KHC - Kraft Heinz Co.

[petec]

Spek

 

I’ve said earlier that I think there’s a misperception in the market about 3G just being cost cutters. They’re not, and I’m not surprised to see them investing for growth. Whether it will work is another thing but 3.8% positive volume/mix in the US is the one positive thing in these results.

 

Ultimately if growth doesn’t work then they’ll stop investing and run this for cash. It’ll become a tobacco stock. They’ve done ok.

 

P

[undervalued]

 

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.

 

 

Looking Morningstar data, Revenue was flat before the merger. Net income has double since the merger (since July 2015).

https://imgur.com/AMZje9K

[CorpRaider]

The Kraft brands kind of suck, don't they?  I like Heinz and maybe Philadelphia, but other than that...

[gfp]

Yeah, Philadelphia is one of their best brands outside of Heinz.  I liked the Heinz move to try to take over French's territory without paying up to buy French's.  Planters nuts and Classico sauces are decent brands as well.  No idea on Oscar Mayer...  But yeah - Jell-o and Kool-Aid will only get you so far.

 

Its easy to see why Buffett was so pissed when they sold DiGiorno to Nestle in a taxable cash transaction.  That was an extremely valuable brand.  His interview at that time was funny, "Q: How do you feel about the deal?" A: "I feel poorer"  [bRK was a KFT common shareholder at the time]

 

The Kraft brands kind of suck, don't they?  I like Heinz and maybe Philadelphia, but other than that...

[wabuffo]

Its easy to see why Buffett was so pissed when they sold DiGiorno to Nestle in a taxable cash transaction. 

 

That was only a part of the reason why he was upset. 

 

The fire sale of DiGiornio was a desperate attempt to quickly raise cash so that KFT could bump up the cash portion of their Cadbury offer.  This additional cash allowed the stock portion of the offer to be reduced such that the issuance of new KFT common shares as part of the transaction would fall below a key threshold of 20% of common outstanding prior to the sale of the new shares. 

 

Going below 20% met a NYSE requirement that allowed KFT mgmt to issue shares without conducting a shareholder vote for approval.  Buffett had already been public about his displeasure of issuing undervalued KFT shares to buy overvalued Cadbury.  In one fell swoop, KFT mgmt had put Buffett (and their shareholders) in a box and he didn't like it one bit.  No wonder Buffett was so angry.

 

And of course, the Cadbury biz was part of Mondelez in the split with Kraft that came shortly thereafter.

 

wabuffo

[petec]

Worth pointing out that that was old management, not this lot.

 

Splitting Mondelez and Kraft was a terrible idea.

[undervalued]

I am just saying the revenue has been flat for a while, even before 3G took over in 2015. So 3G must have realized that customers prefer fresh food rather than package food before 2015?

[ander]

Has anyone dug into the Mondelez agreement re: international brands? I remember reading a few years ago that the non-compete / licensing for international expires in the coming years. I thought it could have been a substantial opportunity for KHC and may require little incremental capital.

 

I recall in an interview when Buffett was asked re: interest in buying Mondelez and he said no - my thought was probably because he can compete once the agreement expires - why pay for it. Though it's not something I've followed closely.

 

[Liberty]

Good thread by MarAzul about Buffett's investment in Kraft-Heinz:

 

 

In 2013, Berkshire and 3g acquired Heinz...Berkshire invested ~$12.3bn, out of that amount $8bn was in a preferred paying 9%!! he also got some warrants. Then in 2015 he exercised these warrants and invested an additional $5.3bn.

 

For ~3 years, Buffett earned that 9% yield on the prefs and then got called at a premium! ($8.3bn). Close to 10% IRR on a very safe FI security, classic Buffett.

 

His common equity stake even after this big decline in stock price is worth $16.8bn, compared to an investment of $9.6bn...pretty good...but it gets better, Buffett has earned fat dividends over these years (current div/inv. amount =8.5%).

