Is Kraft Heinz A Bargain Or A Falling Knife?

April 27, 2018

Is Kraft Heinz A Bargain Or A Falling Knife?

The Kraft Heinz Company (NASDAQ: KHC) is one of Warren Buffett’s strongholds and as we often discuss Buffett here, it’s appropriate that we also discuss his holdings.

KHC is especially interesting now that it’s 40% cheaper than it was a year ago.



Today, we are going to discuss:

  • What happened to KHC.
  • Is it an opportunity or trap?
  • Packaged foods trends.
  • What can we expect on the business side of returns?
  • Berkshire buying Kraft for $40 billion.
  • How to invest in KHC – Strategy.

What Happened To KHC?

KHC’s stock was trading around $93 a year ago and now it trades at $57. This is an immense thing for a company like KHC which was considered a blue-chip defensive dividend yielder. Let’s see what happened.

Figure 1: KHC’s stock price in the last year. Source: CNN Money.

The first issue with KHC is growth. If Wall Street had to pick one thing over anything else, it’s growth, everlasting growth, and unfortunately for KHC, it hasn’t had that.

Figure 2: KHC’s fundamentals over the past 10 years. Source: Morningstar.

Apart from the 2015 merger with Heinz, KHC’s revenue has been flat over the past 10 years, earnings have been volatile, and don’t look at the current PE ratio of 7 as a bargain because it’s due to the tax legislation change event in 2017. Book value has also improved thanks to the one-off event.

KHC has seen organic declines in sales both in the U.S. and in Canada, and now the question is whether this will continue, reverse, or stabilize. The lack of organic growth comes from a multitude of reasons:

  • Shift in consumer preferences (less processed foods – better quality) – packaged foods decline.
  • Increased competition.
  • Declining sales in 9 of 12 product categories.
  • Difficulty in scaling Kraft’s U.S. brands internationally.
  • Debt burden.

What weights on the stock price is the following:

  • Amazon/Whole Foods competition.
  • Company missing revenue estimates 13 times over the last 19 quarters.
  • KHC’s stock price increased over the last 5 years just on expanding valuations.
  • Higher interest rates for a bond-like dividend payer.
  • Many downgrades (Goldman, Morgan, and Credit Suisse lately).

Is It An Opportunity Or A Trap?

Before digging into the growth or potential turnaround for KHC, let me touch on the company’s debt and higher interest rates.

KHC’s debt burden is at $29 billion where the yearly interest expense was $1.2 billion in 2017 giving an average interest rate of around 4.1%. As interest rates increase, KHC’s debt adds up as a 1% increase in interest rates would add $300 million to KHC’s payments. For a company that is looking to grow and to consistently spend $2.8 billion on dividends, higher interest rates aren’t a good sign. Further, yield investors might prefer Treasuries in place of a stagnating blue chip where we could see an even higher dividend yield which isn’t always a bad thing.

So, we have a company with strong brands that is seeing declining sales in the U.S. but global growth is a bit better.

Figure 3: KHC has declined 8.6% in Canada in the last quarter. Source: KHC.

Rest of World sales are up 7%, but they make up just 12% of total sales and the EBITDA for the Rest of World is just 7.7% showing how margins aren’t what KHC is used to elsewhere.

It will take some time for global sales to be significant and displace the U.S. Therefore, the U.S. market is still the key to watch when it comes to KHC.

Let’s look at some food trends.



Food Trends

Different Eating Habits

Consumer preferences are shifting and the biggest risk for KHC is that the strongest brands in the past few decades are seeing their power slowly deteriorate due to new, different eating habits.

Demographics

Further, the biggest growth drivers for consumer packaged foods have been demographics which aren’t that positive in developed markets anymore as birth rates in Europe and the U.S. are below the replacement rate.

Fragmentation Of Market

In the past decades, developed markets have had a quite homogeneous middle class living the American dream which included lots of packaged foods. However, according to PWC, we now have two groups: survivalists and selectionists. You’ll find survivalists in Lidl and Aldi buying unbranded products while selectionists will be buying organic at Whole Foods. Brands in the middle, like KHC, suffer.

