Kraft Stocks Up on Ingredients for Long-Term Success

Although Kraft Heinz’s KHC share price retreated following the fourth-quarter earnings release, we don’t think there has been a material enough deterioration in the story over the past several months to merit such a pullback. We believe that under the direction of CEO Miguel Patricio, who joined the company in July 2019 from Anheuser-Busch InBev, Kraft Heinz is stocking up on the ingredients necessary for long-term success. It’s pivoting away from blindly rooting out costs in favor of sustainable efficiencies, with the intent to use a portion of savings realized to elevate the standing of its brands.

We attribute some of the market’s disfavor to the delay in when the company intends to convey the details of its strategic direction; it now plans to do so in early May, as opposed to March. However, the premise behind this shift seems reasonable: It affords new U.S. head Carlos Abrams-Rivera, who joined Feb. 3 from Campbell Soup, time to reflect on the tenets of its approach and interject his perspective. We don’t think the extended horizon means that the drive to incite change is on hold.

In the aggregate, we see little in the fourth-quarter results or near-term guidance to warrant a material change in our $50 fair value estimate. The company reported a 2.2% decline in organic sales, a 20-basis-point shortfall in gross margins to 32.2%, and an 80-basis-point erosion in adjusted operating margins to 20.0%, while suggesting that pressure on the sales and profit lines is unlikely to subside in 2020. This was generally in line with our expectations. We’re holding the line on our long-term outlook for 2%-3% annual organic sales growth and operating margins remaining in the low 20s over our 10-year explicit forecast. We believe patient investors should consider stocking up on this no-moat name, which trades more than 45% below our fair value estimate.

On Kraft Heinz’s home turf, where the company derives more than 70% of its annual sales, the challenges were particularly acute, as organic sales fell 2.7%; a 3.1% uptick in prices was more than offset by a 5.8% hit resulting from lower volume and unfavorable mix. Management attributed the sales shortfall to lost distribution (concentrated in its cold cuts and frozen foods) as well as lower promotional spending, which we think signals a focus on driving sustained and profitable sales and share gains. While we don’t expect industry competition to subside anytime soon, we don’t think management is sitting still.

Since taking the helm, Patricio has been forthright regarding the ill effects of past management’s ratcheting back of brand spending, which has lagged peers since the 2015 merger, and pursuing margin gains at any costs. He has prioritized rectifying Kraft Heinz’s tarnished retail relations, meeting with the leaders of the largest U.S. retailers during his first two months as CEO. We think it is taking longer to mend these fences than anticipated, as brick-and-mortar retailers have yet to forget the executional challenges that resulted from the company’s underinvestment. However, we view the emphasis on upping brand spending (both in terms of marketing and product innovation) and capabilities (including category management and e-commerce) favorably and think this investment should aid Kraft Heinz’s sales trajectory and bolster its standing with its retail partners. As such, we continue to expect spending on marketing, research, and development to expand to more than 5% of sales in the aggregate over our 10-year forecast versus less than 5% the last few years.

From a capital-allocation perspective, the company continues to churn out sufficient cash--a double-digit percentage of sales in fiscal 2019, by our estimate. And in a move that was probably contrary to market sentiment, Kraft Heinz held the line on its $0.40 per share quarterly dividend payout (implying a mid-single-digit yield on an annual basis) instead of cutting it for the second consecutive year. We expect the company to increase its dividend at a mid-single-digit clip annually longer term, implying a payout ratio that hovers around 50%. Management emphasized that this decision showcases the confidence the board has in its turnaround strategy as well as its commitment to bolstering shareholder returns, and that it will not jeopardize reinvestments in the business.

Outsize leverage is likely to remain a concern, with debt/adjusted EBITDA still near 5 times at the end of last year. However, we think the company has taken steps over the past several months to enhance its financial flexibility, reducing its leverage by more than $2 billion, putting its pension in an overfunded position, and prefunding its other postretirement benefits, and we think it will maintain these efforts. We continue to believe that acquisitions will take a back seat to getting the house in order.

We expect the revamped strategic agenda will include the pursuit of divestitures as a means to focus resources on the highest-return opportunities while also shoring up the balance sheet. However, we were encouraged that management said it will not be beholden to a pre-established timetable; rather, it will entertain opportunities to slim down only at a fair price, which we view as prudent. Given that he has yet to divulge the results of his business review, Patricio has been reluctant to commit to any specific brands or businesses to part ways with, but we think the company could end up shedding around 5% of its consolidated sales base, not dissimilar from others in the packaged food realm. Based on our estimate of past deals (about 2 times sales, according to data from company filings and PitchBook), such actions could bring in more than $2.5 billion in funds.