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Kraft Heinz: A Warren Buffett Holding Trading Below His Purchase Price

Investment thesis

Investors, at times, presume that every stock owned and embraced by top gurus will likely outperform the broad market each year. This could turn out to be a costly mistake, and the Kraft Heinz Co. (NASDAQ:KHC) is a classic example. According to company filings, Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) owns 26.69% of Kraft Heinz's outstanding shares and is the top investor of the company. The share price, on the other hand, has declined 50% over the last 12 months, and the total return, which takes dividends into account, is a negative 48% in the same period.


The recent transactions of institutions reveal net sales of Kraft Heinz shares, but Berkshire Hathaway has not sold any of its holdings.

Source: Reuters

Despite keeping this investment position steady, Buffett, in an interview with CNBC in June, admitted that he had made a mistake by paying too much for Kraft Heinz.

"I made a mistake in the Kraft purchase in terms of paying too much. It will take time to whittle that down."

There is fear in the market, which could be one of the reasons why the share price has plummeted to record lows. Amidst this fear, there is an opportunity for investors as well. The prospects of the company will likely improve in the next couple of years, and the newly appointed CEO is making some much-needed changes.

Investors can buy Kraft Heinz shares at a bargain to what Buffett paid, and the company is undervalued by at least 15%.

The reasons behind Kraft Heinz's share price decline

The decline of the share price can be attributed to a few adverse developments.

First, the profitability of the company deteriorated in the last 12 months, as evidenced by declining net income to common shareholders and revenue. The primary driver behind the loss of revenue is the changing dietary habits of consumers. There is a global emphasis on living a healthier life, and this has prompted consumers to search for less-processed food. This secular trend is proving to be a difficult-to-manage development for Kraft Heinz.

Revenue growth

Net income growth

Q2 2018

0.80%

-34.94%

Q3 2018

1.56%

-33.26%

Q4 2018

0.95%

-7%

Q1 2019

-5.47%

-59.62%

Q2 2019

-4.25%

-40.45%



Source: Company filings

The problems for the company do not end with lower-than-expected financial performance. The Securities and Exchange Commission probed into the accounting practices of Kraft Heinz in February this year, and the company had to initiate an investigation. In June, the company admitted to filing erroneous financial statements and said that nearly three years of financial reports will be restated to omit these errors. This created panic among investors and triggered a sell-off.

To add to all these problems, the then-CEO Bernardo Hees decided to step down from his position on June 30. Investors did not welcome this news, and analysts were concerned that this was a sign of further trouble ahead for the company. Miguel Patricio, a former Anheuser-Busch InBev (NYSE:BUD) executive, agreed to take the helm to move the company out of trouble.

The company took significant impairment charges to reduce the carrying value of some of its brand names, including the $15.4 billion write-down of Kraft and Oscar Mayer last December. This was not helpful at all, and the company eventually decided in the first half of this year to cut the quarterly dividend from 62 cents to 40 cents.

These ongoing troubles continued to exert pressure on the share price throughout the last 12 months, which resulted in a notable underperformance compared to its peer group.

Kraft Heinz and peers' share price performance in the last 12 months

Source: Reuters

The outlook for Kraft Heinz: silver lines among dark clouds

The debt has declined, and the majority of maturities occur beyond 2040, which leaves the company with enough time to recover its business operations and make sufficient cash to service these repayments.

Source: Reuters

Freeing up money by cutting back on dividends and repaying debt is always the right strategy when a company is constrained for growth, and the management has already taken this bold decision. It's crucial to allocate cash for the best use, and making unpopular decisions with investors might be required to ensure the long-term sustainability of the business.

Kraft Heinz generates sufficient operating cash flow to support interest payments. The $29 billion debt pile of the company would have turned out to be a massive burden if not for the cash-rich nature of the business.

Source: Company filings

There is some insider buying going on as well, which could be an early indication of a turnaround in Kraft Heinz's prospects. The management and top-level executives of public companies have a thorough understanding of the respective companies they represent, often exceeding that of analysts and retail investors. While insider activity is not a stand-alone indicator of the prospects of a company, it's a signal for investors to dig deep into company fundamentals.

Insider transactions history

Source: MarketWatch

Kraft Heinz needs to take a better look at its advertising and marketing budgets as well. In the last two years, the company has reduced its allocation for promotional activities, which might have been a reason for the brand value impairment. The newly appointed CEO shares this view, and in the second-quarter earnings conference call, said that the company will take a fresh look at ways and means to uplift the deteriorating brand value of the company.

Source: Company filings

Kraft Heinz is investing money to support the ongoing expansion of the digital capabilities of the company. For instance, in 2018, the company tripled its headcount in the technology team in a bid to address the demands of a digitizing society, as per data from company filings. These investments could turn out to be a catalyst for the company's growth story in the future.