Emerging Markets Aren’t Easy For Packaged Goods Companies

If we look at China, where there is staggering growth, we see that the markets are extremely fragmented with lots of local players and each region is different.

In a world where fewer and fewer watch television, the mass media ads KHC-like companies used in the past don’t work anymore. Plus, 15% of purchases are done online in China now and this will probably grow globally, that’s a tough environment for KHC to grow in which explains the much lower margins.

Figure 4: Big players are losing market share. Source: PWC.

Different Marketing Potential

With social media, things have further changed for big brands as people more and more frequently like the specialized, tailored experience in place of the mass produced. Billboards, TV commercials, magazine ads are becoming obsolete and Facebook, Youtube ads, Siri and Echo promotions are becoming the ways to get people’s attention.

The world is simply changing faster than big brands that have enjoyed 50 years of dominance can handle. In the biggest land grab in social media history, big brands look like obsolete behemoths trying to be your friend while selling you sugary and colored products.



Higher Costs

Like it or not when you are in the food industry, you depend on costs and when costs go up while the competitive environment is fierce and you can’t transfer higher prices to the customer that easily, you aren’t in a good situation. Just a month ago, General Mills cut its forecast on rising commodity prices, freight prices, and oil prices. Will KHC do the same in the upcoming earnings on the 5th of May? We will see.

Figure 5: GIS’s panic scream. Source: Reuters.

GIS expects an operating profit decline of around 5 to 6% which is much higher than the 1% expected prior to the announcement.

Berkshire & 3G Buying Kraft For $40 billion

BRK and 3G bought Kraft in 2015 and went onto slashing costs which significantly improved margins. The operating margin expanded from 15% to 25%. So, even though Buffett was wrong on Kraft, he did invest with a margin of safety as always. Don’t forget that Buffett was also wrong on Berkshire Hathaway when he bought it.

However, this cost cutting and further cost cutting coming up in 2018, where CAPEX will be reduced from $1.2 billion to $700 million, shows that there isn’t much interest in development for KHC but more for milking it as a cash cow which is important to consider for an investment strategy.

Investment Strategy

So, given the above, Buffett and 3G have decided to milk this cow as long as they can and not try to do any kind of turnaround, but the speed of what is going on might catch them by surprise as a 7% sales decrease in Canada is a huge deal.

The consensus earnings estimates forecast earnings of $3.83 for 2018 which is 28 cents higher than 2017 earnings thanks to lower taxes. At the current price, this leads us to a forward PE ratio of 15 which implies an 6.6% earnings yield. The dividend yield of 4.33% is probably going to stay there as long as the strategy is to milk KHC as much as possible.

Figure 6: Consensus estimates. Source: Nasdaq.



So, what would be the most likely scenario for KHC? So far we’ve seen:

The negatives:

  • Declining sales,
  • Rising interest rates,
  • Rising input costs,
  • Declining markets,
  • High competition, and
  • Changing consumer preferences.

The positives:

  • Cost cutting strategies worked,
  • Growth in emerging markets but at much lower margins,
  • Strong brands, and a
  • High dividend yield.

So, we can take the base of $3.83 as an earnings estimation which could be 30 cents lower if the same scenario as with General Mills happens to KHC. If it does, the question is, what can we expect in the future?

If interest rates continue to increase and the 10-year Treasury hits 4%, investors are going to demand a dividend of 6% from KHC which implies a price of $41 and lots of dividends will be needed to cover for the lost ground. On top of it, higher interest rates will increase interest costs which will further limit profits and, God forbid, lead to a dividend cut. If that happens in a higher interest rate environment, KHC might go even lower. So, even if the management delivers but we see higher rates, KHC might go lower.

Where Could The Upside Come From?

The upside could come from a turnaround, U.S. market growth, or improved margins but given what we have described above, it’s unlikely. Kraft is a yield play now with significant downside and limited upside.

If it comes down to $40, I will take another look at it. For now, the risk is too high for me despite the potential reward.



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