Kraft Heinz: The Current State Of Play

by The Compound Investor

A lot of ink has been spilled on the malaise afflicting Kraft Heinz (KHC) stock. Broadly speaking, there seem to be four key points of concern. Firstly, the lingering issue of debt vis-a-vis earnings and cashflow. Secondly, the pressing need for the company to invest in its brands and stabilize operations. Thirdly, the $15b impairment charge against brands like Kraft and Oscar Mayer. Finally, accounting issues regarding procurement practices that delayed the release of last year’s results until early last month. I don’t think too much needs to be said on that last point because the financial impact is pretty minor. It is points one, two, three and four that are the most concerning.

Let’s start with the debt load. As things stood at the end of last year, Kraft had total outstanding net debt of around $30b. The business pumps out annual EBITDA in the $6.5b area, while net profit is currently running at $3-$3.5b. Between cash from operations and a possible program of non-core brand divestments, there’s probably enough to make meaningful progress on getting leverage down. Indeed, the company recently closed the sale of its Canadian cheese business for around $1.25b. Still, don’t be surprised if the $1.60 per share annual dividend – worth around $2b in cash terms – sees another cut.

Regular readers know that I tend to focus a lot on debt reduction. I was pounding the table for a dividend cut here before Kraft announced the 90¢ reduction last year. One of the reasons for that is pretty straightforward: at a depressed equity valuation it is easy to generate decent shareholder returns simply by deleveraging. For instance, last year the company paid around $1.05 per share in interest to service said debt. If Kraft reduced its debt load from 4.5x EBITDA to 2.5x EBITDA, it would save around 45¢ per share in annual interest. That alone is worth around 15% of current annual net profit per share. Achieve that over, say, five years, and all of a sudden it leads to 3% annual earnings growth.

Brands

There is another good reason for a distribution cut: the company needs the spare cash to invest in its brands, and that brings us neatly on to points two and three. The thing with Kraft is that not all of its brands are of equal quality. Heinz Ketchup, for example, is probably still on the gold standard and well in the first tier of global consumer brands. It is the number one ketchup brand in seven of the the ten largest global ketchup markets, including the largest – the USA. Not only is it utterly dominant – US market share is around 60%, while in the UK it is closer to 80% – but the global ketchup market is growing at around 5% per annum. 

Unfortunately, many of its brands are much weaker. The $15b write-down, which included hits to the Kraft, Oscar Mayer, Philadelphia and Velveeta brands, is a case in point. The temptation here is to view this as a lessor issue since it isn’t actually a cash loss. I mean, it isn’t like that money literally disappeared from a Kraft bank account after they announced it. So what does it mean? Put simply: cashflows from these brands will be lower in the future.

According to management this is due to a number of reasons including higher interest rates and supply chain issues. They also mention lower future net sales growth and profit margin downgrades. Those latter two reasons are the ones to concentrate on. These brands are simply proving much more susceptible to the two commonly cited threats to fast moving consumer goods: competition from store owned discount brands and changing consumer trends.

Valuation

If that proves to be the case, then the risk to the overall business is quite clear. I mean, total group EBITDA was around $7.8b in 2017. This year management have guided for annual EBITDA of around $6.4b. You can see the direction of travel, and it isn’t good. On top of that, management have told us that future growth and margins will be lower on a big chunk of sales. That is why the write-down is of major importance.

The one final point worth talking about is valuation. This is where we finally reach something of a positive point because the current earnings yield is around 10%. The firm can grind out EPS growth on top of that simply by reducing debt. So, the base case only really depends on one thing: profits not falling off a cliff. What if the company returns to organic growth one day? What if the earnings multiple expands from 10x to 15x on the back of stable operations and a lower debt load? You’d be looking at double-digit returns pretty quickly. In terms of risk/reward, that strikes me as a reasonable proposition.

Note

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