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Morningstar | No-Moat Kraft Heinz's Languishing Sales and Profits Leave Bitter Taste; Shares Offer Modest Upside

Sustained sales growth has proved elusive for no-moat Kraft Heinz in the past three years, as the firm's strategic agenda has centered on eliminating substantial costs from its operations, resulting in operating margins that have consistently towered above peers (mid-20s versus mid- to high teens). However, third-quarter results failed to hit the mark on profits, with adjusted operating margins eroding 480 basis points to 21.4%, reflecting commodity and transportation cost inflation as well as increased investments to support its brands, all of which management has suggested will be temporary.

Although organic sales growth edged up 2.6%, we think this performance is evidence that Kraft Heinz has failed to build much in the way of pricing power; prices slipped 0.9% on a consolidated basis, which ate into the 3.5% benefit from higher volume and favorable mix. The need for increased promotional spending was even more pronounced on the company's home turf (70% of sales), where organic sales ticked up 1.8%, reflecting a 3.8% bump in volume that was partially offset by a 2% pullback in prices. This runs in contrast to other consumer product companies, which have suggested the need to raise prices to offset the uptick in commodity and transportation cost inflation.

We are likely to shave a low-single-digit percentage off our $62 fair value estimate as results through the first nine months are lagging our full-year forecast for 30 basis points of operating margin improvement to 26.4%. However, we don’t expect to alter our long-term outlook of 2%-3% annual sales growth and operating margins hovering in the mid-20s. After a high-single-digit drop in price in after-hours trading (which we think reflects the market’s previous outsize long-run margin outlook), the stock now strikes us as mildly undervalued.

While past rhetoric had suggested management maintained an appetite to up brand spending to support its competitive prowess (both with its retail partners and end consumers), we think this runs in contrast to more recent references that current levels of elevated spending are unlikely to persist longer term. As such, we aren’t confident that management is willing to sacrifice margin over the longer term to carve out a competitive edge. Research, development, and marketing spending at Kraft Heinz has amounted to just 2%-3% of sales over the past few years, which pales in comparison with the mid- to high single digits other industry foes expend. Beyond hindering its sales trajectory and market share potential, this has eroded the firm's retail relationships. For example, 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 in 2017, which contributed to a nearly 2% volume shortfall in the fourth quarter in the United States.