 

Also, these are tax efficient paying only 7% as they hold more than 25% of the shares OS. It is true results have dissapointed lately and trends don´t look good, but this has been a home run.

[undervalued]

Good thread by MarAzul about Buffett's investment in Kraft-Heinz:

 

 

In 2013, Berkshire and 3g acquired Heinz...Berkshire invested ~$12.3bn, out of that amount $8bn was in a preferred paying 9%!! he also got some warrants. Then in 2015 he exercised these warrants and invested an additional $5.3bn.

 

For ~3 years, Buffett earned that 9% yield on the prefs and then got called at a premium! ($8.3bn). Close to 10% IRR on a very safe FI security, classic Buffett.

 

His common equity stake even after this big decline in stock price is worth $16.8bn, compared to an investment of $9.6bn...pretty good...but it gets better, Buffett has earned fat dividends over these years (current div/inv. amount =8.5%).

 

Also, these are tax efficient paying only 7% as they hold more than 25% of the shares OS. It is true results have dissapointed lately and trends don´t look good, but this has been a home run.

 

He always gets a good deal. There is no deal if it's not good.

[petec]

I read over the last 4 calls, plus a few other things, to try to understand what 3q means for the long run trends. FWIW here are my notes. I am cautiously optimistic - they're struggling with inflation at the moment but that's a fairly normal cyclical thing, and they are starting to grow volumes which is the big question-mark for me.

 

3q18 vl/mix was up 3.5% and price down 0.9%. In the US vol/mix was 1.8%, made up of 0.8% consumption growth in measured channels, 50bps of inventory build to support innovations, and 50bps in unmeasured channels (foodservice and ecommerce mainly, 20% of sales and growing). Vol/mix is clearly accelerating and might be the number to focus on given the consensus view that revenue can't grow, especially in the US, despite repeated guides that vol/mix would pick up in 2H18 on the back of extensive investment. Negative price doesn’t have to be a concern - they manage price/vol/mix to total ebitda dollars so margins aren’t necessarily the thing to focus on, and they also pass through core commodity costs quite fast so headline prices aren’t either. Price was down in the quarter partly on commodities (bacon) and partly on promotions to launch innovations. I don't think they are just buying volume with price, but I can't be sure. They were also explicit that they did not pay retailers for additional slots/volume.

 

On the negative side, margins and ebitda dropped substantially. They called out 6 drivers:

1. higher variable comp partly due to low prior year (which had been guided) but also on payments for growth related KPIs. They quantified this at $75-100m in 2q although they refused to break it out when it actually happened in 3q.

2. higher non-core commodity costs (freight, packaging). Over time these costs are offset by cost savings and if necessary price but there was a timing mismatch between inflation and cost savings this quarter. This is directionally consistent with prior guide. In 1q they foresaw inflation but described an offsetting pipeline of cost projects, especially in procurement and manufacturing, heavily weighted to 2h. In 2q they predicted a timing mismatch in 3q but were clear it would abate in 4q. In the event, 3q inflation was even higher than they anticipated and they delayed some cost savings (discussed below) which exacerbated the timing mismatch, but they were still adamant that the mismatch would abate in 4q. They also discussed potentially pulling the price lever in 2019.

3. higher investments in growth. They have been doing this and talking about it all year, but 3q had a particularly big step I think. This is a 1-off $300m step up in costs and the goal is now volumes driving operating leverage. They’re clear they don’t need another step up soon.

4. higher freight costs due to higher volumes than they expected, driving need to buy at spot. Have now contracted so this is 1-off.

5. delayed cost savings due to need to ensure customer service as volumes rose. While they’ve done a lot of the fixed cost outs they have more to do on the variable side, e.g. headcount in factories, but they didn't  push the button this quarter because volumes accelerated more than they anticipated. This is a timing thing and is 1-off.

6. unanticipated cost on transferring Mideast distribution to Europe, which is 1-off.

