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Kraft-Heinz (KHC): Buy The Dip?

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Kraft-Heinz is a company that most consumers should be familiar with. Many diners carry the all-time favorite Heinz ketchup, and even more grocery stores and supermarkets carry Kraft’s brands of foods such as (yes) Kraft cheeses/spreads, Velveeta, Jell-O and Kool-Aid. All ubiquitous household names.

While this food conglomerate has been a market leader in the aisles for many years, it seems its sales (and growth) had hit some sort of plateau and investors are logically worried about the future runway for the company.

Its recent slew of announcements sent the already-declining stock price at least 25% down yesterday. These announcements included a Q4 net loss, a dividend cut, writedown on intangible assets and an SEC subpoena.

Let us tackle each one of them rationally, and see whether the price drop makes sense.


Kraft-Heinz Subpoena: A Permanent Ketchup Stain or Can It Be Cleaned? + Q4 Earnings Shortsightedness

The SEC has investigated KHC for its Zero-Based Budgeting (ZBB) procurement accounting.

ZBB, as contrasted to the more common incremental budgeting or activity-based budgeting, works by starting all departments’ budgets from scratch each FY or quarter. Each expenditure has to be justified, which in the case of 3G, works because it keeps cost structures lean and improves operational efficiency.

The downside of ZBB is that it “rewards short-term thinking”, according to Investopedia. Expenditures such as R&D generally get neglected because they are not directly tied to revenue. However, considering 3G’s involvement with Buffett and their ideals in “long-term value creation” (from website), I do not see this investigation as a major issue for KHC at all.

Nonetheless, the investigation prompted KHC to incur an additional $25M COGS, contributing to the Q4 net loss.

However, as the company states, “[we do] not expect this [investigation] to be material to financial statements for this period or previous ones.”

Misguided by Dividends

Most investors are taught to see dividends (and dividend increases) as a good thing – while a dividend cut a bad thing.

In reality, dividends and payout ratios don’t tell investors anything about the financial health of a company. It tells more about the management – and how well they are at capital allocation. In this instance, KHC’s management made a necessary (but wise) move to cut back on dividends in their goal of cost-cutting and paying down debt.

Sluggish Sales Woes

KHC’s management understands its own situation far better than any analyst or investor could have – it isn’t oblivious to the pressures it has on increasing sales (or having a revamp/reinvigoration of its business growth strategy). However, it also understands the power of its intangible assets very well. Despite sluggish sales, its margins have not been suffering.

While brand value has not eroded, investors are still concerned about the future of KHC. That is uncertain – as with any company’s future.

Instead of brooding about the future of KHC, let’s objectively look at what could happen with a high likelihood based on historical data. The Motley Fool did an insightful take on just that in 2017. Buffett’s Berkshire Hathaway and 3G Capital both own over 50% of KHC, giving them executive powers in managing the direction of the company. According to the Motley Fool, 3G has a “playbook” set of decisions it makes with its invested companies. They would aim to cut costs dramatically (which include using a special set of accounting rules called Zero-Based Budgeting ZBB). After it has done that successfully, it looks to drive up the revenue side by acquiring yet another company. The M.O. of 3G is essentially… cut-and-stack.

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So far, KHC has been cutting costs successfully (see cost savings below) and has had an (failed) attempt at acquiring Unilever.

Source: Financial Times 2017 (“The lean and mean approach of 3G Capital”)

Looking at the financials, KHC’s horsepower is still strong after having suffered a FCF outflow due to penalties in the failed acquisition.

Looking at KHC from this perspective, there is little to worry about the company’s future. 3G will most likely buy time (and build up more horsepower) to launch KHC into another acquisition again – even if that doesn’t happen in the near future, KHC still has its strong moat of intangible assets and sustaining margins to keep it at the dominant position for many years to come.

Write-off A Sign of Weakening Brand Power?

Having mentioned that the sustainability of KHC is largely dependent on its intangible assets (brands), the recent announcement of the write-down of $15.4B worth of goodwill of Kraft and Oscar Mayer came as a shock to investors.

Touted as “one of the largest write-downs in corporate history”, the write-down caused worried investors to dump shares. Rightfully so, as this write-down was not considered in its routine impairment tests which was already announced in Q3’s results – and it had also suffered some impairment charges.

