By Josh Arnold
Kraft Heinz (KHC) made headlines recently when it cut its quarterly dividend from $0.625 to $0.40 per share. Management cited deleveraging of the balance sheet, supporting investments in its products, as well as affording the company the ability to divest additional brands as reasons for the cut. In short, the dividend had grown too large for Kraft Heinz to service, and something had to give.
This sent shares down rather violently as they fell from $48 prior to the cut, to just $32 today. Not only has that made the valuation quite cheap, but it has also boosted the yield back to 5%, even on the lower payout amount of $1.60 per share annually. Kraft Heinz is one of less than 400 stocks that yield at least 5%. You can see our full list of high-yield stocks here.
Kraft Heinz has certainly had its issues with earnings growth since it became the company it is today, following the merger of Kraft and Heinz, and we do not believe huge rates of growth are on the horizon. However, the strategic plan is prudent given where the company is today and management is on the right track in terms of where they are focused.
Coupled with a low valuation and a 5% yield, this recent period of weakness in the share price could be a buying opportunity for those with a long-term investing focus, and for those seeking a high dividend yield.
Overview Of Recent Events
Kraft Heinz is a processed food and beverage company that owns a vast and diverse portfolio of brands spanning a wide array of product categories. Those products include condiments, sauces, cheese and other dairy products, frozen meals, infant nutrition, and others. The company in its current form came into existence in 2015 when Kraft and Heinz merged in a massive deal. The company’s total annual revenue should reach about $26 billion this year, down fractionally from 2018, and its market capitalization is $39 billion after the recent selloff in the stock.
Source: Investor Relations
This graphic gives us an idea of the breadth and depth of Kraft Heinz’s portfolio as it contains not only the very popular flagship brands, but others that have become staples around the world over the years. The company’s strategy of owning just the right brands that are a good fit instead of trying to be everything to everyone has resulted in a more focused portfolio of brands that we believe is a competitive advantage for Kraft Heinz.
Kraft Heinz reported Q4 earnings on February 21, 2019, and while results were okay, but not great, the headline was the now-infamous dividend cut. As mentioned, the payout was slashed from 62.5 cents to 40 cents per share quarterly, and shares reacted very poorly as a result. Operationally, Kraft Heinz certainly didn’t turn in a perfect quarter by any means, but it is clear the selloff was due to the dividend cut and not entirely the fundamentals.
Total sales came in at $6.9 billion in Q4, up 70bps versus the year-ago period. However, on an organic basis, sales rose a much more impressive 2.4%, with the difference coming from a 220bps loss from currency translation – owed to Kraft Heinz’ global footprint – as well as a net 50bps gain from acquisitions and divestitures.
Pricing fell 160bps in Q4 as increased promotional activity and pricing to reflect commodity deflation in North America took their toll. Pricing was better in EMEA and the Rest of World markets, helping to offset weakness in North America. Volume and mix were up 4% in Q4 as a combination of strong consumption gains in condiments and sauces helped drive the top line higher. Taking all of this into account, we see Kraft Heinz’s organic revenue growth number of +2.4% as fairly strong and indicative of its long-term potential, although currency headwinds are a force to be reckoned with for a company with global scale like Kraft Heinz.
The company’s adjusted EBITDA came in 13.9% lower than the year-ago period to $1.7 billion. This was due in part to a 2.4% decrease from currency translation, but weakness in the US more than offset strength elsewhere.
In the US, which is far and away the company’s largest geographical segment, total sales rose 1.1% and organic sales were up similarly. Pricing fell 2.8% in Q4, driven by a combination of commodity-driven pricing actions in coffee and dairy products, as well as increased promotional activities in ready-to-drink beverages, Lunchables, and natural cheese products. Volume and mix helped offset this weakness, however, rising 3.9% in Q4 due to gains across the majority of the company’s categories.
US adjusted EBITDA fell 16%, however, to $1.3 billion as the benefits of favorable key commodity costs and volume and mix growth were more than offset by the combination of higher operating costs and lower pricing.
In Canada, which is Kraft Heinz’s smallest segment by revenue, the company fared better in Q4. Sales were up 1.8% year-over-year despite a sizable 4.2% loss from currency translation. Organic net sales soared 6% in Q4 thanks to a 7.7% increase from volume and mix, driven by a combination of consumption growth in cheese products as well as retailer restocking that occurred during the period. That growth was partially offset by a 1.7% decline in pricing as increased promotional activity in cheese and pasta products was partially offset by better foodservice pricing.
Canada adjusted EBITDA increased 1.1% year over year to $163 million despite a 4.4% negative impact from currency translation, thanks to growth in volume and mix, as well as lower input costs that were partially offset by weak pricing and higher overhead expenses.
