KHC - Kraft Heinz Co.

[Okonomen]

There are some strategic problems with KHC and its moat:

 

1) The number of competing brands - private label from discounters etc - is increasing, thus giving multiple alternatives to Heinz

2) A big challenge for a big brand company like Heinz is to sustain its brand power and value through generations. A man aged 50 today is probably more inclined to use Heinz like always, while his son has grown up with Heinz, brand B, brand C not to mention all the cheap private label products at discounters or the like

 

These factors puts a pressure on price and erodes some of the moat, i.e. others are stealing some of the profits which drives down ROIC

[Contra123]

CPB or other M&A is a dubious reason to own KHC, in my view.

Those kinds of synergy/bootstrapping-led stories are more attractive when they are at much earlier stages (eg back at the Heinz stage, or even earlier), not when it’s a $50B+ company IMO. Everything follows a cycle. These types of companies are put together and taken apart, over and over again. Say they improve their cash conversion and margins massively and do $5 billion in unlevered cash flow (against a total EV capital stack of $100B; current unlevered FCF closer to maybe $3B) - then what? Is that attractive?

 

Why play this hand, especially when cash-conversion is currently rather atrocious and the business is close to generating zero equity cash flows (especially if there’s a further unexpected bump in operations or industrywide)? Of all the things out there (including other fine ideas on this forum), why own this?

 

 

[vince]

CPB or other M&A is a dubious reason to own KHC, in my view.

Those kinds of synergy/bootstrapping-led stories are more attractive when they are at much earlier stages (eg back at the Heinz stage, or even earlier), not when it’s a $50B+ company IMO. Everything follows a cycle. These types of companies are put together and taken apart, over and over again. Say they improve their cash conversion and margins massively and do $5 billion in unlevered cash flow (against a total EV capital stack of $100B; current unlevered FCF closer to maybe $3B) - then what? Is that attractive?

 

Why play this hand, especially when cash-conversion is currently rather atrocious and the business is close to generating zero equity cash flows (especially if there’s a further unexpected bump in operations or industrywide)? Of all the things out there (including other fine ideas on this forum), why own this?

 

U own this because 3G has proven over and over again that they create enormous value over time.  You get to partner with the best operators.  A very high probability that returns will be at least reasonably good at these prices

[Viking]

The consumer brand model (for food companies) has been hurting for many years. The big challenge is distribution. In the past, the large multinational companies largely  controlled the distribution channel. This gave them enormous pricing power and this drove profitability.

 

This is no longer the case. Distribution power has changed in two important ways:

1.) retailers (Walmart, Costco, Krogers etc) have much more power today and as a result have been growing their own store brands at the expense of national brands; this trend is long term.

2.) the internet (Amazon prime) is allowing consumers more choice. You go to a retail store you have to buy one of the few brands they sell (their own brand or one or two national brands). Online you can pretty much buy whatever you want. It is also easier for small companies to sell online, bypass the retailer and make a go of it by targeting a niche.

 

Kraft/Heinz may do ok by buying perennial underachievers like Kraft and Campbells and cutting costs to the bone (firing their managment teams and cutting back on R&D and marketing). This works when you are small or just getting started. Having access to cheap money also helps. Does it work when you are a massive size? And when debt is getting more expensive?

 

Perhaps another opportunity is to get large enough that you can wrestle control back from the retailers. I do not see it happening.

 

Bottom line is this sector is ugly. Hard to see how things get much better. Lots of downside risks and not many upside opportunities. Not a great formula for a long term investment.

[Contra123]

Ignore 3G, Buffett or any part of the ‘story’ for a minute, and look at the financial statements in isolation, and you might feel different. These are great operators, there is no denying it, but I am not yet aware of any operator who has managed to conquer the cycle. The cycle gets everyone in the end.

[Contra123]

The consumer brand model (for food companies) has been hurting for many years. The big challenge is distribution. In the past, the large multinational companies largely  controlled the distribution channel. This gave them enormous pricing power and this drove profitability.

 

This is no longer the case. Distribution power has changed in two important ways:

1.) retailers (Walmart, Costco, Krogers etc) have much more power today and as a result have been growing their own store brands at the expense of national brands; this trend is long term.

2.) the internet (Amazon prime) is allowing consumers more choice. You go to a retail store you have to buy one of the few brands they sell (their own brand or one or two national brands). Online you can pretty much buy whatever you want. It is also easier for small companies to sell online, bypass the retailer and make a go of it by targeting a niche.

