Kraft Heinz – Is the Elimination of Uncertainty Possible with New CEO?

Kraft Heinz Stock Analysis

The Kraft Heinz Company is one of the largest global food and beverage companies, with a diverse mix of iconic and emerging brands. The manufacturing and marketing categories of Kraft Heinz Co include condiments and sauces, cheese and dairy, ambient foods, frozen and chilled foods, and meats and seafood products. Kraft Heinz Co operates through United States, Canada, EMEA, and rest of the world (especially in Latin America and Asia Pacific regions).

The Kraft Heinz Company, the merged company of Kraft Foods, which performs in various sectors, and Heinz, which concentrates on soups and canned vegetables.

According to Fitch, Heinz, which has been owned by Berkshire Hathaway and 3G Capital since 2013, was buoyed by its rising emerging market exposure and reported robust growth in earnings per share, thanks to acquisitions of Chinese soy sauce maker Foodstar and Brazilian tomato sauce group Coniexpress. However, in the US, consumption of canned food is stagnating, as consumer preference gradually moves to fresh food over ready-made meals and canned goods. Berkshire Hathaway and 3G Capital were behind the acquisition of Kraft by Heinz in March 2015, as a move to address declining sales of Kraft’s legacy brands.

The Kraft Heinz Co’s significant trademarks are Kraft, Oscar Mayer, Heinz, Philadelphia, Lunchables, Velveeta, Planters, Maxwell House, Capri Sun, Ore-Ida, Kool-Aid, and Jell-O. Kraft Heinz sells its products through e-commerce platforms and retailers. The company’s largest customer, Walmart Inc., represented approximately 21% of its net sales in 2018.

The company employs approximately 38,000 employees as of December 29, 2018.

Overview

The US Food and Drug Administration evaluates that canned meals exhibit about 17% of an average person’s diet. Consumers prefer premium products, which are generally overpriced than mass-produced commodities. The canned foods market is expanding at a rapid pace in terms of value than volume due to premium alternatives surge market share.

Another dominant rival in the canned food industry is Campbell Soup, which has encountered the same obstacles as Heinz and Kraft lately, as consumers step away from canned products to freeze, fresh food.

Kraft Heinz is suffering to sell its Maxwell House coffee brand and seeking a sale of its frozen potato brand Ore-Ida.

Kraft Heinz has a general strategy of lowering its labor force, strengthening its supply chain, and having adequate manufacturing operations. We have observed pronounced increases in an operating margin of mid-20% since 2016, which is higher than packaged-food competitors.

Kraft Heinz has been facing one of its declining and indeterminate positions in its stock price and prestige. The company is experiencing significant confidence issues with its current investors and suffering to convince potential investors.

Kraft Heinz obtained an order from the SEC in October 2018 regarding an investigation into the company’s accounting policies, procedures, and internal controls related to its procurement function. In its annual report, Kraft Heinz reported that the company understated its cost of products sold amounted to USD 208 million, along with USD 175 million in misstatements.

KHC Goodwill Impairment 20181229
Source: KHC Form 10-K for the fiscal year ended December 29, 2018, edited by BrightHedge
KHC Intangible Impairment 20181229
Source: KHC Form 10-K for the fiscal year ended December 29, 2018, edited by BrightHedge

* Remaining USD 400 million goodwill and intangible asset impairment losses resulted from other brands and reporting units.

Kraft Heinz incurred a USD 15.9 billion impairment write-down in the fourth quarter of 2018, originating from goodwill and intangible asset impairments of the natural cheese and meats categories of Kraft and intangible asset impairments of Oscar Mayer brand. The impairments are mostly related to lower prospective net sales growth and margins.

The new management has a greater desire to spend on new products and marketing; however, material internal control failure of Kraft Heinz indicates that the company might be prone to oversight and approval issues.

While we understand that the company is focusing on efficiency and cost-cutting, Kraft Heinz may face inflation of raw materials, labor, and transportation costs. These cost barriers cause our operating margin expectations at its current levels (lower band of the mid-20s).

Investment Characteristics

Kraft Heinz has a return on invested capital (ROIC) of approximately 6%.

Return on Invested Capital (ROIC) of Kraft Heinz

ROIC=Net Operating Profit After Tax/Invested Capital (ave)

USD 5,716 million x (1-9.4%)/[((USD 30,770 million+USD 51,657 million)+(USD 28,308 million+USD 65,863 million))/2]

5.86%

Kraft Heinz has a weighted average cost of capital (WACC) of more than 6%.

Weighted Average Cost of Capital (WACC) of Kraft Heinz

WACC=E/(E+D) x Cost of Equity + D/(E+D) x Cost of Debt x (1-Tax rate)

USD 37,777 million/(USD 31,168 million+USD 37,777 million)x[1.96%+(1.08×6%)] + USD 31,168 million /(USD 31,168 million+USD 37,777 million)x(USD 1,284 million/USD 31,168million)x(1-9.4%)

54.80% x 8.44% + 45.20% x 4.11%

6.31%

Kraft Heinz has higher WACC comparing to ROIC indicates that the management is concentrating on current cash flows, however not adequately supporting its long-term competitive position.

Kraft Heinz has an operating margin of more than 20%, which is materially higher than its peers.

