Contrarian Value Ideas

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>>> Kraft Heinz Could Have Bad News. It’s Time to Buy the Stock.


Barron's

By Al Root

Feb. 7, 2020


https://www.barrons.com/articles/kraft-heinz-could-have-bad-news-its-time-to-buy-the-stock-51581073202


Kraft Heinz makes, arguably, the best-tasting ketchup in the world. Yet the merger that created the company has left a bad taste in investors’ mouths. With a new CEO on board, it may be time to start nibbling on shares—even in the face of a likely dividend cut.

When Warren Buffett’s Berkshire Hathaway (ticker: BRK.A) and Brazilian investment firm 3G Capital created Kraft Heinz (KHC) in 2015, it looked like a perfect match: two iconic food companies brought together by two savvy investors. It hasn’t worked out that way. Kraft Heinz has lost about 60% of its value since then, suffering double-digit share-price declines in each of the past three years.

The big problem is sales, which are down about 7% from peak levels. The drop was part of the reason that Kraft Heinz took a $15.4 billion noncash impairment charge in 2018.

Still, hope remains. Last July, Miguel Patricio became the new CEO. He arrived from Anheuser-Busch InBev (BUD), where he served as global chief marketing officer from 2012 to 2018. He’s expected to provide his strategic vision early this year, perhaps on the fourth-quarter earnings call on Feb. 13. If he can lay out a credible path forward, Kraft Heinz stock could pop. Its cheap valuation, particularly relative to other consumer staples, makes the risk-reward attractive. The beaten-down stock trades at about 11.5 times estimated 2020 earnings. Peers trade at about 20 times estimated earnings.

Patricio has his work cut out for him. Kraft Heinz’s earnings before interest, taxes, depreciation, and amortization have been steadily declining since 2017, when it earned about $2 billion a quarter in Ebitda. By the first quarter of 2019, Ebitda had fallen to $1.3 billion. This coming week, Kraft Heinz is expected to report fourth-quarter Ebitda of about $1.5 billion from sales of $6.6 billion.

Margins haven’t been the problem. Cost-cutting has kept them well above 20% for years—about seven percentage points higher than peers. In fact, margins might be too high: The company’s lack of brand investment is part of the reason that sales are down.

And there’s the company’s debt—about $30 billion. Combine that with falling sales and Ebitda, and investors are worried about the security of the company’s $1.60 annual dividend.

That’s why Patricio’s turnaround plan is so important. We don’t know what he has in store, as Kraft Heinz declined to make him available before the earnings call. But we can hazard a guess based on what another struggling U.S. icon, General Electric (GE), was forced to do over the past year. GE’s new CEO sold assets, paid down debt, and cut the dividend to preserve cash. Investors cheered, and the stock jumped more than 50% in 2019.

Kraft Heinz is almost certainly going to start selling off assets—and it has a lot to sell. Its iconic brands include Heinz ketchup, Kraft mac and cheese, Oscar Mayer, Jell-O, and Philadelphia cream cheese, among many others.

Some of the more challenged brands suffering market-share declines—such as Velveeta, Planters, and Maxwell House—might benefit from a combination with another industry player. (Mr. Peanut may have to go for good this time.) Bernstein analyst Alexia Howard worries that the prices the company will fetch might be underwhelming. It’s a valid concern, but acting fast is better than hanging on and attempting to fix all of the brands at once.

“One key question is how to reshape the portfolio through divestitures to enhance Kraft Heinz’s competitive positioning,” Howard says.

The cash coming from asset sales could be used to pay down debt. A goal of about three times debt to Ebitda—down from about five times, based on estimated 2020 earnings—would calm investor concerns. S&P and Moody’s might still decide to cut Kraft Heinz’s investment-grade rating to junk, but the company has only $2 billion in debt to refinance in the next two years. What’s more, Kraft Heinz bonds aren’t trading at distressed levels.

That could mean part of Kraft Heinz’s dividend is salvageable, though some cut appears baked into today’s share price. The company pays out about $2 billion in dividends each year and spends another $2 to $3 billion on plant and equipment, plus interest. But it also generated $3 billion in free cash over the past 12 troubled months. A dividend cut to zero seems unlikely.

Still, at 5.5%, its dividend yield is certainly high. The Dow Jones Industrial Average yields 2.2%, while the S&P 500 index yields 1.8%.

GE cut costs to help bring troubled divisions back to profitability. That’s not likely at Kraft Heinz, which, after years of slashing costs, should start spending again. In fact, investors might cheer costs going up if it meant sales growth and market share gains.

Kraft Heinz earned $3 a share over the past four quarters. But Wall Street believes that its current debt and margin structure is unsustainable. If the company executes a smart plan under Patricio, it could still earn $2 to $3 a share in 2021. That’s a wide range, but asset sales are a wild card.

At a market price/earnings ratio of 17 times 2021 earnings of $2.50 a share, the stock could hit $43, up more than 40% from a recent $29.

That’s one optimistic scenario. If asset sales don’t bring in enough cash and the stock keeps trading at a discount, shares could hit $26 over the next 12 months. Still, that’s down only about 10% from recent levels. The risk-reward ratio—a 40% gain or a 10% loss—looks attractive for investors willing to accept a little volatility.

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