Kraft Heinz (KHC) shares suffered a complete collapse when they announced their fourth quarter results last Thursday, for good reason. In almost all indicators, operating results were poor, reaffirming the changing tastes of consumers around the world. The first shortfall is in earnings, where adjusted EPS of US $ 0.84 has already lowered earnings estimates by 11 percent and was down nearly 7 percent from the same quarter of last year, while he posted a profit of 0.90 USD per share. Sales also missed estimates, reaching $ 6.89 billion against $ 6.93 billion. These figures were disappointing, but they were only the beginning of the problems of the company.
The biggest problem was a huge $ 15.4 billion charge on the goodwill of some of its most iconic companies, including the Kraft and Oscar Mayer brands. Investors have clearly understood for some time that because of the transformation of the consumption of packaged products instead of healthier and more natural alternatives, the value of these assets is much lower than before. In one fell swoop, management has admitted this change. But the excuse that they provided is mind-boggling. David Knopf, CFO, explains the reasoning behind this massive depreciation.
To be clear, by far and away, most of the depreciation … was … driven by the performance of the second half and the new level of profitability and margin we are talking about compared to what it was previously . So, the profile of the margin and what we established in the second half were really the main factor behind the degradation. "
Source: Kraft Heinz Fourth Quarter Earnings Conference Call
What he says here is that recent developments in the second half of 2018 alone have led to a decline in the value of these companies. That's why a $ 15.4 billion charge was needed to readjust their value. Not very logical, is it? As JPMorgan's Kenneth Goldman's call rightly pointed out, companies generally do not make significant write-downs because of short-term performance or market fluctuations. It is often a very methodical process, especially considering the magnitude of this loss. Kraft's write-down is the second-largest among all companies in the past year, unlike General Electric's $ 22 billion write-down this past October. In addition, the US consumer goods sector is not known to suffer many losses in value. The valuation firm Duff & Phelps said that between 2013 and 2017, there had been 88 writedowns in the sector, for a total of $ 9.6 billion only. The fees charged by Kraft to its consumer brands are approximately $ 7.3 billion, which is more than the entire industry in the last three years combined.
To add to the situation, management announced in its earnings report that the SEC had initiated an investigation into its accounting practices. As a result, Kraft said it opened an internal investigation and discovered a $ 25 million accounting error. At this point, it is difficult to know whether there is an isolated incident or part of a larger problem affecting the company. Only time will tell. In the meantime, the company appears to be cooperating fully with the regulators and continues to insist that any mistakes made would not have a material impact on previous financial results.
All of these problems have led to a massive wave of analyst demotion and a reduction in price targets from $ 70 to about $ 40. As if all this was not enough, the decline in earnings led Kraft to reduce its dividend by 36% to $ 0.40 per quarter.
Without a doubt, Kraft Heinz is struggling. When the company was founded by Warren Buffett's (NYSE: BRK.A) 3G and Berkshire Hathaway (BRK.B) in 2015, it should be the perfect type of boring and reliable business that can bring value to investors by reducing the costs around. However, almost 4 years later, it is clear that the company has significantly overestimated the potential savings and synergies. And the savings realized were at the expense of the value of its brands, many of which have experienced difficulties due to changing consumer trends. But the recent collapse of equities has also created an opportunity for investors. Regardless of the evolution of short-term tastes, Kraft Heinz's portfolio of iconic American brands remains strong and their leading position in the marketplace will not be easily erased. In the following sections, I will explain in detail why the exaggerated fears have made KHC a good choice for those looking for long-term value investments.
Major brands renew with growth
Sales barely missed expectations in the fourth quarter, but were significantly higher than in previous quarters. In fact, total product volume increased by 4% and organic sales by more than 5% in all geographic areas except the United States, where sales increased by 1.1%. These figures represent a major improvement over the third quarter where, for comparison, sales in Europe grew organically by only 0.6% and sales in Canada actually decreased by 1.4% .
Unfortunately, sales growth has been largely overshadowed by rising costs. The current inflationary environment has resulted in more expensive raw materials and manufacturing, and the severe shortage of US truckers has also made logistics more expensive and complex. Previously, management expected to overcome these additional costs by realizing savings elsewhere in its supply chain. But by their own admission, this quarter, they have significantly overestimated the effect and magnitude of these savings measures.
Prices have also been a negative drag on society. The continued emergence of private label products, or store brands, that rival many of Kraft Heinz's products is a constant trend in grocery stores. In recent times, competition has become fierce and the company has been forced to lower its prices in order to reduce its price gap and remain competitive with other products in the same range. This problem has been most important in international markets, but has also had a significant impact on the domestic market.
Higher input costs and downward pressure on prices have limited the ability of KHC brands to express and offer their true value. However, significant progress has been made over the last year, which seems to be turning this ship into a free fall. In contrast to the investment thesis of 3G, Kraft has increased its spending on marketing and branding, which has fueled the resurgence of many traditional brands. Products such as Kraft Mac & Cheese hot dogs and Oscar Mayer have gone from a steady decline in sales to single-digit growth in 2018. Even distressed products such as Kraft salad dressings have seen sales and share market stabilize after Kraft has invested its capital in R & D to grow. more creative products, such as their new portable pouch design for salad dressing.
Prices for all products should also stabilize and become positive in 2019 worldwide. Following the price cuts last year, it seems that the company has found the optimal prices for its products. While private labels should remain under pressure, if the price is relatively similar, the brand will win most of the time the battle to gain space in the customer's basket. The strong recognition and reputation of the Kraft brand gives it the boost it desperately needs.
