Kraft Heinz Company (KHC)

[FUNMAN]

Kraft Heinz Turnaround Taking Shape, With Perfect Timing Given Economic Cycle
Nov. 13, 2019 4:31 PM ET
About: The Kraft Heinz Company (KHC)

By: Zoltan Ban

To read with the charts and graphs, click on this link:

https://seekingalpha.com/account/portfolio/latest

Summary

At the root of Kraft Heinz misery in the past few years has been a flawed strategy of focusing on mergers followed by cost-cutting.

New leadership is bringing in new strategy of product innovation, combined with better marketing. Latest quarterly results suggest that Kraft Heinz has necessary financial strength to sustain the turnaround.

The global economic outlook suggests consumer staples companies may be in favor going forward, providing an extra boost for Kraft Heinz.

I bought Kraft Heinz (NASDAQ:KHC) stock at the end of 2018, the idea being that I should start adding more non-cyclical stocks to the portfolio in preparation for a global economic slowdown. I by no means think the idea is bad, and I will continue to increase the non-cyclical proportion of my investments. But it goes without saying that my timing in regards to the Kraft Heinz investment was by no means ideal. Soon after I bought some shares, there was the dividend cut. The announcement came along with the $15 billion write-down in assets, which sent the stock into a tailspin. The pain continued for the rest of the year, until the third quarter results were released, which seems to signal a stabilization of the situation. It shows an improvement in profitability trends. An early sign of perhaps a turnaround being in its early stages. Or at least, a sign that the new corporate leadership in place has put an end to the continued collapse and managed to stabilize the situation. New refocus on product development is welcome news, which I have been insisting all along, that it will be key to a turnaround. Early signs of a turnaround are welcome and may work to the advantage of this stock as the global economy continues to show signs of slowing down, which should benefit consumer staples companies, like Kraft Heinz.

Declining sales revenue, but improved profitability
Looking at the reported financial results of the third quarter, we see a slight decline in revenues from $6.4 billion in the third quarter of 2018, to $6.1 billion for the latest quarter. This is a troubling trend, which in my view will need to at the very least stabilize before we can have any chance of seeing this stock begin to forge a path towards regaining the value it lost in the past few years. Given that the stock currently trades at just under $33/share while it traded at a peak of just under $97/share at the beginning of 2017, it would have a very long way to go. The only way to sustain a return to such levels in the next decade will be to find ways to grow sales.

The aspect of the latest quarterly report which excited the market, which helped this stock rise by about 30% compared with the low it hit in August of $25/share, was the improvement in profitability. Net income came in at $899 million, compared with $619 million in the corresponding quarter from a year ago. It seems that write-downs are no longer weighing down results as they did in the last few quarters. The cost of products sold also declined in line with revenues, meaning that its profitability prospects are stable. The one major negative trend is the increase in debt servicing costs. Interest payments amounted to $398 million, versus $326 million for the same quarter from a year ago.

Kraft Heinz's plan to focus on product development and marketing is promising
The losing business model which was mostly focused on growth through acquisitions is now gone. It did not focus on innovation but rather on cutting costs, to the point of arguably hollowing out the company brand as well as its human capital. It goes without saying that once opportunities for major mergers dried out, the model's flaws were exposed. With new leadership in place, in the form of CEO Miguel Patricio, who worked as chief marketing officer at AB InBev, I feel that Kraft Heinz is being steered in the right direction.

As stated in recent CEO statements in regards to the new direction of the company, the re-focus will be on maximizing the brand power of its product lineup, through better advertising as well as product innovation. What this means is that more effective advertising, combined with fine-tuning efforts to evolve brands in a direction that meets consumer preferences, will be relied on to grow sales. It is something I have been saying for a while now that the company needs, which I expressed in a number of articles on the subject.

