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Beckley
Tuesday, October 27, 2020 2:15pm

Kraft Heinz Turnaround – I Am Still Not Convinced (NASDAQ:KHC)


Here

Source: cnbc

As one of the largest holdings of Berkshire Hathaway, Kraft Heinz (KHC) often checks all the boxes for investors looking for so-called value companies.

To begin with, KHC had been through a rough period, marked by impairments and organic growth headwinds as it lost more than 50% of its value.

ChartData by YCharts

As a result of this decline, the company has become very cheap which attracts investors looking for conservative valuations. For example, Kraft Heinz trades both at the lowest forward P/E multiple on a non-GAAP basis and the lowest P/S multiple.

Source: prepared by the author using data from Seeking Alpha

In addition to all that, KHC owns many of the world’s strongest food brands, such as Heinz, Philadelphia, Oscar Mayers, and many more. And as we all know, brands are the most important competitive advantage in the stable consumer staples industry and exceptionally strong ones bring a wide moat with them.

Source: money.com

So, at first glance, we have a perfect fit for a classic value investor – conservative valuation with wide moat. And, of course, let’s not forget that KHC is the fifth largest holding for Berkshire Hathaway, so where could this go wrong. Well, as it turns out it can.

Implications of Extreme Cost-Cutting Measures

Even though the pain of the large asset impairments seems to be behind Kraft Heinz, the implications for investors could linger for much longer, even after the massive drop in share price.

Following the massive $15bn asset impairments in 2018, both goodwill and indefinite-lived brands impairments continued well into 2019 and 2020.

Source: prepared by the author using data annual and quarterly reports

Although assumptions behind these asset impairments are not disclosed, each year since 2018 the most important and strongest brands of KHC have been impaired on the grounds of either lower sales growth or further margin compression expectations.

We recognized a $4.3 billion impairment loss related to the Kraft brand, primarily due to lower long-term net sales growth expectations

We recognized a $3.3 billion impairment loss related to the Oscar Mayer brand, primarily due to revised 2019 annual and future margin expectations

We recognized a $797 million impairment loss related to the Philadelphia brand, primarily due to revised 2019 annual and future margin expectations, and to a lesser extent, lower future positive net sales growth expectations

Source: Kraft Heinz Annual Report 2018

Then, in 2019, a number of cheese brands were again impaired due to discount rate assumptions, which one would have thought does not have much to do with sales and margin expectations.

we recognized a non-cash impairment loss of $474 million in SG&A in the second quarter of 2019 primarily related to six brands (Miracle Whip, Velveeta, Lunchables, Maxwell House, Philadelphia, and Cool Whip) (…) largely due to an increase in the discount rate assumptions used for the fair value estimations

Source: Kraft Heinz Annual Report 2019

But, then, this year, the cheese brands mentioned above got impaired once again and this time lower expectations about margins and revenue growth were quoted as the main reasons. On top of that, the company’s iconic brand Oscar Mayer was once again impaired, after $3.3bn reduction in 2018. Interestingly, the coffee brand Maxwell House was also impaired at a time when coffee business is booming and this suggests that Kraft Heinz might be facing deeper difficulties than initially anticipated.

We recognized a $626 million impairment loss related to the Oscar Mayer brand. As the meats business has grown more competitive

We recognized a $140 million impairment loss related to the Maxwell House brand, primarily due to downward revised revenue expectations

We recognized a $290 million impairment loss primarily related to seven other brands (Velveeta, Cool Whip, Plasmon, ABC, Classico, Wattie’s, and Planters) (…) we established new expectations for revenue growth, margins, long-term growth rates, and discount rates

Source: Kraft Heinz Q2 2020 10-Q SEC Filing

After years of struggle, Kraft Heinz has finally decided to sell part of its cheese business in a $3.2bn deal.

Source: businesswire.com

Although simplifying the business and reducing costs does make sense, it is usually a sign of bad management when a company is selling business units after years of underperformance and after it has just acquired/merged them.

The extreme cost-cutting under the 3G Capital approach is perhaps what lead to this underperformance over the recent years.

The 3G Capital approach to business is ruthless and revolves around cost-cutting. Every employee must justify his existence every single day. Promotions are quick and merit-based, and underperformers get fired with the same alacrity. Budgets are zero based and evaluated unsparingly every year, or even sometimes with more frequency. Expenses are eliminated if they’re no longer judged worth incurring.

Source: forbes.com

Reducing costs could easily be great corporate move, but taken to extremes could prove to be a long-term problem even for the strongest brands in the world. I recently wrote a thought piece on AB InBev (BUD), which resembles what happened with KHC.

In hindsight, extreme cost-cutting at Kraft Heinz has been easy to see, but what many people do not understand is that lower reinvestment rates in brands, human capital and property, plant and equipment usually takes years to translate into a struggling business.

KHC has been the company spending the least on advertising relative to sales from its large peers in the sector.

* Nestle not included due to lack of data

Source: prepared by the author using data annual and quarterly reports

Suddenly, after so many years of underinvesting, the company has finally declared its intentions to increase marketing and advertising spend by 30% by 2024 (see below).

Even though this is a step in the right direction, it would most likely take years to reinvigorate brand performance, of course, if done right.