Kraft has undoubtedly faced many challenges in 2018. Nevertheless, it has nevertheless been able to generate volume-led sales growth in all segments of the market. In the future, he is well positioned to succeed and continue the recovery he has achieved. But this time, prices will no longer be a negative drag but will become positive and will better capitalize on the higher volume of products sold. The higher costs will continue to affect Kraft, but it is an inevitable problem that affects all businesses in this operating environment.
Solid portfolio of popular brands
As mentioned many times, the evolution of consumer tastes has hurt Kraft Heinz since their merger in 2015 and probably also before. Like many of its competitors, such as General Mills (GIS) and PepsiCo (PEP), they have seen consumption move away from packaged foods to more natural and healthier alternatives. People do not want to buy fat and fat vinaigrette, but rather the new light and organic vinaigrette. Finally, Kraft seems to be aware of this and is taking steps to better adapt to it in the future. They can not continue with the 3G mantra on reduction costs, as this is done at the expense of less valuable brands, which is evident with the $ 15 billion write-down. One of the reasons why sales of many products have resumed growth in 2018 is that the company finally understands that, to create value, it must reinvest capital in its brands. He has become more willing to spend money on marketing as well as on research and development of new products in order to innovate and meet the needs of consumers. These efforts have already paid off with products such as Just Crack an Egg, a quick and easy line of breakfast products, and Food Network Kitchen Inspirations, a line of lunch kits and sauces.
Investing in one's own brands is perhaps the most profitable and sustainable way for Kraft to grow in the future. Many have indicated that a voluminous acquisition was a quick fix, but they forget that the initial merger is one of the main reasons why the company faces many challenges today. ; hui. Its investments in itself are already bearing fruit. After launching Just Crack an Egg about a year ago, the brand has already become a $ 50 million brand with a strong growth trajectory yet to come. Other products, such as P3 protein packages, have been even more successful. After being launched in 2014 under the Oscar Mayer brand, these meat, cheese and nut packages have become a $ 120 million mark. They have recently announced the creation of a partnership with UFC to become the "official protein snack" of the organization. This new marketing campaign will bring this relatively new product to a large and targeted audience and become a catalyst for future growth.
Kraft Heinz learns from its mistakes caused by its inability to invest properly in its brands. It must continue to make progress and leverage the strength of its iconic businesses to take advantage of new opportunities. In this new era, a business just can not stand still and sell. the direction knows it. It must act openly to promote and develop its products and take the time to build relationships with different customers. This is the only way to achieve long-term sustainable growth.
The assessment is too attractive
The recent collapse of KHC shares is certainly well deserved, but it has also created an opportunity for investors. The company is forecasting earnings of between $ 6.3 billion and $ 6.5 billion in 2019, and with the current market capitalization of about $ 40 billion, this translates into a futures PE of 6.25. Such a multiple is more than justified for a company that, despite facing the recent challenges, is not one without a future. 2019 will be another difficult transition year, but after that, the company, as noted above, is well positioned to succeed.
One of the main problems of the company is its considerable financial burden. This is a reasonable concern given that long-term debt has risen to nearly $ 31 billion by the end of 2018. While it is a result of considerable amount, the company is actively working to reduce this burden. The most obvious example is the recent dividend reduction from $ 2.50 a year to $ 1.60 or $ 0.40 a quarter. Such a measure makes sense because with the down payment the yield would be above 7.5%. The new dividend still yields nearly 5% for investors, more than just. During this process, Kraft will save about $ 1.1 billion a year and can then strengthen its heavy balance sheet. The other solution envisioned by the company is the sale of assets. In the past year, it has already announced the sale of all of its Indian operations to Zydus for $ 625 million, as well as its natural cheese business in Canada to Parmalat for $ 1.23 billion. Management has also planned other divestments. A few days ago, Kraft plans to sell Maxwell House, the second largest coffee brand in America. If sold, it could yield more than $ 3 billion or more.
These divestments are not only aimed at achieving its 3x leverage goal, but also represent a way for the company to refocus on its key areas of growth. Some companies, such as its operations in India, provide little or no strategic value to society, apart from a limited increase in profits. By selling these areas "without a clear path to a competitive advantage", Kraft is better able to focus its energy and resources on more valuable and performing assets. These sales will certainly result in a dilution of profits, but it is worth it if the company can better capitalize on its best performing areas.
Kraft Heinz is a perfect illustration of the fact that cost reduction is not always the right solution. Since its merger, 3G has brutally damaged the company's value brands by refusing to allow adequate reinvestment, innovation and marketing. But management has learned its lesson and is now taking active steps to reverse the course of the business: and it works. Sales of its troubled flagship brands began to take a decisive turn and many began to show sales growth rather than decline. This sales growth occurred despite private label price pressures, which the Company does not expect to continue this year. Even with positive pricing capabilities, 2019 will be a year of transition for the company, which is looking to quickly deleverage its balance sheet and make the necessary investments that have been lacking for years. But now, for investors, there is a clear path to future growth. As everyone fears for Kraft Heinz, the time has come to buy.
Disclosure: I / we have no position on the actions mentioned, but I could initiate a long position on KHC over the next 72 hours. I have written this article myself and it expresses my own opinions. I do not receive compensation for this (other than Seeking Alpha). I do not have any business relationship with a company whose actions are mentioned in this article.