Kraft Heinz Company: A Large Scale Efficient Food Manufacturer
Aug. 20, 2020 3:18 PM ET|4 comments | About: The Kraft Heinz Company (KHC), Includes: GIS, MDLZ
By: Chetan Woodun
Summary
The doubters have been proved wrong and the Kraft and Heinz company is benefiting from improvement in both top-line and bottom-line.
The reason is not only due to COVID as evidenced by the tracker I use to analyze results of the transformation plan launched last year.
The company is also looking stronger than competitors.
I take a deep look at the challenges for the next quarter taking into consideration the very ingredients which led to an upbeat performance in the first half of the year.
KHC is undervalued when taking into consideration its ability to derive better operational margins from COVID-19.
Many were doubting that the higher consumer demand the Kraft Heinz Company (KHC) was witnessing for its products in Q1-2020 would continue in the second quarter.
This high demand in the first quarter was solely being attributed to panic-led stockpiling amid the coronavirus outbreak.
However, higher second quarter sales both in comparison to Q2-2019 and Q1-2020 figures proved that there was more to it than just stockpiling.
Also, in terms of bottom-line, there were better-than-expected EBITDA margins.
Figure 1: KHC's quarterly revenue
ChartData by YCharts
Still, despite these positives, challenges still lie ahead.
Hence, I evaluate how the action plan formulated in the third quarter of 2019 by the new management team to address marketing, supply chain and operational efficiency has delivered results and can continue to bring improvements in the second half of the year.
For this purpose, I have elaborated a strategic plan tracker.
I will also address the competitive position as well as touch upon COVID-related specific consumer patterns which can impact on growth.
To begin with, I analyze the revenues and finances.
Preliminary results of the strategic plan
The company is still amid a re-organization process as the pandemic weathers through. The COVID-induced stay-at-home phenomenon has resulted in increased demand and this has been beneficial.
However, the pandemic has also brought challenges especially in terms of supply chain. Here the operations team has worked hard to optimize manufacturing capacity to meet demand with some plants running on a 24/7 basis.
Despite their efforts, there was some loss of market share for meat and cheese products as products were not available in time.
Still, KHC managed to increase gross margins to 37% for Q2-2020, more than 4% higher compared to the previous quarter as the company was able to mitigate incremental COVID costs incurred in terms of overtime and protective equipment costs.
The company owes this success to a re-examination the stock-keeping process in the US and streamlining the complexities out of the system resulting in the route from production lines to market becoming more nimble.
Figure 2: Tracker to evaluate how strategy has been translated to action
Source: Keylogin strategic analysis
Also, KHC is working hard on marketing and consumer profiling in terms of geography and demographics in order to target a more diverse population.
In this context, younger consumers with higher income levels coming from areas which were not previously indexed by KHC have been buying items like peanut butter and pasta sauce, thus providing the company with a diversification opportunity.
KHC's customer base has traditionally included more of the baby-boomer generation of shoppers.
In terms of figures, higher sales has resulted in 75% of KHC's brands being adopted by more households and also increasing repeat rate among the new buyers.
Promotional campaigns carried out during the second quarter have resulted in higher SG&A expenses compared to Q1-2020 but this was money well-spent as the revenues and profitability figures show.
Figure 2: Revenues by quarter with all figures in millions of dollars.
Source: SeekingAlpha
Going forward, KHC plans to re-deploy more of its marketing expenses towards loyalty campaigns thus further tapping into its new base of recently acquired customers.
Also, I see more promotional activities leading to lower prices and more sales in the second half.
Figure 3: McCafé
Good is Brewing
Source: MacDonald
On the other hand, one of the headwinds is constituted by the McCafé's exit that has been underway in Canada in the first half of the year and which also began impacting US sales as from July.
Other possible headwinds going forward are incentive compensation and unfavorable commodity costs mainly to be incurred for cheese.
However on the positive side, the higher COVID-led demand seen in the first half should be maintained through aggressive marketing and the ability of the company's supply chain to channel goods more efficiently.
To this end, some of the supply chain constraints faced for meat products have already been mitigated.
Here, higher gross margins together with the fact that the company is redeploying marketing resources instead of incurring in additional recruitment should result in operational margins staying on the high side.
Moreover, to a lesser extent, foreign exchange translation which was a headwind in the first half with the strong dollar could be less of a drag in the third quarter with both the Canadian Dollar and British Pound having seen strength in international FOREX markets.
Most importantly, KHC has been able to establish a strong base from where it should not only sustain top-line growth but also maintain profitability.
Therefore, going forward, there is real possibility for the headwinds to be offset.
Figure 4: Evaluation of the headwinds in the second half of the year.
Source: Keylogin evaluation matrix built with some data obtained from earnings report for Q2-2020.
I now go deeper into the finances.
In this respect, as of June 30 cash available was $2.8 billion while long term debt was $28.1 billion. Now, through July, $1 billion of the 2020 debt maturities was paid with cash, reducing outstanding gross debt.
