Heinz Retains the Neutral Tag

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We maintain a Neutral recommendation on H. J. Heinz Company (HNZ) following our evaluation of the company’s fiscal third quarter 2012 results.

Heinz’s third-quarter fiscal 2012 adjusted earnings came in at 95 cents per share, beating the Zacks Consensus Estimate of 85 cents and the year-ago figure of 84 cents. The impressive results were driven by higher operating income, lower share count and a lower tax rate. Revenues were up 7.2% to $2.92 billion in the third quarter led by strong growth demonstrated by the emerging markets, products such as ketchup and sauce, as well the top 15 brands.

Overall, we are encouraged by the company’s strong portfolio of brands, especially its top 15 brands, which make up more than 70% of sales and continue to drive growth. Heinz’s major brands are Heinz Ketchup, Ore-Ida frozen potatoes, Weight Watchers Smart Ones frozen dinners, Classico sauces, Jack Daniels barbeque sauces, Quero tomato-based sauces and ketchup, ABC Indonesian sauces, Master soya sauces and TGI Friday's single serve meals . The company’s top 15 brands recorded 5.9% organic sales growth in the third quarter of fiscal 2012, driven by Heinz, Master and ABC. The company is also increasing its marketing spend to push up the performance of its top 15 brands.

The company has a significant presence in India, China and Indonesia. The economic outlook of these fast growing nations is positive given the improving standard of living of the middle class. All these markets are showing good growth in all Heinz products, especially ketchup, sauces and infant nutrition goods due to brisk demand. Management estimates that almost a quarter of the ketchup and sauces business is now in the emerging markets led by ABC, Master and Heinz Ketchup. The company’s heavy investments in the emerging markets are thus paying rich dividends as the largest top-line growth driver.

Heinz has planned to invest in productivity initiatives and reduce fixed costs during fiscal 2012 by increasing manufacturing efficiency, reducing overcapacity and streamlining its operations. Per these initiatives, Heinz plans to exit up to eight factories, establish a European supply chain hub in the Netherlands, and reduce the workforce by around 1000 employees. These initiatives are expected to negatively impact operating income by approximately $215 million in fiscal 2012. This will result in an earnings headwind of $0.50 per share as well as reduce cash flows by $150 million. In addition, the company is also investing in Project Keystone, a multi-year program aimed at increasing Heinz’s competitiveness by improving processes and systems through SAP. Project Keystone is also expected to improve the company’s productivity against an incremental cost of $40 million, or $0.08 cents per share, during fiscal 2012. Though these productivity initiatives will hurt earnings and cash flows in the near term the steps taken would make the company stronger and more competitive in the long haul.

However, we are concerned about the sluggish performance of the core North American businesses, both consumer products and food service since the past few quarters. Volumes have declined in both the segments consistently. If the businesses continue to perform poorly, the top-line might come under pressure. Other than that, commodity inflation has been constricting the company’s margins. In order to mitigate the impact from rising input costs, the company is taking steps like launching smaller-sized packages in the US to bring the products to lower price points, thereby making them affordable to the economically constrained US consumers.

Other than that, the company’s customers are sensitive to macro-economic factors including interest rate hikes, credit availability, unemployment levels, and high household debt levels, which may negatively impact their discretionary spending, and in turn, the company’s growth and profitability. Besides, the Euro-zone crisis has capped overall economic activity with spill-over effects felt in the US too, limiting top-line growth.

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