Kraft Heinz Company (KHC)

[FUNMAN]

Kraft Heinz: Stability Might Be Arriving
Nov. 19, 2019
12:54 PM ET

https://seekingalpha.com/article/4307771-kraft-heinz-stability-might-arriving?app=1


Summary

* Kraft Heinz is showing some signs of stabilization, as EBITDA declines are much less pronounced.

* This is comforting to see as the company torches along a big net debt load, while deleveraging potential is modest absent of further divestments.

* Low expectations and solid earnings potential in relation to the current valuation mean that I am still upbeat here.

Kraft Heinz (KHC) has seen better days as of recent as the third quarter earnings report was better than feared. Back in August, I concluded that there was blood & ketchup in the streets with shares trading at $26 halfway August.

The company was making large investments into the business, while it furthermore faced inflationary pressures, was forced to cut prices and saw deleveraging from lower volumes. The other concern is that reduced earnings power furthermore jacks up leverage ratios which meant that there was quite some bad news for investors to digest.

Despite the dismal outlook, I saw some green shoots as 3G/Buffett might take the company private of course and divestments have the potential to reduce leverage. The biggest upside might come from the fact that expectations were simply very low, making the situation still very much "fixable".

The Thesis, Zooming In On The Numbers

For the first half of the year, Kraft Heinz reported a 4.8% fall in sales to $12.36 billion. A strong dollar reduced sales by 2.6%, divestments reduced sales by 0.7% and organic sales declines came in at 1.5%. The latter was mostly driven by lower prices, rather than declining volumes.

The company reported adjusted EBITDA of $3.03 billion in the first half of the year, down from $3.76 billion reported in the first half of 2018. This was my main cause of concern. At this rate the company is generating $6 billion in EBITDA per year. With net debt totaling $29.7 billion, this translates into a heavy 5 times leverage ratio.

Working with D&A expenses at a rate of $500 million a year, I pegged adjusted EBIT at $5.5 billion. Using a 4% cost of debt and a 20% tax rate, I saw potential for after-tax profits around $3.5 billion, for earnings equal to $2.90 per share. While the challenges were very high, equity traded at just 9 times the earnings potential in August. Not only did earnings come down a lot in recent times, multiples have compressed a lot as well, meaning that shares were down nearly three quarters from their highs.

An Update Following Q3

In August I concluded to be a happy buyer of the shares at levels in the mid-twenties, and fortunately I did as shares recovered to $33, before now settling around $31 per share.

Third quarter reported sales fell 4.8% to $6.08 billion although divestments are responsible for a 2.0% decline in sales. Currencies reduced sales by 170 basis points as organic growth improved to a decline of 1.1%. In contrast to recent quarters, prices were actually up a percent, indicating that volume declines were still quite severe.

Reported net earnings improved thanks to a one-time gain on the divestment of the Canadian natural cheese business. Adjusted EBITDA fell just 8% to $1.47 billion (note that this is a seasonally softer quarter), while adjusted earnings came in at $0.69 per share. The limited declines in these earnings metrics stem from positive pricing and the impact of cost cuts starting to play through on the bottom line.

Retaining some earnings and factoring in the proceeds from some recent divestments, the company has been cutting its net debt position, although very gradually. With the proceeds from the sale of the Canadian cheese business, net debt has fallen to $28.0 billion. This reduces the leverage ratio from 5.0 to 4.7 times, assuming a similar $6 billion EBITDA number for the year.

Remaining Constructive

Following the latest results the earnings power of the company remains more or less intact at around $2.90 per share, resulting in a low double digit earnings multiple, as leverage has come down a bit. It is furthermore comforting to see the decline in adjusted EBITDA nearly coming to a halt. With some divestments still at hand and the company being aware that dramatic improvements are needed, the situation is getting more manageable. This is certainly the case as the company cut the dividend earlier this year from $2.50 per share to $1.60 per share, allowing for more earnings to be retained along the way.

Hence I firmly believe that while margins are still very high, and perhaps not sustainable, and most brands still have a positioning issue, there are reasons to become upbeat as well. These include the modest expectations, signs of stabilization in sales and EBITDA, and the fact that takeover interest might arrive at some point in time at these levels. Furthermore, low expectations (and thus valuation multiples) have an advantage as well. If the company can sell non-core assets at higher multiples, it might not just address the leverage situation, yet make the ''remainder'' of the company even cheaper.

With the company is getting closer to achieve real stabilization, I am still a happy holder which has averaged down to $29-$30, making for essentially a break-even investment at this point in time at these levels. If the company can stabilize sales in short term, that implies that leverage ratios will fall given that a portion of earnings will be retained, causing debt overhang concerns to come down. This and growth prospects could, in such a case, result in real room for valuation multiple expansion. Even at just 15 times earnings, while not counting on any earnings per share growth, fair value of $40-$50 could be achieved in a year or two.

This is far from a given however, as it requires real operational execution, real investments into the brand and healthier foods. With the appointment of a central R&D head and Growth Officer, Kraft Heinz is showing its commitment to achieve such things, although ambitions still have to turn into reality of course.

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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.