Figure 5: Balance sheet with all figures in millions of dollars
Source: SEC filings
The liquidity position is strong with no meaningful refinancing needs for the next five years and the refinancing transaction performed back in May.
KHC is reducing debt and ensuring that there is sufficient free cash flow ($2.3 billion as at June 30) to ensure dividend payments.
Debt to equity is at 58.70, the lowest among peers.
Current payout ratio is currently at 62% for a yield of 4.5% and this is the highest among competitors.
The competition
First, there seems to be a lot of outdated information when it comes to looking for KHC's competitors.
This is also the case with some commentators whose memories appear to be stuck in the past, more particularly in February of 2019 when KHC had lost the one thing for which it was prized by investors: its profit margins.
Hence, there is a general sentiment that the stock is "struggling".
Figure 5: Outdated results when comparing KHC with Mondelez (MDLZ) through a google search.
Source: Google.com
However, things have now changed, and the company's operating margin is back to above the 20% mark.
That steep rise from March to June when compared to the competition shows that KHC has been able to take advantage of COVID-led opportunities in a much more efficient way.
Figure 6: A comparison of the operating margins showing how KHC has benefited more from COVID-led demand than competitors Mondelez and General Mills (GIS).
Source: Chart built from data from SeekingAlpha
The underlying reasons for this achievement a better leverage on supply chain, higher volumes and better product mix.
Now, some may be wondering if the margins could burst through the 25% level by the end of the year as the improvements the company is bringing to its operational efficiency start to really bite.
In order to get more clarity, I go through the challenges.
The challenges
The first challenge is the favorable consumer behavior seen in the first half simply being absent in the second half of the year.
However, there are studies which indicate otherwise.
In this context, a study by restaurants.org indicates that restaurant sales continued to rise in July, but at a much slower pace.
For consumer staples plays, this means that the "favorable shift" between retail and food-service (people eating in restaurants instead of purchasing packaged food) they benefited from in the first half of the year is not completely gone.
Moreover, according to the same survey, "after the initial bounce in May and June, July's sales results are a reminder that the restaurant industry's road to recovery will be long and uneven".
Figure 7: Sales generated by eating and drinking places.
Source: Restaurants.org
Also, in the UK, one of KHC's largest international markets, restaurants were allowed to re-open on July 4, 2020 only under strict hygiene conditions to prevent a second wave of virus.
This means that while there will be a reduction in volume of good sold, the trend seen in the packaged food industry should continue to be favorable to KHC.
Now, according to another study by McKinsley, COVID-19 has disrupted the positive trend seen in small packaged food manufacturers during recent years.
The study also mentions of a more pronounced liking for conscious eating and living.
These two findings can only be beneficial to larger food manufacturers like KHC offering natural food brands.
Therefore, customer consumption pattern should continue to be favorable going forward.
Interestingly, Michael Lavery, an analyst at Piper Sandler's also expects pronounced eating-at-home trends to drive a "sustainable lift" at least into 2021.
According to him, KHC is well-positioned with a more meal-oriented product offerings and lesser food-service exposure.
Now, less food-service exposure also means less vulnerability to an economic downturn.
Also, the ability of KHC's operations team to drive down the cost of goods sold and its marketing department to re-deploy resources (instead of spending money on additional resources) during promotional campaigns are key to maintaining profitability levels.
I now provide an indication for the target price.
Valuations and key takeaways
With superior profitability margins, KHC is the only company which seems to have taken the most advantage from the surge in COVID-led demand, may be as a result of the new CEO being able to think out-of-the box.
Figure 8: Comparing the valuations
Source: SeekingAlpha
Hence, according to all metrics, namely price to earnings, price to sales and EV to EBITDA ratios, valuations for KHC is on the lower side.
I get a value of $38-42 which is aligned with Piper Sandler's target of $39.
My bullish instance is reinforced through the actions of the new management which is implementing a new operating model to improve performance on a sustainable basis.
Second, winning younger customers with more purchasing power means greater opportunity to sell natural food as the Gen-Z and millennials are more likely to favor organic Foods according to Packaged Facts.
In this context, it would be useful to get updated as to the amount of sales being conducted online given the fact that behaviors are changing as more adults stay and therefore dine alone and kids eat more lunches at home versus school.
Looking further down the road, some of the progress made has delivered results but much still remains to be seen as changes are still being brought to the organization.
As a holder since March 2018, I am now confident that the ingredients are here to ensure profitable and sustainable growth after some stimulus from the coronavirus.
In addition, the fact that the company has less exposure to the food-service business earns it a better position to weather the forthcoming economic downturn.
Finally, food is an essential commodity and KHC as a large scale food-manufacturing company ensures that despite disruptions, it continues to be available in retail stores.
Therefore, at current stock prices, the company is a buy.
Disclosure: I am/we are long KHC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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