To tackle the goodwill impairment problem, we need to consider what the father of value investing, Benjamin Graham, says about goodwill:

“The writing down of good-will does not mean that it is actually worth less than before, but only that the management has decided to be more conservative in its accounting policy.

The Interpretation of Financial Statements, Benjamin Graham

He continues by saying,

“In most cases the writing off of good-will takes place after the company‚Äôs position has improved. But this means that the good-will is in fact considerably more valuable than it was at the beginning”

The Interpretation of Financial Statements, Benjamin Graham

This is befuddling – because on one hand, the financials tell us that over the last few years after its merger, its margins have improved (sales have also leaped up in a step-like fashion and sustained in the last year, too). On the other hand, there is this constant market rumble about how KHC is not investing in its brands, causing a loss of brand equity and price power. Moreover, consumers’ tastes have been shifting toward healthier food options instead of prepackaged frozen foods – explaining the sluggish demand for its products.

We thus need to see whether these claims hold water…

The (Over)hype of Changing Consumer Tastes?

For quite a few years now, analysts have been commenting on the growth in healthier options of foods. While that is a recurring trend, we tend to lambast the other side – ie. the death of “regular” foods.

The gloom over regular consumer products in favor of the all-healthy trend is quite possibly overstated. I’ve done some market research and found that consumer packaged goods (or CPG) is not going anywhere. Growth is still expected till 2020, however, it just may not be as exciting as the growth numbers for the health food trend.

For KHC, sales mainly come from two segments – the condiments & sauces; and its cheese & dairy segments.

Similarly, my research shows that although growth may not be fantastic, revenues and sales volumes aren’t in the doom scenario of falling YOY.

Furthermore, the threat of online channels like Amazon is overstated. According to Statista, online channels like Amazon (and Whole Foods) barely affect grocery stores and supermarkets in terms of specifically KHC’s top 2 segments.

On the subject of health trends once again, KHC has launched Springboard, a brand incubator that focuses on researching new products and brands for growth.

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Now according to other sources, Springboard does not seem to provide KHC with competitive advantages as other competitors have similar brand incubators that started earlier on.

However, I beg to differ. A couple of years’ difference will not make much difference in the larger context of a trend of “changing consumer tastes”. In fact, Springboard can learn from the failures of the competing incubators so that they can minimize R&D costs in creating successful brands for KHC.

Furthermore, according to Statista, the US did a census on American cheese in 2018 and it showed that a disproportionate amount of Americans still consume Regular cheese. That is 207 million Americans out of 330 million Americans surveyed!

So, while the health-food trend is just beginning, the “regular” foods have been around forever and they’re not going anywhere.

Regarding brand equity erosion, let us again look at some 2018 research from Statista.

Again, US census showed that a whopping 195 million Americans out of 330m consume Heinz ketchup the most often. It beats Hunt’s from ConAgra by a fair margin, and then some.

How about Cheeses?

Specifically on sliced American cheese, Kraft Singles also dominates by a fair margin. If you look further, Kraft also takes the 3rd place and more in the list.

As you can see, the KHC brands still take up a good portion of the consumer mind and awareness. Although some might argue that such brands can be commoditized and consumers can easily switch to another product, the familiarity and ubiquity (of KHC’s multiple brands) is hard to ignore, especially for the busy consumer who has no time to prepare their own meals and would simply pick the familiar Singles for breakfast, and Lunchables for their kids to bring to school.

The Bottom Line

While there is still much to be concerned about with regard to the uncertainty surrounding KHC, investors should look at the long-shot of KHC.

It’s intangible assets, the economies of scale, the lean cost structure, the big-picture decision framework by 3G and Buffett… all conspire to make KHC the giant it is today. Think about it, there definitely is a reason why these two decade-old companies have survived for years…

Regarding management, it has been a number of transitions since the 1800s, with Bernardo Hees as current CEO. With a focus on delivering good margins and ROCs, I say that the management is doing fairly well.

Regarding valuation, we see that historically since 2015, Book Value per share of KHC hovers at $47. As at Feb 22, BVPS stands at $42.6. At a current price of $34.95, this gives us a P/B of 0.82.

In 2017, KHC’s P/E is around 8.7 times (using diluted EPS) and 22 times (using adjusted EPS). As at Feb 22, P/E is around 4.1 times (using 2017’s diluted EPS) 9.9 times (using adjusted EPS, with impairment backed out).

With such irrationally discounted valuations, KHC is an attractive buy at this dip.

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