Kraft Heinz Company (KHC)

[FUNMAN]

Kraft Heinz: Possible Dividend Cut May Overshadow Solid Earnings

Nov. 1, 2019 12:32 PM ET
About: The Kraft Heinz Company (KHC)

By Ian Bezek
Long/short equity
MARKETPLACE Ian's Insider Corner

IMO the author is a very angry investor. Personally, I think the turnaround is well underway, and the EPS pretty much locked the dividend in place. Reducing the debt is a priority, but as long as the EPS can be maintained or increased, paying down debt doesn't have to come at the expense of stimulating another selloff further punishing the PPS and shareholders with another dividend cut.

Read the article here to see all of the charts and graphs.

https://seekingalpha.com/article/4301470-kraft-heinz-possible-dividend-cut-may-overshadow-solid-earnings?app=1

Summary

* Kraft Heinz reported significantly better than expected earnings Thursday.

* The stock bounced in a major way and is now well off its August lows.

* Don't expect a straight path higher from here, however.

* The company signaled Thursday that it may cut the dividend in 2020 to shore up the balance sheet.


This idea was discussed in more depth with members of my private investing community, Ian's Insider Corner. Get started today »

Kraft Heinz (KHC) surprised a lot of folks on Thursday. The company announced quarterly earnings that - while far from spectacular - significantly topped expectations. Not surprisingly, KHC stock exploded higher, enjoying its best trading day of the year:



Source: Finviz

In fact, shares have gotten back nearly all their post-February losses and are up a quick 30% off the August lows.

Unfortunately, I got to the Kraft Heinz story way too early. I started buying in the $50s, thinking that was a fine discount to the prices that original 3G/Buffett followers had paid. Don't forget that KHC stock traded as high as $90 at the height of optimism around 3G building a packaged foods M&A platform. It's been a long tumble for this former blue chip company. Regardless, with more purchases subsequent to the February collapse, I lowered my overall cost basis to $43. All that to say, I'm certainly not taking a victory lap with Kraft's recovery Thursday.

In fact, I write this to offer a note of caution. While I'm still bullish on the stock, it won't be a painless recovery, and the earnings report gives us at least one big reason to be cautious going forward.

Over the long-haul, I expect Kraft Heinz stock to trade higher, at least back to $40. If you compare it to other mediocre packaged foods companies, it still looks cheap; Kraft Heinz went from being overly-loved with its Buffett/3G backing to being overly shunned following the dividend cut, write-offs, management changes, and so on. Take all the drama away and imagine Kraft Heinz was a generic food company selling so-so products at high profit margins and generating a lot of cash. The $25 share price this August made no sense given that the company can still do nearly $3/share in annual EPS (8x earnings at that price). But don't mistake Thursday's price action for everything being fixed in a day.

These Were Hardly Amazing Quarterly Results
If you read Kraft Heinz's quarterly earnings in a vacuum, with no knowledge of the drama around the stock, you'd probably be shocked to see that folks bid the stock up 13% Thursday on these results. Overall, the company's organic revenues dropped 1.1%. The headline number was even weaker still, though that was driven by brand divestitures and currency translation.

The organic sales figure should raise concern though. A company with a clean balance sheet can survive a lot of boneheaded management decisions and other hardships. A levered-up company needs most things to break correctly, by contrast. Kraft Heinz has a huge debtload, and has already optimized its business as far as overhead costs and profit margins go. You can fault 3G all you want for a lack of skill in R&D and marketing, but they keep a lid on costs. Thus, Kraft Heinz really needs to figure out the top line to turn things around. There's simply not much left to cut on the cost side of the equation, other than the dividend (more on that in a second).

Kraft Heinz did manage to push through price increases this quarter, which is a good sign. Packaged foods companies have had to deal with flat pricing or even decreases as they face stiffer store brand and online competition. So, it's nice to see Kraft Heinz be able to show some pricing power. Unfortunately, it came at the expense of volumes - organic sales volumes dropped 2.1% on the quarter. I just want to reiterate that a shrinking business is a particularly dangerous place to be when your balance sheet is weak; you can't shrink your way to prosperity when your debtload remains the same size.

