EUR 850.00 For Business Accounts Only

Morningstar | Due to Ineffective Capital Allocation, We No Longer Believe Kraft Heinz Brews Up a Competitive Edge

Following the merger of Kraft Heinz, we had surmised the combined business stood to tout a competitive advantage stemming from both intangible assets and a cost edge. However, we no longer believe that to be the case and now assign it no moat. In support of our thinking, Kraft Heinz has chalked up paltry returns (amounting to just a mid-single-digit level on average the past three years--including goodwill--lagging our 7% weighted average cost of capital estimate), which we think reflect management’s decision to prioritize near-term cash flow at the expense of protecting its long-term competitive position. And as such, we have also lowered our stewardship rating to Poor from Standard.

The crux of its strategy since 2015 has centered on eliminating substantial costs from its operations, boasting operating margins that tower above peers (mid-20s versus mid- to high-teens). However, we attribute its outsize level of profits partly due to the failure to allocate sufficient resources to support its brand (with research, development, and marketing spend amounting to just 2%-3% of sales, which pales in comparison to the mid- to high-single-digits other industry foes expend) as opposed to evidencing a scale edge. Beyond hindering its sales trajectory and share potential, this has also eroded the firm's retail relationships. In this context, Kraft Heinz lost distribution of Planters (one of its eight brands that generates more than $1 billion in annual sales) through the domestic club channel earlier in 2017, which contributed to a nearly 2% volume shortfall in the fourth quarter in the U.S.

As a result, we’ve trimmed our fair value estimate to $62, from $66, to reflect a more limited horizon over which we project the firm is poised to generate excess returns (to 10 years from 15). However, we haven’t altered our long-term outlook, which continues to call for 2%-3% annual sales growth and operating margins hovering in the mid-20s (consistent with the past two years).

Further, we portend the pricing power of its brand intangible asset is continuing to erode, and as such, lowered our moat trend rating for Kraft Heinz to negative, from stable. In this context, Kraft Heinz volumes have eroded around 2% on average over the past three years on its home turf (where it derives around 70% of its total sales), despite price holding about flat over the same time horizon. And on a consolidated basis, we estimate Kraft Heinz’s price/mix, adjusted for inflation, has amounted to around negative 2% during the past four years on average, among the weakest performance within the packaged-food peer set. These pressures are compounded by the fact that Kraft Heinz derives around one third of its consolidated sales from the packaged meat and cheese aisle, where consumers tend to consider price rather than brand when making purchase decisions.

However, we don’t ascribe to the belief that merely ratcheting up its brand-related investments will bolster returns or work to defend its intangible assets from intensifying competition (especially as penetration of the online channel serves to level the playing field with smaller, niche packaged food firms). As such, real pricing power could remain elusive as competition in center-store categories fails to abate.