In the EMEA segment, which is the company’s third-largest segment by revenue, total sales fell 1.1% against the comparable period last year. This included a 4.3% negative impact from currency translation and a 1.9% negative impact from the divestiture of a joint venture in South Africa. Organic net sales were up a very strong 5.1% in Q4 as pricing was up 2.6% and volume and mix increased 2.5%. Strong pricing in the UK, the Middle East, and Africa were partially offset by weaker pricing in Eastern Europe. Volume and mix increased thanks to growth in condiments and sauces as well as foodservice gains across most of its regions, which more than offset lower shipment volumes in Africa and the Middle East.
Adjusted EBITDA in the EMEA segment fell 2.6% to $171 million, including a 4.3% loss from currency translation. Excluding that, adjusted EBITDA would have risen 1.7%, reflecting the organic sales gain, which was partially offset by higher overhead costs.
Finally, the company’s second-largest segment by revenue, Rest of World, saw its total sales decrease 0.8% year-over-year to $789 million. The segment suffered a massive 12.6% loss from currency translation during the quarter, which more than offset a 6.5% gain from acquisitions and an organic sales increase of 5.3%. That gain was driven by stronger pricing, which was up 1.8% thanks to inflationary markets in South America, as well as a 3.5% increase in volume and mix from condiments and sauces.
The segment’s adjusted EBITDA fell 6% year over year to $134 million due to a staggering 31.8% decline from currency translation. Excluding this, adjusted EBITDA would have moved 25.8% higher thanks to gains from organic sales that were partially offset by higher local currency input costs.
The company also reported a massive $15.4 billion non-cash goodwill impairment charge in Q4 thanks to lowering the carrying value of some of its intangible assets, primarily in US Refrigerated and Canada Retail, as well as the carrying value of the Kraft and Oscar Mayer trademarks. That sent headline earnings per share down to -$10.34 in Q4, but we’d caution investors to ignore this goodwill impairment as it is non-cash and does not reflect long-term operational stability of the company’s results.
Ignoring this, adjusted earnings-per-share in Q4 was down 6.7% to 84 cents thanks to lower adjusted EBITDA, and higher interest expense. These factors were partially offset by higher revenue and lower taxes, but Kraft Heinz’s Q4 certainly reflected some challenges the company is facing.
After the Q4 report, we’ve set our initial earnings per share estimate for 2019 at $3.68 per share, representing decent growth from 2018 earnings per share of $3.51.
Source: Q4 earnings presentation, page 6
This estimate is based upon the factors discussed in the company’s guidance for this year, as seen above. Kraft Heinz sees organic sales gains from continued strength in consumption as well as mix growth. In addition, it looks to balance cost inflation and market share goals by taking action in pricing as the year goes on, keeping margins in mind. In total, the company sees a 3% to 4% headwind from currency translation and divestitures combined, which will offset some of the gains in organic sales.
EBITDA will be fairly tough early in the year thanks to strong comparables in 2018, but overall, management believes it can hit ~$6.4 billion in 2019. We also think this will be the bottom in terms of profitability in the years to come as the company’s revenue and margin efforts should begin to bear fruit in earnest in 2020 and beyond.
The company’s new dividend of $1.60 per share annually is still good for a 5% yield at today’s share price. The cut obviously is painful for investors that own the shares, not only because of the cut itself, but also the huge selloff that ensued. However, given largely in-line financial performance in Q4 and 2018, as well as the rationale given for the dividend cut, we think this is a good time for investors with a long-term horizon to initiate positions in Kraft Heinz.
It is no secret that Kraft Heinz has had a difficult time growing in recent years. Indeed, after producing $3.55 in earnings per share in 2017, last year’s value was fractionally below that. The point is that while the company isn’t in some sort of fundamental decline, it has had a difficult time growing its earnings per share, which ultimately led to the dividend being cut.
Moving forward, we think Kraft Heinz can produce low to mid single-digit growth annually in the coming years. There are many factors to consider, and we’ll lay out the case for the company’s growth below.
Source: Q4 earnings presentation, page 2
To begin, let’s take a look at how the company fared last year in its strategic priorities. Kraft Heinz did make some progress on reestablishing its commercial growth as consumption trends were strong across most of its geographical segments. This leads to volume gains, as was evident in Q4 results. We can see in the chart above that North American consumption trends were vastly improved in the second half of 2018, something which we believe will continue into 2019. This will help drive revenue growth and leverage down some of the company’s fixed and operating costs.