Source: Kraft Heinz Investor Presentation

Kraft Heinz has also been spending one of the lowest amounts on Capital Expenditures relative to Depreciation and Amortization Expenditure, which of course could be attributed to its higher level of intangible assets on the balance sheet due to the merger and is also a sign of low rate of fixed asset reinvestment.

Source: prepared by the author using data annual and quarterly reports

This way KHC has achieved much higher operating profitability, than what its gross margins would suggest, thus temporarily boosting its return on capital and valuation.

Source: prepared by the author using data annual and quarterly reports

As the cost-cutting strategy obviously did not work out as intended, Kraft Heinz now targets a further $2bn in cost reductions to boost future growth.

Source: cnbc.com

This time, however, the management seems to have shifted its focus and intends to use the proceeds to reinvest more into the business. Perhaps, it’s not at all surprising that it is exactly marketing and advertising spend and capital expenditures that Kraft Heinz’s management is planning to increase, after years of low spending.

The billions of dollars in savings are expected to come from integrated business planning for more efficiency between its manufacturing, procurement and logistics operations. Its procurement division alone is supposed to see $1.2 billion in savings over five years, in part due to closer collaboration with suppliers.

CEO Miguel Patricio, who joined the company in July 2019, said during investor presentations that the cost savings will fuel its investment back into Kraft Heinz. For example, the company will raise its marketing and advertising spending by 30%. Kraft Heinz will also spend 20% more on capital expenditures over the next three years on projects like renovating its packaging and making production more efficient.

This seems to be a step in the right direction for KHC, but there are important implications of this strategy. Firstly, higher spending does not instantaneously mean higher growth and market share. High brand reinvestment usually takes years to bear fruit. Secondly, Kraft Heinz’s operating profitability would most likely slowly revert to one more in line with the company’s gross margins which would have implications on KHC valuation.

Low multiples do not mean high future returns

To begin with, operating margins on a cross-sectional basis seem to be a poor indicator of where companies in the Food industry trade in terms of premium to book value. As a matter of fact, at first glance, it seems that the higher the operating margins are, the lower the valuation is which makes no sense.

Source: prepared by the author using data annual and quarterly reports

The reason for that is the wide dispersion of goodwill and intangible assets on companies’ balance sheets due to mergers and acquisitions. From Nestle’s (OTCPK:NSRGY) predominantly organic growth over the years which gives it one of the lowest Intangible Assets to Total Assets ratio, to Kraft Heinz and J.M. Smucker (SJM) which have extremely high share of intangible assets on their balance sheets.

Source: prepared by the author using data annual and quarterly reports

This does not necessarily mean that M&A deals are a bad thing, but rather that current accounting standards regarding intangible assets are not perfect and require adjustments to be made in order to correctly compare companies’ performance. This is the case since when a deal happens, intangibles that usually are unaccounted for in financial statements are recognized on companies’ balance sheets which reduces the equity book value premium to market value.

Source: prepared by the author using data annual and quarterly reports

Thus, if we exclude book value of intangibles and goodwill and compare operating profitability to Enterprise to Tangible Assets ratio, there is a much stronger relationship. A relationship where only Kraft Heinz stands out from the rest of the peers.

Source: prepared by the author using data annual and quarterly reports

Consistent with the expectation of lower operating margins going forward for KHC that I laid out in the previous section, the company is more likely to the left on the graph above and much closer to Kellogg (K).

Another interesting relationship emerges if we map companies based on their Intangible Assets to Total Assets ratio (a proxy for higher integration risk due to M&A deals) and Net Debt to Tangible Assets (a proxy for financial health).

Source: prepared by the author using data annual and quarterly reports

Kraft Heinz appears at the very top of the ranking as the highest risk company on these two measures. J.M. Smucker, a company that I also recently covered due to its risky M&A strategy, also appears at the very top together with General Mills (GIS).

That is why KHC, SJM, and GIS trade at a significantly higher Free Cash Flow Yield relative to the three less risky companies shown above.

Source: prepared by the author using data annual and quarterly reports

Having said all that, KHC appears fairly valued at this point. The company’s extreme low multiples that many find attractive, in fact, seem to accurately account for the company’s significantly higher risks and the expectation of lower operating profitability.

Conclusion

At first glance, Kraft Heinz might appear as misunderstood by the market and its extremely low multiples could easily attract investors believing that valuation is too conservative. However, the company’s price seems to accurately incorporate the company’s much higher risk and the expectation of lower margins going forward.

Although a fairly valued business such as KHC, which also has a relatively wide moat due to its brands, might still appear as an attractive investment, I would still stay away. The reason being that years of underinvesting have made the business and its brands more vulnerable and a higher reinvestment rate in the company would likely take years to provide meaningful results. I am also not convinced that the culture of extreme cost-cutting measures that led to this mess in the first place is a thing of the past for Kraft Heinz. I might as well be wrong on this, but at this point there seem to be better opportunities for me in the sector (you can check these here and here).

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MDLZ over 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.

Additional disclosure: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including a detailed review of the companies’ SEC filings. Any opinions or estimates constitute the author’s best judgment as of the date of publication and are subject to change without notice.





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