 

These impacts were all either one off costs which will fade, or short term impacts due to volumes being better than expected, or one off increases in costs which will drive revenue growth and pay for themselves, starting in 4q and into 2019. They were adamant that 4q and 2019 ebitda would look better.

 

The problem is they didn't really see this coming. Commentary around growth has been consistently bullish, and if anything they are ahead of their own expectations there. But commentary around ebitda, profits, and cash flows have also been bullish. Indeed, in 4q they said they were "very, very" confident in ebitda growth for the year and said 2H would be stronger than 1H. Oops. In 2q they reversed this and guided 3q down, giving 3 of the 6 reasons above, but nowhere near enough. The generous interpretation is that the costs they didn't foresee were the ones attributable to the volume surprise.

 

Interestingly what they call commercial profits were positive in the quarter. This is vol + price + mix less merchandising costs (promotions etc). In other words it’s the impact on ebitda excluding commodity impacts, SG&A investments, and cost savings. I'm in two minds as to whether this is a relevant measure.

 

---

 

For the longer term outlook it's interesting to look at how they are growing volumes. Their basic growth formula is:

• population growth +\- inflation in dev

• better than population growth +/- inflation in emerging markets

• fixed cost leverage

• cost savings

• deviation in any one year driven by brand strength vs commodity cycles or price competition, and investment cycle vs cost curve. 

 

Obviously to do that, given the headwinds they face from changing brand preferences, private label, etc, they have to reinvigorate their portfolio and go-to-market. To this end they are:

- Globalising their brands. They claim to have 3 global brands (Heinz, Kraft, Planters). 10% or countries had two of these or more in 2016 and the target is 80% in 3-5 years.

- Ramping up innovation. I am always sceptical of how innovation is measured, but recent innovations are rising as a % of sales etc. Part of this is rethinking products to make them healthier. This can drive trade up. Another part is extending brands into white space. Examples are Heinz into mustard and mayo, Kraft into desserts with cheesecake.

- Doubling the number of staff they have in customers' stores, targeting specific customers. This is counter to what most of the competition is doing and it is paying off in terms of better arrangements on shelves, fewer stock outs, better new product launches, etc. This was piloted in 2016/7 and worked well. This is a big part of the $300m they are investing in COGS and SG&A in 2018, funded by the tax cut (they decided to do 3 years' worth of investments in 1). This is a 1-off investment that they expect to leverage in 2019 and beyond.

- Pushing hard into channels that are growing faster than retail overall and where they are underpenetrated. This requires he right price/pack architecture, go-to-market, and supply chain. These channels include clubs, convenience, gas stations, drugstores, dollar stores, as well as ecommerce and foodservice:

○ ecommerce - growing 80% off a small base in 3q and accelerating steadily. Overall they have higher share online than off.

○ foodservice, which they refer to as a $3.5bn startup. They are the biggest player in foodservice with a small share.

- Improving revenue management: better price pack architecture, better price strategy vs category price ladder, and better-designed promotions.

- Simplifying the assortment to focus on high-velocity SKU's.

 

It is early days but I think the results here are starting to look good. Overall vol/mix was has been accelerating and reached 3.5% in 3q as discussed. It has turned positive in the US. They are starting to hold share in the US and are gaining in RoW. Heinz, a 150 year old brand, has been growing 5% a year since 2015 and has the highest ketchup shares in recent history.

 

Note that revenue splits roughly 50/50 US/other, but ebitda is more like 75/25.

 

---

 

The other thing I was concerned about is FCF. This is because I missed an accounting change. As of last year proceeds from selling accounts receivable turn up in investing cash flows. Before, it was netted against accounts receivable in operating cash flow. You can see this by comparing data for 2016 in the original reporting vs. how it was reported in 2017. Operating cash flow halved. As of mid-2018 they have stopped selling receivables so this will revert in FY19.

 

This has obscured real progress in working capital. According to the company (I have not tried to replicate this calc) working capital/sales (defined as rcbl + inventory + sold rcbl - payables) came down 5.9 percentage points from 2015 to 2017 and is now negative.

