Kraft Heinz Company (KHC)

[FUNMAN]

Kraft Heinz: A Low Expectation Investment
Sep. 18, 2019 2:30 PM ET
About: The Kraft Heinz Company (KHC)
By Mark Dockray

https://seekingalpha.com/article/4292286-kraft-heinz-low-expectation-investment


Summary

* Falling earnings and a contracting valuation multiple have proved a toxic combination for Kraft Heinz stock over the past few years.

* The scruffy-looking cash flow statements have led to legitimate concerns that management will cut the distribution again.

* In reality, underlying cash generation is not as bad as the headline figures suggest.

* That said, if management felt compelled to accelerate debt reduction plans and invest in the company's brands, then I'd be more than happy for a cut.

* The stock has become a sufficiently low expectation investment that it doesn't need to deliver much beyond stabilizing profits and reducing debt.

To say that Kraft Heinz (NASDAQ:KHC) has been a disaster zone for investors is probably an understatement. Ultimately, two things have gone very horribly wrong here over the past few years.

First, its underlying business has clearly come under severe pressure. Adjusted EBITDA figures for 2016, 2017, and 2018 read as follows: $7.724B, $7.810B, and $7.014B, respectively. Before 2019 guidance was pulled, management had 2019 EBITDA clocking in at $6.3B at the low end. Needless to say, that's not a particularly encouraging trend.

Second, the stock's valuation as it entered this rough patch was clearly ridiculous. At its peak in 2017, it traded in the low-$90 per share range - equivalent to a P/E ratio of 26.5 and an EV/EBITDA multiple of 18.4.


Given the drop in EBITDA, it is hardly surprising that the valuation then followed suit; the upshot proving an ugly double whammy for a stock price, which is now down around 70% on that 2017 peak.

Another Dividend Cut On The Horizon?

Unfortunately, for investors, the cash flow statement (along with nearly everything else) has looked pretty scruffy here over the past few years. For instance, in 2017, CFFO seemingly clocked in at a paltry $500M for the entire year. Last year's figure showed a notable improvement - up to $2.5B - though still below the current combined outgoings on CapEx (~$850M) and cash dividends (~$1.95B at the current rate quarterly rate of $0.40 per share).

This apparent discrepancy between cash coming in and cash going out has led to speculation that Kraft will announce another dividend cut at some point in the near future. Given there's an obvious need for the company to spend more on its brands, not to mention the existence of a near $30B net debt load, this isn't all that surprising.

The reality is that the situation is not quite as tight as those headline number suggest. For instance, an accounting rule change affecting the reporting of securitized trade receivables shunted $2.29B from the 2017 CFFO figure to another part of the cash flow statement.

For a more representative figure of the business performance, it's better to strip out working capital movements entirely. Doing so for the first six months of 2019 gives us around $2B in underlying CFFO. Call it $4B for the year, which is about what you'd expect when knocking off the cash charges from the company's EBITDA number. Subtract our combined annual CapEx and dividend bill and there should be some surplus cash left over for deleveraging.

On that basis, management's view that they don't envisage another cut makes a bit more sense. That said, if they came out and tomorrow and told us they wanted the extra cash to accelerate debt reduction and invest in the business, then I'd be all for it.

AB InBev: A Possible Blueprint?

On the subject of brand investment, it's a relief to see that the idea is finally hitting home. Watching the decline in advertising spend over the past three years - down from $708M in 2016 to $584M last year - has been worrying, to say the least. I remember iconic TV ads for Heinz Soup from two decades ago when I was kid. Nowadays, I couldn't tell you the last time I saw one of the company's commercials.

On that note, could beer giant Anheuser-Busch InBev (BUD) offer us a useful blueprint? Aside from both being consumer defensives, these two names share a lot in common: high levels of debt, low levels of growth, a myopic focus on cost cutting and, of course, the boys from Brazil: 3G Capital.

It's no secret that AB InBev has been investing in its beer brands recently. Here, in the UK, for example, we've been bombarded with campaigns for Budweiser (e.g. EPL tie-in and the "King of Beer" commercials) and Bud Light (e.g. "Dilly Dilly" - one of the best TV ad campaigns for a long time).

The net result is that the business numbers coming out of the Belgium-based brewer look pretty good. Volumes are up, as are the top and bottom lines. The share price hasn't done too badly either - BUD stock is up around 50% from its late-2018 lows. Is it too much of a stretch to imagine a similar strategy might pay off just as well in Chicago as it has done in Leuven?

Light At The End Of The Tunnel?

In light of all of the above, the bullish stance adopted by this article might seem odd. That said, there are three things that keep me cautiously optimistic here.

First, though the company has provided plenty of ammo to support even the worst bear case, there is a still a decent business buried here somewhere. After-tax returns on tangible capital were 50%-plus last year if you set the $15B write-downs to intangibles and goodwill to one side.

On the subject of write-downs, it would be an error to come across too blasé. The temptation here is to simply chalk it up as some kind of non-cash accounting necessity. Speaking as a shareholder, anything that's telling me in no uncertain terms that the future cash-generating ability of my assets is permanently lower is anything but "non-cash". Just because that big red $16.6B headline figure (the company reported write-downs worth a further $1.2B in Q1 2019) doesn't vanish out of a Kraft bank account is besides the point.

However, this leads me to point two: not all of the company's brands were created equal. For instance, I'd wager that the Condiments & Sauces segment, led by the iconic Heinz Ketchup, remains at the higher quality and better-performing end of the combined Kraft/Heinz stable. Any name that can compel an 'A'-list musician to permanently tattoo its crest on his arm has got some serious brand equity going for it.

Third, could there be some signs, albeit tentative ones, that the business is on a more stable footing? For instance, here in the UK, operations look to be perking up. At £750M, revenue for 2018 came in 5% higher than 2017's figure of £715M. Pre-tax profit also moved in the right direction, up 8% to £129.5M from £120M in 2017. Granted, this represents only a small slice of the global pie, but I'll take every positive sign I can get right now.

The Benefits Of Low Expectations

Ordinarily, the kind of mid-single digit growth environment outlined above wouldn't get anyone too excited. Certainly not at a $90 stock price and a 30x P/E ratio as Kraft was a few years back. However, those days are long gone. As I type, the stock trades under $30 for a TTM earnings yield of 11.8%. Never-mind mid-single digits, even just treading water could lead to very respectable long-term returns from here.

Take the debt load as a good example. As it stands, net financial debt is probably somewhere in the $28.5B region after taking into account the recent sale of its Canadian cheese business to Italian firm Parmalat (OTCPK:PLATF). When that represents 4.5x annual EBITDA - with the latter potentially not out of reverse gear - then, clearly, reducing debt is a valid endeavor in its own right.


That aside, there's another reason to enthusiastically target debt reduction: the interest bill. As it stands, Kraft is paying around $1.25B a year to service its debt. Needless to say that's a decent-sized pot of gold to go after when you are a business struggling for any kind of growth.

Indeed, it's not too hard to outline a debt reduction plan which throws up an earnings tailwind worth a couple of percentage points per annum. Pin that to an earnings yield north of 10% and throw in some very modest organic growth and we would be more than back in the game here.

Such are the benefits of low expectations that, even though Kraft Heinz's business is clearly not out of the woods yet, the stock could be in the perverse position of offering prospective investors its best outlook since the 2015 merger.

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.