Kraft Heinz Company (KHC)

[FUNMAN]

Changing My Tune On Kraft Heinz: It's Now A Buy

Sep. 25, 2019
3:32 PM ET

https://seekingalpha.com/article/4293546-changing-tune-kraft-heinz-now-buy?app=1

By Patrick Doyle
The Fox of Wall Street

Summary

* In the 20 months since I wrote my bearish piece on Kraft Heinz, the shares are down ~65%. What was a terrible investment at $80 is a great investment now.

* I'll go through my bullish thesis by reviewing the financial history here, by looking at the stock, and by noting recent dramatic insider activity.

* For those still nervous about buying at these levels, I think short puts offer a great alternative.

Since I wrote my bearish piece on Kraft Heinz Co. (KHC), the shares are down about 65%, against a gain of ~5% on the S&P 500. While this is somewhat gratifying, I want to look in on the name to see if it still deserves an “avoid” rating. After all, what was a terrible investment at $80 may be a wonderful investment at $28. I’ll go through the short financial history here and will look at the stock as a thing distinct from the business. I’ll also note some interesting recent insider activity. I’ll also suggest an options trade for those comfortable with the idea of following in the footsteps of the “Oracle of Omaha” as these present a great “win-win” trade in my estimation. For those who lack the time or patience to wade through my entire article, I’ll come right to the point. This is now a decent investment opportunity, and I’m changing from bearish to bullish on Kraft Heinz at these levels.

Financial Snapshot
A quick look at the financial history here suggests that Kraft Heinz is a so-called “cash cow.” The company generates relatively flat, predictable revenues. Along with that, gross profit remains relatively constant. Net income was obviously impacted recently by the fourth quarter 2018 writedown of goodwill and intangible assets. From page 29 of the most recent 10-K, it was a confluence of factors that caused this writedown, as elaborated on below:

Source: Kraft Heinz 2018 10-K, pp 29

Absent this near $16 billion event, net income for 2018 would have obviously been positive. Now that it’s in the “rear view mirror”, it doesn’t really impact my analysis of the quality of the business going forward. Hopefully, I don’t sound too harsh, but the writedown is the problem of the people who were long in early 2019. From my perspective, and the perspective of prospective longs at this point, this writedown is in a sense a positive as it clears the deck of weak assets.

Turning briefly to the capital structure, I’m not that worried about a credit or solvency crisis anytime soon for a few reasons. First, fully 73% of long-term debt is due after 2023. Second, the interest rate of ~4.2% isn’t excessive in my view. Thirdly, the company has cash and trade receivables represent about 11% of long-term debt. Finally, the debt load has declined over the past six months, which is a very good sign.

The Stock

As I’ve said repeatedly on this forum, investing well is about much more than buying companies that have a chance at growing their cash flows. At least as important is the need to buy those future cash flows at a reasonable price. In my view, it’s axiomatic that the more you pay for something, the lower will be your subsequent returns. While buying companies that are inexpensive won’t guarantee a great result, buying expensive makes failure almost inevitable.

I use a few ways to determine whether shares are expensive or not. Among these, I look at price to free cash flow, and I unpack the market’s assumptions about growth. My problem with Kraft Heinz several months ago was the fact that it was trading at a price to free cash flow of about 34. What a difference 20 months makes. The shares are now objectively inexpensive, in my view, trading for only ~12 times cash flow per the chart below.

In addition to looking at the standard price to free cash flow values, I employ the methodology outlined by Professor Stephen Penman in his great book, “Accounting for Value.” I do this in order to work out what the market assumes about the future growth path for a given company. If the market is too optimistic (as it was in January of 2018, for instance), I’ll avoid the name. The methodology is beyond the scope of this article, but Penman basically uses a standard finance formula (and some high school algebra) to isolate the “g” (growth) variable in a given stock. According to this methodology, the market is assuming a perpetual growth rate of -2.6% from Kraft Heinz which I consider to be excessively pessimistic.

Insider Activity
I’ve said it before, and I’ll say it again. No doubt very often. Not all investors are created equal. Some people, because of training or emotional disposition, are simply better at this activity than most. Additionally, those people who live and breathe the business, and who likely know it better than any Wall Street analyst ever will, do better than most with a particular stock. Thankfully, we have an opportunity to ride the coattails of these institutional and insider investors. I won’t use the activities of other investors as the reason to buy a name (I didn’t accept the “Buffett owns it so I’ll close my eyes and buy” argument back in January of 2018, for instance). That said, I like getting confirmation from people who likely know much more about a given stock than I do, and their recent activity lines up quite nicely with my bullish thesis.

Specifically, Directors Jorge Lemann and Alexander Van Damme have recently spent $100 million and $7 million, respectively, to acquire 3.5 million and 250,000 shares, respectively. When people who know this business best put this much capital into it, I feel ever more comfortable with my bullish thesis.

Options to the Rescue
For those who remain nervous about buying the shares at these levels, I think short put options offer an attractive alternative. If the shares rally from these levels, as I suspect they will, the investor will simply pocket the premiums received, which is never a hardship. If the shares fall from these levels, the investor will be obliged to buy at a predetermined price.

At the moment, my favorite options are the March 2020 Kraft Heinz puts with a strike of $22.50. These are currently bid-asked at $.7-$.85. If the investor simply takes the bid, and is subsequently exercised, they will be obliged to buy the shares at a net price about 22% below the already heavily discounted level. If, as I suspect, the shares rally from here, the investor will simply pocket the premiums.

Conclusion

I think the case of Kraft Heinz reveals the fact that a business can be either a terrible or great investment depending on the price paid. When the shares were trading at a premium because of the “Buffett effect” or whatever else, and were priced as though the underlying business would grow at a rate of 8% in perpetuity, this was a terrible investment. Optimism kills in this business. Now that the market has reversed polarity and is despondent about the shares, that very similar business represents a great investment in my estimation. Insiders seem to agree by their actions. If investors remain worried about the shares, I think put options offer a great “win-win” opportunity at these levels. I think price and value can remain unmoored for a long time, but will meet sooner or later. I think investors would be wise to buy this name now before price rises to match value.