EUR 850.00 For Business Accounts Only

Morningstar | Kraft Heinz Ends the Year on a Sour Note, But Shares Still Look Undervalued

While no-moat Kraft Heinz boasted its second-consecutive period of more than 2% organic sales growth (an about-face for a firm that has struggled to string together much in the way of top-line gains since the businesses merged four years ago) in the last quarter of 2018, this was overshadowed by a rash of unfavorable headlines surrounding profit contraction, an SEC investigation into its procurement accounting, and a reduction in its quarterly dividend to $0.40 per share from $0.625. The combination of this news sent shares tumbling at a high-teens clip in after-hours trading.

In the quarter, adjusted operating margins contracted 440 basis points to 21.1%, partly due to a 260-basis-point erosion in gross margins to 32.4% as manufacturing and transportation cost inflation remained elevated (and failed to be offset by cost saves). Although this pressure is likely to persist, we view the firm’s emphasis on ratcheting up spend behind its brands (both in terms of marketing and product innovation) and capabilities (including category management and e-commerce) favorably. More specifically, research, development, and marketing spending at Kraft Heinz has hovered in the low-single digits of sales the past few years--lagging the mid- to high single digits peers expend--but we expect investments will expand to a mid-single-digit range annually over our 10-year forecast.

In light of profit headwinds, we intend to edge down our $60 fair value estimate by a mid-single-digit rate, but still view shares as undervalued given the pronounced pullback the last few months. From our vantage point, Kraft Heinz’s concern on delivering outsize margins (in the mid-20s versus the mid to high-teens peers chalk up) has been to the detriment of its competitive position, impairing not only its top-line trajectory (as sales amounted to $26.3 billion in 2018, which is down from $27.4 billion the year the tie-up was inked) but also its retailer relationships.

As evidence of its eroding competitive position, the firm incurred a $15 billion goodwill impairment write-down in the fourth quarter, particularly stemming from its Canadian retail business, its Oscar Meyer cold cut line, and its Kraft natural cheese mix. While we attribute a portion of this to the firm's tepid brand investments, we also surmise that lagging category dynamics are contributing to the recent demise.

However, building on the previously announced sales of three Indian brands and its natural cheese business in Canada (for around $1.8 billion in the aggregate), management expressed heightened interest in parting ways with less profitable, noncore brands and businesses (without quantifying the percentage of sales it targets stripping from its operations or what it might shed). We view these efforts as a favorable means by which to focus its resources (both financial and personnel) on the highest return opportunities. Further, the firm seems intent on reducing its debt load with the proceeds from these initiatives, which we perceive as prudent given debt/adjusted EBITDA stood at 4.4 times at the end of 2018. When combination with the reduction in the firm’s dividend, management aims for leverage to approach 3 times over the next few years (which strikes us as reasonable).

Management suggested these efforts could better position the firm to remain a consolidator in the space (following its thwarted bid for Unilever just two years ago). While it is far from clear where its intentions lie, we surmise Kraft Heinz could ultimately opt for a partner with outsize exposure to faster-growing emerging markets (where its penetration is not robust, representing just more than 10% of total sales) and the opportunity to extract meaningful costs persists (in line with the strategic benefits a deal with Unilever stood to offer). However, we don’t expect Kraft Heinz will opt for a hostile tie-up, as evidenced by its prompt decision to abandon its pursuit of Unilever.

As it relates to the ongoing SEC investigation, management attributes this to issues related to its procurement accounting (including vendor agreements). After an internal investigation, Kraft Heinz reversed previously recorded savings of $25 million in the fourth quarter. Despite this, it doesn’t appear to be a pervasive issue, given the small size, relative to its cost base of $12 billion spent annually excluding key commodities.