The appointment of the new CEO can be expected to result in noteworthy changes in the business structure and approach of the company as well. In his first-ever earnings conference call in June, Patricio got straight to the point and addressed many concerns of investors, starting with the importance of innovation. He went on to elaborate that the success of Kraft Heinz in the last 100 years or so has been fixated on introducing new products and keeping customers obsessed with the brand network. This is something the company failed to do in the last two years.

The ongoing and expected changes resulting from this new appointment are discussed below.

Kraft Heinz is divesting unprofitable business operations in an attempt to free up cash that could be allocated toward debt repayments. According to company filings, Kraft Heinz divested two international operations in 2019; India nutritional beverages and Canada natural cheese. These asset sales resulted in $1.5 billion of after-tax proceeds, which would be used for further deleveraging processes.

As noted in the second-quarter earnings call, there were a few reasons behind the deterioration of Ebitda margin from 29.4% in 2017 to 24.5% for the 12 months ended June 30. The major contributors were the inflation in Kraft Heinz's supply chain, including packaging, freight, overtime, maintenance costs and the growth of fixed costs related to sales. On the other hand, price increases have lagged behind these higher expenditures.

The company management revealed several initiatives to combat all these problems and expand margins in the future. These resolutions include onboarding a specialized team of experts to identify supply chain problems, revamping the operations of the business to focus more on productivity instead of cost-cutting, identifying unnecessary operating costs and eliminating these and investing in improving the brand awareness so that the company can charge higher prices for its products in the future.

As one of the first steps of these initiatives, Kraft Heinz will be increasing the prices of its products in the U.S. before the end of this year, which is expected to boost profit margins and revenue as the demand for its products are inelastic.

Overall, the future looks much better for the company in comparison to the last two years. If all these plans are executed, Kraft Heinz's brand value would once again rise, resulting in higher revenue and earnings. It would, however, take time for these initiatives to deliver the promised results. Therefore, investors need to remain patient and not be carried away by short-term fluctuations of the share price.

The safety of Kraft Heinz's high yielding dividend

It's not often that a consumer staple company offers a very high dividend yield. The secular downtrend of the share price has pushed the yield to 5.8% at the market price of around $28 on Monday. The company has the highest dividend yield among its peers.

Source: Reuters

The annual payout ratio of 58.72% is well below the five-year average of close to 70%. The recent dividend cut was primarily responsible for this change. In the next few years, Kraft Heinz should be able to maintain the annual dividend per share at $1.60. However, even if the company is forced to cut back once again, the dividend yield would still be attractive because of the depressed stock price. In any case, another dividend cut would result in a sell-off as well.

Under the assumption that company revenue will stabilize or grow in the next five years, and the expectation for Ebitda margin expansion, the dividend payout is much safer than it was six months ago.

Valuation

Investing in a mature company is not as tricky as picking growth stocks with virtually no proven track record. That said, buying a stable business at the wrong price could end in massive losses. Investors who were bullish on Kraft Heinz back in early 2017 certainly missed this trick.

The price-earnings ratio was well above 30 in mid-2017. Such high earnings multiples are generally associated with fast-growing companies, not consumer staples companies. Over the last 24 months, this ratio has declined steadily, but investors are now more fearful than ever when it should be the other way around.

However, a low price-earnings ratio is not a guaranteed sign of undervaluation. A discounted cash flow model was used to derive the intrinsic value of Kraft Heinz shares.

The below assumptions were used in this model to calculate a value per share that represents a worst-case scenario for the company. All the assumptions used are very conservative.

  1. Revenue to decline 5% in the current fiscal year and remain flat over the forecast period through 2023. Sales will likely grow in low single digits, but zero growth is assumed to ensure a sufficient margin of safety.
  2. Ebitda margin to deteriorate from 24.5% to 23.5%.
  3. Capital expenditures to average 3.4% of revenue.
  4. An average tax rate of 22%.
  5. A cost of capital of 7.6%.
  6. An Ebitda multiple of 12.5 to calculate the terminal value. (the current EBITDA multiple of Kraft Heinz is 10.1, and the sector multiple is 15.8)



Based on these inputs, the intrinsic value per share of Kraft Heinz comes to $32.33, which is 15% higher than the market price of around $28 on Tuesday.

Conclusion

Kraft Heinz is a Buffett holding that has not delivered positive returns in the last two years, which is surprising considering the record-breaking bull run of the current market. Multiple factors contributed to this underperformance, but finally, things are taking a different turn with the appointment of a new CEO. The pessimism about the company's prospects has pushed the shares into undervalued territory, and now is a good time to invest in Kraft Heinz at a much lower price than Buffett did back in 2015. His investment of $16.7 billion to acquire 325.63 million shares translate to a per-share cost of $51. Kraft Heinz is a buy.

Disclosure: I do not own any stocks mentioned in this article.

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This article first appeared on GuruFocus.