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Kraft Heinz (KHC: $29)

Key Measures

52-Week High $34
52-Week Low  $20
Shares Outstanding:  1.2 billion
Market Capitalization:  $35 billion

Dividend Yield: 5.5%
BMR Target Price:  $50
BMR Sell Price:  $25

 

Coverage initiated May 6, 2020 at $29 in the Special Opportunities portfolio.

Company Overview. Kraft Heinz was formed after Heinz acquired Kraft Foods in 2015, although each company was founded more than 100 years ago. A couple of years before that, Private Equity firm 3G Capital and Warren Buffett’s Berkshire Hathaway purchased Heinz for $23 billion. The combined company has an impressive stable of food and beverage brands. These include the namesake Kraft and Heinz along with Oscar Mayer, Lunchables, Velveeta, Planters, Maxwell House, Capri Sun, Kool-Aid, Ore-Ida, and Jell-O.

The Heinz-Kraft combination has not gone smoothly. In early-2019, the company took a large $15 billion write down of the Kraft and Oscar Mayer brands, cut its dividend by 36% from $0.625 to $0.40, and announced that the SEC was investigating its accounting practices relating to procurement. In the wake of this bad news, the company replaced its CEO.

There has been good news after this grim news. While the SEC continues its look into the matter, after completing an internal review in mid-2019, management discovered that they understated cost of goods sold and restated results. The company is working on fixing its “material weakness” in its financial reporting, and the government’s investigation is a wild card that has to run its course. But we doubt the SEC will deliver a devastating blow.

One bright sign ahead is management’s turnaround plan. They originally planned to release the details in March, but pushed the timing back to May. This may get delayed further due to the coronavirus, which has caused the company to reschedule Investor’s Day from May to sometime in the 2nd half of 2020.

We are confident better days lie ahead for the company. What is the basis of our strong conviction? After 3G combined the companies, it continued pursuing zero-based budgeting, which placed too much emphasis on cost cutting and not enough investment in its brands. Since then, the new CEO has ramped up marketing spending. This will lead to improved market share as the company competes with smaller, more nimble companies. Kraft Heinz’s large size gives it competitive advantages. This includes shelf space in the competitive food industry and economies case. Combined with outstanding, well-known brands, higher marketing will continue to pay dividends for years.

Competitive Analysis. Kraft Heinz is one of the world’s largest packaged food companies. It does have large competitors, including General Mills and Kellogg. While formidable, there is room in the marketplace for all of these companies to exist. There are also lower-priced private label brands.

The company competes on several factors, including price, quality, and innovation. Luckily, there hasn’t been a price war with bigger players like General Mills raising prices over the past couple of years.

With higher marketing spending, Kraft will defend its market share. While hurt after a period of underinvesting, it had eight brands with over $1 billion in annual sales.

Financial Analysis. The company’s financial performance has undergone a rough stretch. Sales fell last year by 5% to $25 billion. This wasn’t as bad as it appears. Granted it’s hard to get excited about a top-line decline. It’s just that most of the drop was unfavorable foreign currency translations and divestitures. When those are stripped out, sales dropped by 2% due to lower volume. Income was $2 billion compared to a what appears to be about a $5 billion profit in the year-ago period. It’s difficult to compare since 2018’s figure included that large $15 billion charge for goodwill and asset impairments that we mentioned above.

1Q20 sales rose 6%, well ahead of their prior low-single-digit decline. This is partly due to consumers picking up everyday items during the pandemic, pushing purchases forward. There is more to it than that, though. It shows that consumers remain attracted to the company’s brands. With the economy’s sluggishness, people will continue flocking to its packaged goods.

We’ve stripped out goodwill impairment to make profit comparisons more meaningful. On that basis, 1Q20’s income was $605 million, down from $1.0 billion in the year-ago period. Earnings per share declined to 58 cents from 66 cents but was above consensus. We are quite pleased because we feel that as long as the company continues to generate higher sales, profit will follow, especially with management’s turnaround plan just a few months off.

The company remains highly leveraged. There was $30 billion of debt and $2 billion of cash. It has been working on reducing its burden, repaying about $2 billion of debt last year. Admittedly, it has more work to do.

Stock Performance.The stock has been hammered, falling from 2017’s all-time high of $97. The stock collapsed to $22 last month during the worst of the selloff but has risen 37% since then.

There is plenty more upside. This company is too big and its brands are too strong for sales growth and profitability not to ramp up. There is early evidence the company is on the right track.

It is comforting that Warren Buffett, the Oracle of Omaha, owns nearly 27% of the company. His partner in this deal, 3G, still owns 20% even after selling 25 million shares last September.

BMR TAKE: Kraft Heinz’s commitment to its brands will push sales growth, and higher profitability will follow. The company must deal with the lower operating margins, but we expect them to recover as sales recover.

There are still issues the company has to overcome. Chiefly, these are continuing to reinvigorate sales growth and reducing debt. Hence, owning the stock requires a higher risk tolerance. Even at the reduced dividend rate, there is an attractive 5.5% yield while you wait for the company’s plan to bear fruit. We certainly believe in the company and have a $50 Target Price.