Kraft Heinz's recovery taking shape just as global economic climate favors non-cyclical stocks going forward
It is still early, of course, to know whether the new Kraft Heinz direction will be successful. Latest quarterly results only go as far as confirming that the situation has now stabilized, providing the company a good solid platform for a strategic relaunch. Assuming that the relaunch will bring some success, it could not come at a better time than now, given the global economic climate. The global economy is showing more and more signs of weakening. Kraft Heinz is considered to be a non-cyclical, safe heaven stock, at least when it comes to its product lineup. The stock has not been trading as such in the past few years, because of all the problems that stemmed from the company's flawed leadership. With the turnaround, however, it can once more become such a stock.

The global economic picture is starting to look worse across the world, with industrial production seeing a significant decline in most major economies. The trade war issue is assumed to be the main culprit. Therefore, it is often assumed that things will get back on track once the issues are resolved. I, however, believe there are some problems which go beyond the trade issue. For instance, EU industrial production started shrinking in late 2017.

EU industrial production
Source: Eurostat

As we can see, especially within the Eurozone, which is represented by the red line, it has been declining at a pace that was last experienced in the 2011 to 2013 period, as the Greek crisis caused the EU to experience a second dip in economic growth. The EU is not in recession at this moment, but Eurozone growth has permanently downshifted into the 1%/year range, and there is nothing I see on the horizon which could bring back its growth pace to 2% or higher. Europe's lack of growth potential is found in many faults, such as a dysfunctional Euro currency, or too much emphasis on unilaterally reducing emissions, with little acknowledgement of negative economic consequences. This obsession has in my view taken up too much of the continent's economic efforts and resources. One of the resulting negative consequences has been a dramatic deterioration in innovation across the EU. For instance, at this point in time, South Korea registers more patents every year than the entire EU.

EU versus South Korea Patent applications
Source: World Bank

While few indications suggest there is potential for a European economic revival, especially within the Eurozone core, there are plenty of reasons to expect the already fragile economy to be pushed into a deep recession in the coming years. There is the never-ending Brexit saga, which will continue to weigh down the EU economy, and then cause a potential shock when it will finally happen. If it does happen in January 2020 as is currently expected, it is more than likely that the entire EU economy will enter a period of crisis. Then, there is the continuing animosity between the Western EU and a number of newer members, over a number of mostly ideological issues. It seems that the richer West is looking at undermining the economies of the developing East, by introducing EU rules which could punish member states financially for not falling in line ideologically speaking. The negative effects of such initiatives on the entire EU economy should not be underestimated. Trade volumes between the Visegrad group (Poland, Slovakia, Hungary and Czechia) and the rest of the EU rival that of the EU with China or the US. These countries are seeing relatively robust growth rates, in the 4%/year range, which is helping to boost economic activity in the rest of the EU as well. If the EU will move to undermine this last bastion of growth within the overall EU economy, it would in my view plunge the EU into a serious economic crisis.

The reason why I pay so much attention to the economic well-being of Europe, when contemplating the future of Kraft Heinz stock, is because I believe that the EU economy is the best indicator in regards to what we should expect in regards to the entire global economy. If the EU enters an economic crisis, it will affect the rest of the world. A weak global economy in turn means that more people will be likely to skip going out to eat and make something cheaper at home to eat instead, which is where Kraft Heinz products come into play. It could see a boost in sales, even as the world sees a contraction in overall consumption. Not to mention that it will be one of the few companies around which will be able to report a profit. The latest profit margin numbers are encouraging in this regard, with net earnings at almost 15% of revenue, providing for enough of a cushion to help the company remain profitable, even if it has to discount its products somewhat in response to a potentially severe economic downturn.

While much market sentiment negativity continues to surround this company and its stock, I do believe that between a potentially successful company turnaround story, combined with an economic environment which will most likely be beneficial for consumer staples companies, such as Kraft Heinz, it could be one of the best-performing stocks in the next few years. There is, of course, a risk, not so much in regards to the wider economic outlook, but because a successful turnaround is by no means certain at this point. The fact that the company leadership is making the right decisions, however, is very encouraging, and from my perspective, it makes it worth remaining invested in its stock, because odds of success are now likely higher than odds of failure in the longer term, even if there may be a bit more turbulence in coming quarters.

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.