Did Management Just Signal A Dividend Cut Next Year?
Here's the facts as far as the Kraft Heinz dividend goes. The company is currently paying $1.60/share per year in dividends. Across 1.22 billion shares of KHC stock, this results in the company sending roughly $1.95 billion annually to shareholders.

As the company noted in its most recent conference call, between the merger and the end of the 2018, the company paid down just $2.4 billion of gross debt. For a company with about $30 billion in total debt, that's not a particularly satisfying rate of debt retirement. Sending nearly $2 billion out the door in dividends annually when it is struggling to repay debt - even with asset sales - doesn't necessarily make a lot of sense.

Take this just announced quarter. As management noted, in Q3 they generated $860 million of free cash flow and used just shy of $500 million of that on the dividend. If your top priority is the debt, you might not want to maintain a dividend policy of paying out roughly 60% of your cash flow.

To that end, CFO Paulo Basilio, gave a non-committal answer when asked on the call if the company was planning to cut the dividend. He started by talking of investment grade status - not maintaining the dividend - and then went on to seemingly hint that there will be significant changes in capital allocation next year:

[F]irst of all, I think investment-grade status for us is -- continues to be very important. We've just declared the dividend, as you saw. And again, we are in a very solid position in terms of liquidity after the recent refi we did and also in the cash flow generation that would allow us to reduce our leverage over time. But now we are going to a very deep strategic review of the business, understanding how we're going to see the future performance of the company. And in this analysis, in this review, a capital structure is going to be a very important chapter. So we expect to come back to the market with our full view and full picture of how we're expecting the company's performance, the company's strategy for the future, including capital structure at the beginning of next year.

If you own KHC stock for the 5%+ dividend yield, this is your clear warning that the company isn't committed to maintaining it. They might, but it's far from a sure thing. Investment grade status seems to be the highest priority.

And as a shareholder, I can't fault them for this, to be honest. I like the high current dividend income, but it's difficult to argue with them cutting the dividend in half and immediately applying that billion of saved cash annually directly into paying off debt.

KHC Stock: Bullish Long-Term, But It Will Be A Bumpy Ride
Morningstar's analyst Erin Lash reaffirmed her $50 price target for KHC stock following earnings. That price target still offers ~50% upside even after Thursday's festivities. Sounds great, right?

However, to get to that $50 valuation estimate, Lash assumes that Kraft Heinz will achieve steady 2-3% organic revenue growth and stable profit margins in coming years. Kraft Heinz is clearly on the right path if this quarter is any guide; the business appears to have stopped actively deteriorating and is close to achieving flat results. But stabilizing at -1% organic growth is a far cry from 2-3% annual increases. Even CEO Miguel Patricio acknowledged as much - 2020 will be another "stabilization" year and even he doesn't see Kraft Heinz returning to much growth until 2021. On the conference call, addressing a question about the company's three-year outlook, he said:

2020 is going to be more about continued stabilization. And then this is what I aim, is that 2020 is a year that we stabilize the business and that we build the foundation for growth in 2021.

Lash's $50 price target may eventually play out; I certainly hope it does. But the assumptions required to get there seem like a tall order at this point. Management has a big credibility gap to make up before we can start banking on steady and predictable organic growth going forward. Lash concluded her report saying:

However, we don’t expect near-term catalysts to materially narrow the gap relative to our assessment of Kraft Heinz’s intrinsic value and suggest investors employ patience with the no-moat name.

I fully concur with that sentiment. Don't take this earnings beat as a reason to start buying up the stock aggressively here. The stock isn't going to make a V-shaped recovery back to where it traded in 2017. Even the CEO acknowledges that the business needs another year to right itself before it can really reach prosperity again.

As part of that, with a potential dividend cut next year, there could be a sizable dip in the share price again as the ownership base in KHC stock rotates from income investors to other holders. It's great that Kraft Heinz has shown positive signs this quarter and finally gotten sentiment going in the right direction again. But don't expect miracles from the share price over the next six months or year.

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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.