepsiCo, Hershey and Coca-Cola has a 35-40% valuation differential applied to it too. As Buffett said in that 2019 interview: “almost anything at a price can be good”. My guess is the manager that runs the portfolio at the Bill & Melinda Gates Foundation thinks we are at that price now.
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