 

Kraft/Heinz may do ok by buying perennial underachievers like Kraft and Campbells and cutting costs to the bone (firing their managment teams and cutting back on R&D and marketing). This works when you are small or just getting started. Having access to cheap money also helps. Does it work when you are a massive size? And when debt is getting more expensive?

 

Perhaps another opportunity is to get large enough that you can wrestle control back from the retailers. I do not see it happening.

 

Bottom line is this sector is ugly. Hard to see how things get much better. Lots of downside risks and not many upside opportunities. Not a great formula for a long term investment.

 

I concur, but there is a stage and price for everything. The price here ($70B mcap, $30B net debt, $3ish B LTM FCF) is wrong, IMO. The stage of the cycle is also wrong (again, just my 2c). If this was a considerably smaller company (where a greater fool could overpay for a takeout, rather than vice versa), at an earlier stage of a rollup, and cheaper to boot, that would be... something. It is what it is.

[RadMan24]

There are some strategic problems with KHC and its moat:

 

1) The number of competing brands - private label from discounters etc - is increasing, thus giving multiple alternatives to Heinz

2) A big challenge for a big brand company like Heinz is to sustain its brand power and value through generations. A man aged 50 today is probably more inclined to use Heinz like always, while his son has grown up with Heinz, brand B, brand C not to mention all the cheap private label products at discounters or the like

 

These factors puts a pressure on price and erodes some of the moat, i.e. others are stealing some of the profits which drives down ROIC

 

1.In an inflationary cost environment, KHC can hold prices better than private label, and close the "value gap"

2. Heinz has grown 5% annually since 2015

[petec]

I was a bit upset about 3Gs recent sale.  3G was supposed to be long term investors. Selling is not a good sign.

 

https://www.cnbc.com/2018/08/08/kraft-heinz-shares-fall-after-3g-capital-trims-stake.html

 

As discussed above that article might be misleadingly phrased. Bloomberg reported it as a sale by unaffiliated co-investors, not 3G.

[petec]

Lots of good points raised here. Certainly this sector is more challenged than it was by private label (although trends there very much depend on the category) and by the internet making distribution and marketing easier for smaller brands.

 

But,

a) these companies are in the early stages of learning to respond to this threat. There is no particular reason why they must fail.

b) same goes for trends towards healthy foods.

c) there is still huge long term growth to go for in the developing world.

 

I see no real reason why these companies can't grow volumes 1% a year while keeping up with inflation via price increases and efficiency gains and converting 90% of earnings to FCF. At 15x that means you're getting a 7% real return for a very long time, and in Kraft's case you also have best in class management which means deal optionality is on your side.

 

Not the most compelling thing in the market by a long shot but I have a corner of my portfolio for boring inflation-linked cash streams like this.

 

[Viking]

Lots of good points raised here. Certainly this sector is more challenged than it was by private label (although trends there very much depend on the category) and by the internet making distribution and marketing easier for smaller brands.

 

But,

a) these companies are in the early stages of learning to respond to this threat. There is no particular reason why they must fail.

b) same goes for trends towards healthy foods.

c) there is still huge long term growth to go for in the developing world.

 

I see no real reason why these companies can't grow volumes 1% a year while keeping up with inflation via price increases and efficiency gains and converting 90% of earnings to FCF. At 15x that means you're getting a 7% real return for a very long time, and in Kraft's case you also have best in class management which means deal optionality is on your side.

 

Not the most compelling thing in the market by a long shot but I have a corner of my portfolio for boring inflation-linked cash streams like this.

 

Petec, i think the moat for the national brands companies have been growth starved for 10-15 years (as the retailers pusher their own brands). Costco is a great example. Here in Canada every year they are launching more Kirkland Signature brands. Normally it replaces a national brand (or in rare cases competes with it as a dual listing); once this happens that volume is gone from the national brand. Competition is fierce and my guess is national brands will struggle to grow their total volume (even 1%) moving forward. Their opportunity is to cut costs to the bone; however, this gets more difficult over time and often leads to falling sales (unless the managment team is stellar). Here in Canada when Heinz bought Kraft they gassed the whole Kraft managment team. Costs came down; not sure what happened to Kraft sale s over a couple of years. Would make a great case study :-)

[Contra123]

Lots of good points raised here. Certainly this sector is more challenged than it was by private label (although trends there very much depend on the category) and by the internet making distribution and marketing easier for smaller brands.

 

But,

a) these companies are in the early stages of learning to respond to this threat. There is no particular reason why they must fail.

b) same goes for trends towards healthy foods.

c) there is still huge long term growth to go for in the developing world.