Operating Margin of Kraft Heinz and its Peers

The Kraft Heinz Co 21.76% – calculated from 2018 Form 10-K

Nestle SA 16.81% – calculated from 2018 Form 10-K

PepsiCo Inc 15.64% – calculated from 2018 Form 10-K

Danone SA 14.51% – calculated from 2018 Form 10-K

General Mills Inc 16.73% – calculated from 2019 Form 10-K

Campbell Soup Co 12.85% – calculated from 2018 Form 10-K

The synergy of Kraft and Heinz has benefitted the company to increase its operating margin. However, after considering the importance of investing in its brands, and sustaining its marketing efforts, SG&A and R&D expenses of Kraft Heinz have gotten behind of its competitors.

Total revenue to total assets ratio is increased from 22% to 25%. Total revenue of the current year is surged by 0.7%. The favorable shift resulted from goodwill and intangible asset impairments, and investors need to assess this positive ratio with caution.

Kraft Heinz repaid USD 2.7 billion total amount of senior notes in July and August 2018 and funded these debt repayments with long-term notes issued in June 2018. The current ratio is raised by 70.5%, which verifies the periodicity of these debts.

Kraft Heinz has approximately 70% of sales from the United States. The performance of private label brands from Costco and Kroger indicates that consumers tend to favor price due to zero switching barriers. As Warren Buffett stated, Kraft Heinz has “a weaker bargaining hand” over consumers. The weak bargaining power demonstrates fragile sustainable pricing and surging costs of capital.

Kraft Heinz needs to invest in brand recognition, and brand recall to attract healthier food instead of processed meals, which are conveniently located at stores contrary to fresh meals. Surging online stores has helped to gain an advantage to low-cost, niche, and private label healthier food suppliers. The strategy of new Kraft Heinz management is to increase its spending in marketing needs to be mostly on brand awareness to prevent market share deterioration. We believe that Kraft Heinz will eventually safeguard its market share and secure its sales growth with spending on brand awareness.

Valuation

Our fair value estimate for Kraft Heinz is USD 48 per share. We categorized the company as a consumer defensive with unstable brand loyalty. We estimated annual sales growth of 0.7%-1.2% as a result of our volume and price assessment. Our valuation indicates an enterprise value/ EBIT multiple of 15 times, and enterprise value/ EBITDA multiple of 13 times. The increased brand rivalry, considering the intensely competitive environment, resulted in a conservative sales growth forecast. We also measured the management’s marketing efforts in our operating margin calculations. We expect marketing and R&D expenses/revenue multiple increases by approximately 1% in our forecast model. We assume the difficulty of reflection of increases in input and transportation costs to consumers in our model. We forecast operating margins will be around 21%-22% over near and longer term.

Risks to Consider

Kraft Heinz operates in a highly competitive industry. The company has a cost-cutting strategy, initiated by one of its main shareholders, 3G Capital. However, consumers demand hefty price decreases the likes of Kraft cheese slices. The expense reduction approach directs to brand deterioration. Also, in a world where young people demand healthy choices, recovering aging brands like Kool-Aid or Kraft Mac & Cheese will be one of the most challenging tasks for Kraft Heinz. Ongoing negative perceptions and failure to meet consumer preferences may result in uncertainties about the future.

As we mentioned at the beginning, the 21% revenue of Kraft Heinz originated from Walmart sales in 2018. Walmart, the mass retailer, has a strong position due to significant purchase orders, which lead to the weak bargaining power of suppliers.

Severe weather conditions can put an upward burden on input costs for commodities, including dairy products, meat products, coffee beans, nuts, tomatoes, potatoes, soybean and vegetable oils, sugar and other sweeteners, corn products, and wheat products to manufacture Kraft Heinz products. In the past, the company did not successfully pass through input cost inflation, and recent surges in transportation costs limit profit expectations in the industry.

Other Considerations

New CEO, Miguel Patricio announced to concentrate on the marketing and new product development, which are most necessary for Kraft Heinz. However, we also need to observe the company’s owners regarding the new CEO’s intended strategy. Berkshire Hathaway and 3G are leading shareholders may have different agendas, and Kraft Heinz may face control structure conflicts.

Kraft Heinz entered into definitive agreements to sell natural cheese portfolio in Canada for approximately USD 1.2 billion and several Heinz India brands in India for approximately USD 660 million. We favor the management’s interest in focusing on core brands and operations and high return opportunities.

Conclusion

Kraft Heinz Stock Price Graph as of 20190710
Source: tradingview.com

Ongoing investigations raise our uncertainty about Kraft Heinz. Kraft Heinz has an opportunity to benefit Heinz’s established global distribution potential, which seems to an essential factor in increasing sales. Online stores and small retailers are growth potential for Kraft Heinz. The share these stores and retailers in revenue is relatively low in the current period. Investors need to cautiously monitor inflationary pressures in input and freight costs for the company’s future projections.

Disclosure: I do not have any of the securities mentioned above. This article expresses my own views, and I wrote the article by myself. I am not receiving compensation for it. I have no business relationship with any company whose security is mentioned in this article.

Sources: Fitch Solutions- US Food & Drink Report Q3 2019, SEC filings

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Covers investment, financial analysis and related financial market issues for BrightHedge. He has extensive experience in portfolio management, business consulting, risk management, and accounting areas.

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The investment information, comments and recommendations contained herein are not subject to investment advice. The comments and recommendations contained herein are based on personal views. These views may not fit your financial situation and your risk and return preferences. For this reason, based only on the information contained herein, investment decisions may not have the appropriate outcome.