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Morningstar | Kraft Heinz's Sales and Profits Erode in 2Q; Shares No Longer a Bargain

We don’t expect to alter our $66 fair value estimate for narrow-moat Kraft Heinz following second-quarter results that included a 0.4% downtick in organic sales, as a 1.3% benefit from higher prices was more than offset by a 1.7% hit from lower volume and unfavorable mix, and a 100-basis-point degradation in adjusted operating margins to 25.6%. The sales shortfall was concentrated in Kraft Heinz's developed markets, which provide around three fourths of sales, with the United States down 1.9% on an organic basis (on a 2.3% volume decline) and Canada down 8.2% (on an 8.8% volume decline).

Like peers, Kraft Heinz is wrestling with inflationary headwinds in relation to higher inputs, including resin, and freight and logistics. While we don’t expect these challenges to abate in the near term, management reiterated its intent to increase spending to enhance its capabilities, an incremental $300 million this year. We view this as a prudent endeavor in order to withstand the pressures of the intense competitive landscape, a portion of which is likely to be funded by the firm’s stringent eye on driving efficiencies. We forecast Kraft Heinz will ultimately allocate 2%-3% of sales annually to research and development and marketing, versus the low single digits directed to these areas over the past few years and the mid- to high-single-digit levels at peers. Despite the near-term profit hit, we think effective spending could also enhance the stickiness of Kraft Heinz's retailer relationships and subsequently reinforce an aspect of the company's intangible asset moat source.

Following the high-single-digit appreciation in the shares following the release, we now view Kraft Heinz as fairly valued. For investors seeking exposure to the packaged food arena, we’d suggest wide-moat General Mills, which trades at a 20% discount to our valuation and boasts a 4% dividend yield, as a more attractive option.

A significant amount of attention continues to center on Kraft Heinz’s appetite for a deal and where its interests might lie. It was recently rumored that the company had considered bidding for Pinnacle Foods, which was scooped up by narrow-moat Conagra in June, and could be warming to a deal for wide-moat Campbell Soup, which is conducting a strategic review of its operations under interim CEO Keith McLoughlin, who took the helm after former CEO Denise Morrison left abruptly in May.

While it's difficult to ascertain Kraft Heinz’s intentions, our contention has been that the company would favor a partner with outsize exposure to faster-growing emerging markets (where its penetration is not robust, representing a mere 10% of total sales) and where the opportunity to extract meaningful costs persists (in line with the strategic benefits a deal with Unilever stood to offer). As evidenced by its quick decision to abandon its bid for Unilever, we expect Kraft Heinz to steer clear of any potentially hostile tie-ups.

In our view, the addition of Campbell’s business to Kraft Heinz’s mix wouldn’t check these boxes. For one, Campbell’s sales are concentrated in the U.S., with international making up less than one fifth of sales. Further, we don’t believe that Campbell’s Fresh business (10% of sales, where operating margins hover in the high single digits) would afford the opportunity to extract a significant amount of costs (particularly its carrot farming operations). Despite these factors, Campbell’s faster-growing, on-trend snacking segment, which represents around half of its consolidated mix following its tie-up with Snyder’s-Lance earlier this year, could be an avenue for growth and might appeal to Kraft Heinz management. Campbell is a controlled company, though, with the Dorrance family (direct descendants of the man who invented the process by which wet soup is turned into condensed soup) owning about 40% of the outstanding shares and two members of the family on Campbell’s 12-person board. As such, we aren’t convinced that an outright sale of the business is in the cards.