 

Other free cash flow depressants included 2017 investments of $1bn in growing manufacturing capacity and $1.4bn in retirement plans. I believe both these were one offs. Certainly they have guided capex down, although in 2018 it will still be at the top end of the 2.5-3% long run guide.

 

Overall I think FCF will improve and, perhaps importantly, will screen much better once they stop selling receivables. Target net debt is 3x ebitda, or about $24.5bn. At the end of 3q it was $29bn, if you adjust for the two sales (low-margin brands in India and Canada) announced over the last 2 weeks. Consensus 2019 free cash flow is $5bn so in a year they will be at their target. Then they will be able to buy in a lot of stock using free cash flow and, if they are growing ebitda by then (big if) additional debt.

 

---

 

Finally a few thoughts on management. 4 big cultural focuses come across: being data driven, being sustainable, hiring, training, and incentivising staff (they aim for above average variable comp leading to above average cash comp), and endless cost rationalisation. I think 3G's reputation as cost cutters belies their ability to build businesses. Lojas Americanas is a good example. A few metrics I think indicate good management include:

- Recalls, complaints, and reportable incidents are all falling.

- 20% of the white collar employees have been promoted recently - "meritocracy in action".

- Employee engagement has gone from below average to average, and they target above average.

- They had 120k applicants for 150 worldwide trainee spots.

- They aim for 100% reusable, recyclable, or compostable packaging by 2025.

 

On the downside they aren't very precise in the way they answer questions on the call. I wouldn’t call it evasive, personally, but it's vague and they sometimes miss the point of a question.

 

[khturbo]

Thanks for all of that info. Lots of really good stuff in there.

 

I have kind of one main question here. All of that being said, do you really think you can make a lot of money here?

 

If I take analyst estimates for 2019 EBITDA of $7.65bb - using 2019 because I'm trying to be a little charitable as we could be going through a current rough patch as you argue - and their guidance for 2.5 - 3% of sales as capex, I get an EV / (EBITDA - capex) multiple of 14x. So if this thing was unlevered you'd have a fcf yield of 5.7%, before accounting for working capital.

 

That's obviously not terrible but it doesn't scream cheap either, especially for a company where it seems like success might mean 3% organic revenue growth over time. Based on all the underlying trends and the company's brand positions, 0% growth over some amount of years seems like it might be kind of a base case. Revenue has, in fact, come down a bit over the past 3 years since the transaction closed.

 

Obviously the leverage makes the fcf yield to the equity a bit better, even if you assume 3x leverage. I get something a bit over 6%. But similar math still applies.

 

I mark its value every quarter because it's an input into my BRK valuation. I've had it marked around $60 / share pretty much since the deal closed, and with the most recent quarter I've marked it down a bit from that. So I don't follow KHC (or the space) super closely, but just with some rough numbers it's hard for me to see how this could be a big winner.

[CorpRaider]

Worth pointing out that that was old management, not this lot.

 

Splitting Mondelez and Kraft was a terrible idea.

 

Wasn't it Ackman's idea? 

[petec]

Thanks for all of that info. Lots of really good stuff in there.

 

I have kind of one main question here. All of that being said, do you really think you can make a lot of money here?

 

If I take analyst estimates for 2019 EBITDA of $7.65bb - using 2019 because I'm trying to be a little charitable as we could be going through a current rough patch as you argue - and their guidance for 2.5 - 3% of sales as capex, I get an EV / (EBITDA - capex) multiple of 14x. So if this thing was unlevered you'd have a fcf yield of 5.7%, before accounting for working capital.

 

That's obviously not terrible but it doesn't scream cheap either, especially for a company where it seems like success might mean 3% organic revenue growth over time. Based on all the underlying trends and the company's brand positions, 0% growth over some amount of years seems like it might be kind of a base case. Revenue has, in fact, come down a bit over the past 3 years since the transaction closed.