 

I see no real reason why these companies can't grow volumes 1% a year while keeping up with inflation via price increases and efficiency gains and converting 90% of earnings to FCF. At 15x that means you're getting a 7% real return for a very long time, and in Kraft's case you also have best in class management which means deal optionality is on your side.

 

Not the most compelling thing in the market by a long shot but I have a corner of my portfolio for boring inflation-linked cash streams like this.

 

Petec,

 

What numbers get you to 15x FCF?

[petec]

To be clear my 1% volume assumption includes EM. And with private label you need to be careful which category. Private label seems to have stalled out in several of them IIRC.

 

[petec]

Lots of good points raised here. Certainly this sector is more challenged than it was by private label (although trends there very much depend on the category) and by the internet making distribution and marketing easier for smaller brands.

 

But,

a) these companies are in the early stages of learning to respond to this threat. There is no particular reason why they must fail.

b) same goes for trends towards healthy foods.

c) there is still huge long term growth to go for in the developing world.

 

I see no real reason why these companies can't grow volumes 1% a year while keeping up with inflation via price increases and efficiency gains and converting 90% of earnings to FCF. At 15x that means you're getting a 7% real return for a very long time, and in Kraft's case you also have best in class management which means deal optionality is on your side.

 

Not the most compelling thing in the market by a long shot but I have a corner of my portfolio for boring inflation-linked cash streams like this.

 

Petec,

 

What numbers get you to 15x FCF?

 

15x earnings and in the long run I’d expect 90% of earnings to turn into free cash. More if they can’t grow volumes.

 

EDIT: I suppose what I’m saying is working capital shouldn’t consume cash forever so recent FCF might not be a good valuation metric.

 

Incidentally I view 3G as superb business builders. Their record in Brazil suggests that. The characterisation of them as being people who only know how to cut costs may be a big misunderstanding. Their system revolves around incentivising people really well. That both cuts costs but also improves execution.

[vince]

The consumer brand model (for food companies) has been hurting for many years. The big challenge is distribution. In the past, the large multinational companies largely  controlled the distribution channel. This gave them enormous pricing power and this drove profitability.

 

This is no longer the case. Distribution power has changed in two important ways:

1.) retailers (Walmart, Costco, Krogers etc) have much more power today and as a result have been growing their own store brands at the expense of national brands; this trend is long term.

2.) the internet (Amazon prime) is allowing consumers more choice. You go to a retail store you have to buy one of the few brands they sell (their own brand or one or two national brands). Online you can pretty much buy whatever you want. It is also easier for small companies to sell online, bypass the retailer and make a go of it by targeting a niche.

 

Kraft/Heinz may do ok by buying perennial underachievers like Kraft and Campbells and cutting costs to the bone (firing their managment teams and cutting back on R&D and marketing). This works when you are small or just getting started. Having access to cheap money also helps. Does it work when you are a massive size? And when debt is getting more expensive?

 

Perhaps another opportunity is to get large enough that you can wrestle control back from the retailers. I do not see it happening.

 

Bottom line is this sector is ugly. Hard to see how things get much better. Lots of downside risks and not many upside opportunities. Not a great formula for a long term investment.

 

great post viking but I believe they increase marketing when cost savings are realized

[LC]

Bottom line is this sector is ugly. Hard to see how things get much better. Lots of downside risks and not many upside opportunities. Not a great formula for a long term investment.

 

I agree. I don't think there's a turnaround story here. The retail pipeline and consumer tastes have both changed, and it's a generational thing.

 

Buying crappy brands, slashing costs, and smoking the last puff of that cigar butt can only work for so long.

[petec]

Heinz is a crappy brand?!

[LC]

I was referring to this comment:

 

Kraft/Heinz may do ok by buying perennial underachievers like Kraft and Campbells and cutting costs to the bone (firing their managment teams and cutting back on R&D and marketing).

 

Crappy is the wrong word. Old? Diminishing? Not sure the right term - but the point is these brands are no longer the powerhouses they were in the late 20th century.

[petec]

No, they’re not. Still a LOT of cash to come out of them though if run well (low costs and lots of innovation).

 

I found this interesting:

 

www.forbes.com/sites/brittainladd/2018/08/06/campbell-soup-at-a-crossroads-what-the-company-must-do-now/amp/

[frommi]

No, they’re not. Still a LOT of cash to come out of them though if run well (low costs and lots of innovation).

