- By Dilantha De Silva
Warren Buffett (Trades, Portfolio) is known for investing in companies that go on to deliver double or triple-digit returns to shareholders of Berkshire Hathaway Inc. (NYSE:BRK.A)(NYSE:BRK.B). His investment in The Kraft Heinz Co. (NASDAQ:KHC), however, is widely believed to be one of his worst mistakes. In June 2019, the guru himself even said, "I made a mistake in the Kraft purchase in terms of paying too much. It will take time to whittle that down."
A year ago, I suggested investors should keep a close eye on Kraft Heinz as newly appointed CEO Miguel Patricio was making significant changes to the business model. The stock is up around 10% in the last 12 months and this seems to be just the beginning of many good things to come.
The company is addressing key weaknesses
Kraft Heinz stock plummeted 45% in 2018 and another 25% in 2019 as investors punished the company for three primary reasons.
The accounting scandal in which the company was exposed to reporting an erroneous cost of goods sold.
The company's debt load.
The lack of revenue growth, which was a result of cutting down the marketing budget.
While the company cannot undo the mistakes committed in reporting costs inaccurately, Kraft Heinz has certainly taken the necessary steps to address both of the other concerns. For instance, management is now laser-focused on reducing its debt burden by allocating a higher proportion of free cash flow to debt repayments. Answering a question by an analyst during the third-quarter earnings conference call on Oct. 29, Chief Financial Officer Paulo Basilio said:
"As we said, we have a very strong cash generation this year, and we have paid down pretty much more than $1 billion in debt already. And just to say that we intend to keep paying down debt next year with a strong cash flow that this company here generates."
Kraft Heinz signed a deal in mid-September to sell its U.S. natural cheese business and some other North American cheese brands to Groupe Lactalis. The transaction is expected to close by mid-2021. The cash infusion resulting from this divestiture will be allocated to pay down debt as well, which goes on to establish that the management team has made it a priority to reduce its debt burden.
In a bid to deviate from its unsuccessful stance of cutting the marketing budget, Kraft Heinz decided last year to allocate a higher dollar amount to take its brand name in front of global consumers once again and the results are promising. As data in the table below confirms, the company has performed better than the expectations of Wall Street analysts since the fourth quarter of 2019.
Consensus earnings per share estimate
Actual earnings per share
Source: Company filings and data from Reuters.
The increased spending on advertisements played a major role in achieving this success, and management is ready to set aside even more money to target the right audience that would bring in recurring revenues for the company. During the third-quarter analyst call, President of the Kraft Heinz United States business Carlos Abrams-Rivera said:
"To build our loyal base of consumers and keep this momentum going, we are stepping up our marketing investment by 40% in the second half of this year, compared with the second half last year, and 70% compared with the first half of this year."
The company is arguably late in realizing the importance of maintaining the strength of its brands, but Kraft Heinz is finally moving in the right direction under the guidance of Patricio. The company started 2020 with a new business model. Now that it has made steady progress under the revised model, one could expect 2021 to turn out to be a transformational year in the company's history as progress will likely accelerate. In a news release, Patricio wrote:
"We are building momentum, and we are confidently optimistic about our near-term performance. We are heading into 2021 with our new operating model fully implemented, our platform strategy coming to life in the marketplace, and our growth investments ramping up."
Kraft Heinz is proving to be a turnaround story, but the stock is up a meager 10% over the last 12 months. Once the company fully recovers from its 2018 lows and reports stellar revenue and earnings growth, the share price will head toward the five-year highs of over $90 seen in 2017. Even if the stock converges partially with such highs, investors are bound to realize a handsome return by investing in the company at the market price of around $30 on Oct. 30.
The stay-at-home effect
The majority of the global population is remaining indoors to help curb the spread of the Covid-19 virus, which is proving to be a tailwind for Kraft Heinz as food consumption habits have changed in favor of eating at home, benefitting the company's brands. According to Piper Sandler analyst Michael Lavery, the company has a 15% revenue exposure to restaurants and, hence, is among the few packaged food players that would see the least negative impact of declining revenue in the restaurant industry. In a research note sent to clients in August, Lavery wrote, "Greater food at home trends will drive a sustainable lift at least into 2021, and Kraft Heinz is well-positioned with a largely meal-oriented portfolio with modest food service exposure."
What differentiates Kraft Heinz from other companies that are benefiting from the stay-at-home trend is its valuation. The company is valued at just 11 times earnings for next year, whereas the sector forward price-earnings ratio is close to 20, according to data from Reuters. The share price, however, will likely converge with the sector median in the coming months as Kraft Heinz gains momentum, both in the market and from a financial perspective.
Buffett's decision to invest in Kraft Heinz might have come at the wrong time, but the company has certainly lived up to its expectations so far this year. In addition to beating earnings estimates set by analysts, the company has aggressively repaid its debt in a bid to strengthen the balance sheet. Multiple catalysts are helping the company to thrive, and the share price will likely head higher along with the expected improvement in financial performance.
Income-oriented investors might find the stock attractive considering the dividend yield of over 5% at the market price of around $30 on Oct. 30. There is positive momentum when it comes to free cash flow generation as well, which is a welcome sign for dividend investors.
Disclosure: I do not own any stocks mentioned in this article.
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This article first appeared on GuruFocus.