Kraft Heinz Company (KHC)

[FUNMAN]

Kraft Heinz Company Could Potentially Spin Off Kraft As A Separate Company
Dec. 17, 2019 8:48 PM ET

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https://seekingalpha.com/article/4313026-kraft-heinz-company-potentially-spin-off-kraft-separate-company

Summary

* Kraft Heinz can't afford its dividend if it wants to pay down debt. I have written several articles here showing this. The Q3 numbers confirmed this.

* However, both the CFO and new CEO implied that there would be capital structure changes. This will obviously involve large asset sales to pay down debt.

* But theoretically, it could also involve a "carve-out" capital raise of a large portion of the company. This could mean listing Kraft as a separate stock, raising equity as well.

* Of course, theoretically, the company could be taken private again, but I somewhat doubt it. If a carve-out is done, Kraft Heinz could split its dividend between the companies.

* That might be the only way the dividend wouldn't be cut. It could also allow one or both of the companies to both reduce debt and keep the dividend stable.

This idea was discussed in more depth with members of my private investing community, Total Yield Value Guide. Get started today »


My Thoughts Since the Q3 Financial and Conference Call


I've thought a good deal about both the recent financial performance of The Kraft-Heinz Company (KHC) as well as the conference call with analysts. I have written articles here before that Kraft Heinz can't afford its $1.60 per share dividend. I've refined my thoughts a bit.

After looking at the Q3 financials, I believe that KHC can afford its dividend, barely. But this is only if KHC does not want to seriously reduce its large amount of debt.

Debt and Dividends

For example, so far this year, despite paying the dividend and interest associated with the debt, it has fallen by only 0.63%, or by $197 million from $31.147 billion. On a net debt basis, it fell a little more. You can see this in the following table:

On a net basis, the debt fell by $1 billion, or just 3.5%. But dividends paid so far this year have been $1.464 billion.

Moreover, the company can not afford more than about $870 million a year, or $218 million per quarter of debt reduction. At that pace, it would take over 30 years to pay down its large debt pile.

You can see this in my table below, including my projections for Q4 2019:

I forecast that free cash flow in Q4 2019 will be similar to Q4 2018, at 24.3% of sales. I estimate that Q4 sales will be $6.693 billion. After deducting capex, at 3.2% of sales, I project that Q4 free cash flow will be $1.413 billion.

This allows KHC to essentially earn about $2.8 billion in FCF during the year 2019. The dividend costs $1.952 billion at the $1.60 rate. The excess is $870 million, or $218 million per quarter with which KHC can pay down debt.

So management is facing a choice. Do something about the debt through asset sales, like it did this past quarter:



Source: 10-Q 2019 KHC

The 10-Q shows that KHC has made $1.875 billion in asset sales so far this year. Without that the cash balance would not have risen by $1.18 billion (see the bottom part of the cash flow statement).

In fact, net debt would not have fallen by $1 billion, as I showed above, with those asset sales.

In other words, without asset sales, KHC cannot afford both the dividend and large scale debt reduction.

Management's Options and Their Comments During The Conference Call
A mistake on FCF. The first thing that made me think further from the comments during the conference call was the CFO, Paulo Basilio, claimed numbers that are not supportable.

Here is what he said in response to a question about whether the dividend would be cut:


First, of all, his numbers are wrong. In Q3 KHC generated only $532 million in free cash flow, and the dividend cost $488 million. You can see this in the table above. This leaves only $44 million.

Just in case you don't believe me, here the cash flow statement for the six months ending June 30, 2019. We can the FCF number nine months ending Q3 cash flow statement above and subtract the difference to find the Q3 FCF:

Here is how the math works:

So the difference between the nine-month and six-month Cash Flow statements shows that FCF for Q3 was only $532 million, not the $860 million that the CFO claimed. And since dividends use up $488 million of that meager cash flow, there was only $44 million left in Q3 to pay down debt. That is why they sold $1.875 billion in brand assets.

(Why the CFO said this I do not know. He must be thinking about some adjustments, or including asset sales, or referring the average for the whole year. The latter is more likely. I estimate that average quarterly FCF, including the higher amount in Q4 is $706 million. This is close to the CFO's claim that FCF is $860 million, especially if his estimate for Q4 FCF is higher than mine. There were no numbers in the presentation or slides to justify what he said for Q3).

Asset Sales. Now think about that for a minute. You can't keep on financing the dividend and debt reduction with asset sales. Otherwise, there will not be enough FCF left to pay both of these items.