 

I found this interesting:

 

www.forbes.com/sites/brittainladd/2018/08/06/campbell-soup-at-a-crossroads-what-the-company-must-do-now/amp/

 

While CPB is throwing of enough cash, KHC has a cashflow problem at the moment. It doesn`t even cover the dividend right now. It looks like they are not managing their working capital that well, which is strange for such a management team. Even if i just take EBITDA - interest costs - taxes - CAPEX it doesn`t cover the dividend. So if the business just stagnates here you get a <4% return and nothing else because they simply have no cash to invest, pay down debt or take over other businesses.

If they take over CPB and bring operating margins up to 25%, they get ~2 billion in EBIT. If they pay a premium of 10% to the current price of CPB (which is a very small premium) they have to pay 23-24 billion for that, so EV/EBITDA for the takeover is around 12 even when you assume KHC level operating margins. Since this isn`t materially different from where KHC is trading i don`t see how this really changes anything for KHC. CPB might be the better bet right now, since there is at least the chance to get a takeover premium.

[petec]

 

While CPB is throwing of enough cash, KHC has a cashflow problem at the moment. It doesn`t even cover the dividend right now. It looks like they are not managing their working capital that well, which is strange for such a management team. Even if i just take EBITDA - interest costs - taxes - CAPEX it doesn`t cover the dividend.

 

I've also wondered about the working capital and I haven't seen a discussion of this on recent calls (I may be forgetting something). My assumption/positive spin is that they are stocking the channels in advance of growth (e.g. in whitespaces).

 

Also, capex has averaged 4.7% of revenues here for the last 2 years. That's relatively high for the sector and very high for a no-growth company in the sector.

 

I could be very wrong but I read both these stats as evidence that 3G, who are laser-focussed on long term cash flows, are investing for growth not just slashing costs. Clearly it is not working yet but one of two things ought to happen in the future: KHC starts to grow, or 3G admit defeat and run it for cash, in which cash flows have the potential to rise materially.

 

[Spekulatius]

I've also wondered about the working capital and I haven't seen a discussion of this on recent calls (I may be forgetting something). My assumption/positive spin is that they are stocking the channels in advance of growth (e.g. in whitespaces). 

 

KHC mentioned a securitization program that they terminated in their CC impacting working capital. That may be one factor on top of the cost inflation. I agree with others here, unless they can get the share price up, acquisitions are unlikely to be accreditivd, CPB family owner very unlikely will let go for a 10% premium either and they are loaded up with debt already, from their  Snyder Vance acquisition, which looks like a mistake.

[Contra123]

Poor results today.  Still unsure what more they can do to turn this around (and yes, they are trying).  The dividend here is unsustainable and should be cut 80% (or ideally, eliminated), in my view.  BUD/ABI last month should eventually crystallize this for the KHC holder base.

[Contra123]

BTW - probably not a bad short.

[petec]

Under 13x 2019 consensus free cash flow with volumes growing - brave short!

 

But yes, poor results (again) at the headline level and yet more jam tomorrow commentary on the call. I need to listen to the call again and pick through the numbers to see if there’s any evidence backing their fairly bullish commentary.

 

I do tend to agree about the dividend. If they cut it it’ll drop into the 40s and will be a great buy as it delevers.

[Spekulatius]

 

While CPB is throwing of enough cash, KHC has a cashflow problem at the moment. It doesn`t even cover the dividend right now. It looks like they are not managing their working capital that well, which is strange for such a management team. Even if i just take EBITDA - interest costs - taxes - CAPEX it doesn`t cover the dividend.

 

I've also wondered about the working capital and I haven't seen a discussion of this on recent calls (I may be forgetting something). My assumption/positive spin is that they are stocking the channels in advance of growth (e.g. in whitespaces).

 

Also, capex has averaged 4.7% of revenues here for the last 2 years. That's relatively high for the sector and very high for a no-growth company in the sector.

 

I could be very wrong but I read both these stats as evidence that 3G, who are laser-focussed on long term cash flows, are investing for growth not just slashing costs. Clearly it is not working yet but one of two things ought to happen in the future: KHC starts to grow, or 3G admit defeat and run it for cash, in which cash flows have the potential to rise materially.

 

3G is essentially reversing course on their cost cutting strategy and increasing overhead, increasing Capex and marketing spent. The margin reductions are also evidence that they lost their pricing power.  Now we have an expensive stock (12x EV/EBITDA) with a crappy balance sheet in a business that is getting worse and a management that just does a 180deg on their strategy. Why would anyone want to invest in this is unclear to me.