 

Obviously the leverage makes the fcf yield to the equity a bit better, even if you assume 3x leverage. I get something a bit over 6%. But similar math still applies.

 

I mark its value every quarter because it's an input into my BRK valuation. I've had it marked around $60 / share pretty much since the deal closed, and with the most recent quarter I've marked it down a bit from that. So I don't follow KHC (or the space) super closely, but just with some rough numbers it's hard for me to see how this could be a big winner.

 

 

For each investment I make, I try to define what I think success means. For some it's doubling in 3 years. For others its providing a reasonable return forever. This falls into the latter bucket. I essentially think of this as an inflation-linked bond yielding 7.5% (consensus FCF/market cap). If that is what it proves to be then I will hold it for a very long time and I will consider the investment to be successful. If it is not then it is levered enough to do real damage to equity holders, which is why I don't own much.

 

That said I do think there is a case for a decent medium term return. If the next few quarters prove that they can grow the business without sacrificing too much margin, then a) the equity multiple will rerate and b) the debt will come down fast, driving further equity upside. I'm not sure how confident I am in this thesis at the moment but 3q makes me marginally more confident, not less.

 

[khturbo]

Fair enough. I see some other stuff that I think makes a bit more sense in the inflation + type of category, but I see where you're coming from.

[petec]

Fair enough. I see some other stuff that I think makes a bit more sense in the inflation + type of category, but I see where you're coming from.

 

So do I frankly, but if you have a list I'd love to see it!

[ugadawg_98]

Petec,

I enjoyed reading your work here. KHC is down roughly $10 in the five or so weeks since you posted. Do you still believe your thesis?

 

If so, the potential risk/reward in KHC should be much better now than last month.

[petec]

I have not learned anything since posting that changes my thesis. So yes, I’m more confident here than I was at earlier prices. But I did express caution in my view and that remains. I need a few thesis confirming quarters before I’m sure. But if that happens the stock won’t be on 12x earnings and yielding 5.5%! I have a small position which I’m tempted to add to-if I don’t it will be because other things also look attractive in this selloff.

[aws]

News that they are in the bidding process for CPB international assets.

 

https://www.reuters.com/article/us-campbell-soup-divestiture/kraft-heinz-mondelez-make-the-cut-in-campbell-soups-international-business-auction-sources-idUSKCN1OM0GB

 

Not sure if the market movements are related to this, but CPB down 7% today while the stocks of potential bidders KHC and MDLZ each down over 3% more.  All news seems to be bad news in this environment.

[undervalued]

Blood bath in KHC: http://ir.kraftheinzcompany.com/news-releases/news-release-details/kraft-heinz-reports-fourth-quarter-and-full-year-2018-results

[Foreign Tuffett]

I found this particularly notable.

 

"the Company recorded non-cash impairment charges of $15.4 billion to lower the carrying amount of goodwill in certain reporting units, primarily U.S. Refrigerated and Canada Retail, and certain intangible assets, primarily the Kraft and Oscar Mayer trademarks."

 

We are truly living in a brave new world if iconic, consumer non-durable brands like Kraft and Oscar Mayer are impaired.

 

Also, KHC is being investigated by the SEC.

[gfp]

That takes another $3 Billion out of Berkshire's earnings for the quarter right?

[scorpioncapital]

Food is a commodity. It is very hard to build up mega brands I guess. Or possibly , the Standard Generic products they make needs more differentiation and organic/bio/healthy alternatives. Sometimes starting with an experimental no-name brands (like craft beer) might create more consumer excitement. tough business indeed, who would have thought?

[Spekulatius]

The sad thing is that even with the haircut implied by AH quote, this stock looks at best fairly priced, but most likely overvalued, given the business trends. This is now truly a major turnaround situation.

[aws]

Terrible bottom line results, and every stupid accounting adjustment and excuse in the book.  Warren must hate this... unless he's just planning on taking it private at a much lower price.