The company is also rethinking the way it markets and manages its products in stores, which should help drive volumes and potentially pricing as it continues to improve. Again, we saw some progress on this front in Q4 and it should continue to provide a small tailwind to revenue in 2019 as these initiatives continue.
Offsetting some of this progress was higher-than-expected costs as Kraft Heinz missed its own expectations. Remember that when the Kraft Heinz merger was consummated, the company went to work aggressively cutting costs to improve margins. While much work has been done, Kraft Heinz missed the mark in 2018. We don’t see further cost-cutting as a significant source of margin expansion, but certainly the company will continue to work on that in 2019 and beyond to optimize its profitability.
Source: Q4 earnings presentation, page 5
Beginning in 2019, the company will look to grow from a very strong pipeline of new products, as well as reinvigorating existing lines. Examples include the company’s MAYOCHUP product, which is a combination of ketchup and mayonnaise, and its new extensions of that concept, MAYOMUST and MAYOCUE. The company’s recent strength has certainly come from condiments and spreads across a variety of regions, and using this strength to push further into categories where the company is having success should help drive the top line higher in 2019 and beyond.
Source: Q4 earnings presentation, page 7
Another growth avenue Kraft Heinz has at this point is its portfolio optimization, which has been underway for some time. The company has made a point to exit businesses that don’t fit its strategic priorities and/or its desired margin profile. It has done so by unloading unwanted businesses at favorable valuations and with limited impact to earnings, although there has certainly been some of that recently.
Still, the company can use the proceeds from its asset sales to either acquire new growth or deleverage its balance sheet. In all, while we don’t necessarily expect this strategy to add a huge amount to growth in 2019, it should, over the long term, enhance the company’s margin profile through a more favorable portfolio mix and lower leverage.
Source: Q4 earnings presentation, page 8
To that end, reducing leverage is a key priority for Kraft Heinz. It is attacking this problem via the divestitures just mentioned, as well as the dividend cut. These proceeds and savings, respectively, should help the company decrease its currently sizable reliance upon debt in its capital structure and not only improve safety for investors over time, but also improve net income margins as interest expense declines.
Once this is done, the company could potentially use excess cash to buy back stock and boost earnings per share via a lower float, which is something it cannot really afford to do today in any sort of meaningful quantity.
Source: Q4 earnings presentation, page 9
Here’s a look at Kraft Heinz’s long-term strategic priorities, which include many of the things it has already accomplished. The company’s goal in the past was to integrate the two companies and reduce operating costs to improve margins. Today, Kraft Heinz is focused on establishing its growth again now that the company’s cost-cutting is largely complete and that it has divested non-core businesses, creating a more desirable mix of products.
Looking forward, Kraft Heinz is focused on beginning the process of top and bottom-line growth. The company isn’t necessarily looking to reinvent the wheel, but rather through strong execution of product innovation and channel development, we should see much better and sustained profit growth in the years to come.
In total, we are expecting Kraft Heinz to produce ~3% earnings per share growth annually in the coming years, a conservative estimate that takes the company’s somewhat uncertain near-term into account. Longer term, earnings per share growth could well exceed 3% should revenue and margins improve. For now, our conservative estimate is for the company to grow in the low single digits but given where the valuation of the stock is today, that should be more than good enough.
Speaking of the valuation, Kraft Heinz is truly in trough territory today. Shares trade for just 8.7 times our 2019 earnings per share estimate of $3.68. That is, by a wide margin, the cheapest valuation this stock has traded for since the merger. That is cheap by any measure, and our estimate of fair value of 11 times earnings is substantially higher. The stock’s average valuation since the merger has been around 20 times earnings, but given the challenges Kraft Heinz is facing today, we simply do not see that as reasonable anytime in the foreseeable future.
Still, our conservative estimate of 11 times earnings would yield an annual tailwind to total returns for shareholders of ~5%, helping to boost our estimate of total returns to 13% over the next five years. Total returns will consist of the 5% dividend yield, the 5% tailwind from the valuation moving higher, and 3% earnings per share growth. We see upside to the earnings per share growth number if the company’s strategic priorities play out as we expect, but even if they don’t, Kraft Heinz offers investors very strong returns from a 5% yield and a trough valuation.
While food companies tend to be low growth, slow-moving stocks, they also tend to offer nice dividends and generally less volatility than other sectors. Kraft Heinz certainly fits that bill with its 5% dividend yield and very low valuation, which should offer investors a margin of safety if purchasing today. It could also perform relatively well in a recession as its products are largely purchased in the same quantities during a downturn.
Given what appears to be a prudent and achievable roadmap for 2019 and beyond, investors should see a return to EPS growth in the years to come. Combined with the 5% yield and low valuation, the stock could be quite attractive for a variety of investors today.
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.