For example, interest expense so far this year, based on the income statement, has only been $1.035 billion. So even if they sold $15 billion in assets, and paid down half the debt, the savings would only be $500 million over nine months or $667 million per year ($167 million per quarter).

On the other hand, with $15 billion less assets, there would be 15 to 20% less free cash flow, since KHC has $102 billion in assets. So, the net quarterly cash flow gain would be just $26 million, or about $104 million per year. ($167 million - ($706 million x .20) = $167 mil - 141 m = $26 million per quarter).

That is nothing. I have shown that the average estimate for FCF after dividends is only $44 million in Q3 and for the year as a whole, $218 million per quarter. Adding another $26 million through selling half of the assets is not going to make a dent. There would still be remaining $15 billion in debt (after using the $15 billion in asset sales to pay off half the debt). \

Capital Structure Options - Carve Outs?

I got to thinking that possibly the company is thinking of "carving" out some asset and listing it as a separate company along with an equity raise. This could solve two problems in one. They could raise equity for the new brands, pay off debt, and still not have to cut the dividend between the two remaining companies (i.e. adding the two lower dividends per share amounts together).

This is what the company formerly known as DowDuPoint did in March and June of this year. You can read some of my articles about this. They essentially split the company into three parts through both a spin-off and a 2 part split-up: Dow (DOW), Corteva (CTVA) and DuPont (DD). Each pays a separate dividend. The total dividends that shareholders now receive are roughly the same as when the old company paid for them. But now there are three companies, with better balance sheets and management and capital raise abilities.

Here is why I think Kraft-Heinz might be thinking along these lines. Listen carefully to what both the CFO and the CEO said during the call. They mentioned "capital structure" and "strategic review" numerous times:

The latter quotes from the CEO heavily imply that the company will divest a large number of assets. That does not necessarily mean selling them. It could involve a carve-out, spin-off, or something similar to the DowDuPoint moves this summer. I am sure that the company is looking at this option.

After all, a partial or full spin-off of a company or brand, with its own management would allow that company to raise equity. It would come with the transfer of a portion of the debt from KHC to that new company, just like DowduPont did when it spun off Dow in March and then later split itself into both Dupont and Corteva in June.

In addition, the dividend would not have to be cut. It could simply be partitioned among two or three companies.

The Rationale For a Spin-off / Carve-Out
One of KHC's problems with investors right now is there no visibility in the financials about the actual brand performance, either in sales or earnings. The company divides itself into geographical regions. Right now it has 19 reporting units, but they are all just parts of the world.

But this is a food company. Not a single product company that can be split into regions. When the sh hit the fan and the company had to write down $15.6 billion of assets, it did this by citing different food groups that had not performed well enough to live up to their brand values. You can read my article about the analysis of this.

So why not split the company into major brands, especially putting Kraft products as a separate company. It seems to be the "bad bank" so-to-speak. When the write-offs occurred earlier this year, it was mostly their products, as I wrote in my original article on KHC and subsequent articles.

Perhaps Oscar Meyer and Heinz could stay as separate companies, but let's not assume that they need to be. I suspect the problem child really is Kraft. KHC could spin it off as a separate company, or alternatively, sell 20% to the public as a separate company in a new carve-out. Now there would be sufficient cash and cash flow to pay down debt and yet still pay the dividend.

For example, let's say that all of Kraft brands are put into a separate company. 3G Capital paid $23 billion for it in 2013 and inserted it into KHC. Even if they "carved out" $6 billion in an IPO capital raise for say, 25% of the company, would give the KHC both a remaining 75% stake, $6 billion to pay down debt, plus transfer a good portion of existing debt to the new Kraft carve-out company. That makes three birds killed with one stone - (1) a capital raise (2) transfer of debt, (3) dividend remains the same through both companies.

I have no inside knowledge of whether the company is considering this. But I highly suspect that they are reviewing the possibility of doing this, especially after the success of the DowduPont breakup this summer.

Summary and Conclusion
Seeking Alpha pays me to think outside the box. This is what thinking outside of the box looks like. I am trying to be creative about what management could do. Certainly, they have to do more than just asset sales. The dividend is not affordable even if they sell assets.

And here is what is important. Even if the dividend is supportable with asset sales, the stock price will not believe it. There will always be people like me saying the dividend is not supportable with existing cash flow.

In summary, KHC needs to do something creative. That will move the stock. What I have suggested is creative enough to move the stock out of first and second gear, which it seems to be stuck in.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.