Iconic Brands Boost Kraft Heinz

06/18/2019 5:00 am EST

Focus: CONSUMER

George Putnam

Editor, The Turnaround Letter

The Kraft Heinz Company (KHC) is among the world’s largest packaged food companies; it  holds a remarkable portfolio of over 200 brands,  including the iconic Kraft- and Heinz-branded foods, Oscar Meyer meats, Ore-Ida potatoes and Planters nuts, explains George Putnam, editor of The Turnaround Letter.

About 31% of sales are outside of the United States. Following the 2013 acquisition of H.J Heinz Company by Berkshire Hathaway and Brazil’s 3G Capital, Kraft Foods and Heinz merged two years later in a giant $49 billion deal. At first, the combination looked promising, winning praises from investors.

Aggressive cost-cutting helped boost its EBITDA margin to an industry-leading 29%, propelling the shares to over $95 by early 2017, nearly 30% higher than its opening post-merger price. Its zero-based budgeting approach became the envy of the industry, leading peers to adopt a similar strategy.

However, flaws began to emerge in early 2018, as the company struggled with weak revenue and profit growth. The issues culminated on February 22, 2019, with a remarkable five-point roster of bad news, as the company missed the 4Q18 consensus earnings estimate, offered weak guidance, wrote-off $15.4 billion of goodwill, cut its dividend by 36%, andannounced an SEC investigation into its accounting.

Investors were shocked (even part-owner Warren Buffett expressed his surprise), sending the shares down 27%. Rather than creating value, the KHC merger has produced lower revenues and profits, more debt and a much lower share price.

Investors see a company whose dated product line has limited appeal to today’s consumers (who want fresh, healthy, less-processed foods), has weakened bargaining power relative to its grocers and other distribution channels, carries an elevated debt burden, is led by a management that lacks credibility, and hasn’t filed clean financial statements since last October.

It’s little wonder that the shares trade 57% below their post-merger opening price in a stock market that has gained nearly 40%.

While disdained by investors, Kraft Heinz is by no means a lost cause. The company’s revenues remain stable (if not growing), backed by still-popular brands and products. Its profit margins are still robust, and it generates sizable cash flows. Most of the problems are centered on the U.S. operations, as international results have been stronger.

The sharp drop in its stock price has increased the pressure on Kraft Heinz to improve. We expect that Warren Buffett, as the largest shareholder (with 26.7% ownership) will work behind the scenes to rebuild the value of his now-$10 billion holding.

An important first step will be the arrival on July 1st of new CEO Miguel Patricio, who brings needed expertise in rejuvenating products and brands.

Kraft Heinz also has reportedly begun selling part of its trove of valuable brands, including its Maxwell House coffees, Breakstone sour cream/cottage cheese and Plasmon baby food businesses, to streamline its operations and reduce its debt.

Other initiatives under way include more investment in its supply chain, warehouse system and sales force. We anticipate better product innovation ahead.

Kraft Heinz’s accounting issues, while unnerving, appear to be contained at about $200 million, which is less than one percent of revenues.

We would expect the company to be current on its financial filings by the end of the summer. Despite this issue and the company’s elevated debt level, the bond market, which can be an early indicator of deeper problems, remains unfazed: Kraft Heinz bonds currently trade around par.

While the $0.40/share quarterly dividend is well-covered and produces an over five per- cent yield, investors should recognize that the company might choose to cut it further in order to accelerate its debt paydown.

With low expectations, even moderately positive news might help lift the shares. As Kraft Heinz makes more substantial progress toward meeting its combined challenges of producing revenue growth and margin expansion, its stock price will likely produce meaningful gains. We recommend the purchse of shares of The Kraft Heinz Company with a $45 price target.

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