Kraft Heinz shows signs of successful turnaround
Kraft Heinz (NASDAQ: KHC) is one of Warren Buffett’s most beloved brands and one of the largest holdings in Berkshire Hathaway’s (BRK.A) (BRK.B) portfolio. According from Berkshire 13F newest, Kraft Heinz ranks seventh in the portfolio with a total value of $12.4 billion, representing a 26% stake in the company. After the merger orchestrated by Berkshire and 3G Capital in the third quarter of 2015, the stock literally went into a downward spiral right after the IPO:
The stock hit $92 per share in 2017, but has since fallen to $35 per share as of September 8, 2022, a 61% decline. If the price had maintained its 2017 level, Kraft Heinz would be the 6th most important position, just above the current value of Occidental Petroleum (OXY). That being said, Buffett stayed true to his word on this one when he claimed he never wanted to sell.
My thesis is that if Buffett still sees value in it, I agree. After analyzing the value of this stock using Graham’s number combined with an examination of the company’s improving balance sheet, this has the makings of a turnaround. Kraft Heinz is a buy at today’s prices.
The Berkshire 3G merger
For those unfamiliar with the founding story of Kraft Heinz, it was a combined effort of Berkshire Hathaway and a Brazilian private equity firm 3G Capital that put all the pieces together to create the new company. The original shareholder terms of Berkshire’s $23 billion purchase of HJ Heinz were as follows:
HJ Heinz Company (“Heinz”) today announced the completion of its previously announced acquisition by an investment consortium consisting of Berkshire Hathaway and an investment fund affiliated with 3G Capital. The acquisition agreement was first announced on February 14 and the transaction has closed and is effective today.
Heinz shareholders will receive $72.50 in cash for each common share they held at the time of the merger, without interest and less applicable withholding taxes. Following the completion of the merger, Heinz common stock will no longer trade on the New York Stock Exchange and Heinz expects no further trading after the close of business on June 7, 2013.
The purchase of Kraft by Berkshire/3G controlled by Heinz happened afterwards and the combined company went public in 2015. All in Berkshire spent around $23 billion on Kraft Heinz, a stake that is only worth today. today only $12.4 billion. If you’ve been following this story, you’re probably aware that Berkshire is hands-off and 3G is known as cost-cutting engineering for business turnaround. This turnaround is beginning to show signs of success.
Signs of a successful turnaround
The worst of Kraft Heinz’s misfortunes came in 2019 when an SEC investigation into the company’s accounting practices led to asset write-downs resulting in writedowns of $15.4 billion. This included an $7.1 billion goodwill impairment and an $8.3 billion impairment of Kraft and Oscar Mayer intangible assets. The deficiencies left Kraft Heinz with a loss of $12.6 billion that year. The stock reacted accordingly and started falling thereafter.
Fast forward to today and a lot of improvements can be seen in the numbers. When Peter Lynch researched turnaround stories, the balance sheet was his main key indicator of the direction he was headed. Based on the 1989 book One Up on Wall Street a successful turnaround story will have two main components, a decrease in total debt with an increase in cash and cash equivalents, let’s look at:
Here we can see for the years 2017-2021, the cash position grew by an average of 16% per year over this period, from $1.6 billion to $3.45 billion.
In 2017, Kraft Heinz started with $31.5 billion in total debt and ended 2021 with just $21.8 billion in total debt, a reduction of $9.7 billion, a decrease of 30 %.
Both of these indicators are positive for a good turnaround story. While margins have near-static forward projections, debt repayment and share buybacks can boost earnings through conscious engineering.
Target price and valuation
For tangible asset heavy businesses, I like to use Graham’s number when setting my goal. For those unfamiliar, this price target metric was popularized by Benjamin Graham in the original version of the smart investor, one of the first classics of value investing. The formula is simple Graham’s Number = Square Root of (22.5) x (BPA TTM) x (MRQ Book Value per Share). Our entries are as follows, TTM EPS is $1.23 per share and book value per share for the most recent quarter is $39.83. SQRT(22.5) x ($1.23) x ($39.83) = $33.2. Now that number is lower than the current market value, but I would make a slight modification to that equation. In an ideal world, earnings are equal to free cash flow, but when there are a lot of tangible assets on the books and some impairment carryforwards, we often find that free cash flow is greater than earnings due to accounting practices dealing with depreciation and amortization.
Let’s compare this to the income statement to see the difference between earnings and free cash flow:
Looking at the Net Income vs. Free Cash Flow lines, we can see that the Free Cash Flow in 2021, say $4.3 billion, is 4.25x greater than their Net Income of $1.027 billion. dollars in 2021. In the income statement, EBITDA is the best indicator of free. cash flow, but to be fairer in this reassessment, I’ll use EBIT as a better measure since, as Charlie Munger points out, depreciation is a very real expense. Kraft Heinz’s trailing 12-month profit is $1.5 billion and EBIT is $3.2 billion. Consequently, the EBIT per share is 2.13 times higher than the TTM eps.
Let’s rework Graham’s number using EBIT per share instead of EPS. $1.23 TTM EPS x a factor of 2.13 higher for EBIT gives us $2.6 EBIT per share. So again, SQRT (22.5) x ($2.6) x ($39.83) = $48.27 per share, showing that the stock is currently trading at a discount by this new calculation. This formula of the smart investor is not appropriate when evaluating companies that have incredible intellectual property and intangible assets, but still very appropriate when evaluating companies that run on durable assets and some goodwill. This is especially true when some of these durable assets can be sold to generate revenue if needed. These are the businesses that most closely resemble those of the Benjamin Graham era when nearly every salable product or service was 100% tangible.
Based on this, I reiterate my buy rating with a price range of $33 on the low end and $48 on the high end.
And the dividends?
Kraft also pays a high dividend and one of the best ways to build wealth is to collect dividends from companies that grow their dividends and compound them over time. Looking at historical Kraft Heinz dividend data, we can see that the dividend has been reduced after this depreciation year of 2019. The dividend was 0.55 cents per share in 2015, increasing to 0.625 cents per share from 2018, then was reduced to 0.40 cents per share in 2019 and held at that level until now.
For the three years of evidence of dividend increases we have, the dividend CAGR increases from 0.55 to 0.625 at an average of 4.35% per year. We can assume that their internal dividend policy if the turnaround is executed well would be somewhere in that range of a 4% increase per year. Let’s do a 10-year compound dividend analysis and use the current dividend yield of 4.44% as a starting point.
We can see with these assumptions, that a $1000 investment with Drip and a 10-year average annual stock price appreciation of just 7% per year, below the market average, could earn you a 3 bagger , a tripling of your initial investment, over 10 years if the turnaround goes through and dividend increases are rolled over.
Forward annual dividend liability is $1.95 billion and TTM’s free cash flow is $3.2 billion, representing a payout ratio of 60%. While 60% isn’t ideal (we’d like to see less than 50%), they’re certainly on track to have the ability to increase their dividend if free cash flow continues to increase over time.
Investing in emerging markets appears to be a priority in Kraft Heinz’s latest investor presentation. Since Kraft specializes in long-shelf life processed foods, this could be the optimal time to enter emerging markets at full speed, as shortages of fresh foods due to shortages of fertilizers lead to low yields of cultures will make these foods increasingly important. I’m very aware that natural gas is a key component in the multi-step process of producing nitrogen-based fertilizer (needed to produce ammonia), and that this product is only getting scarcer in the world. world with the Russian-Ukrainian war.
Kraft Heinz has also shown a strong ability to mitigate its commodity exposure risk and lower the cost of goods sold through futures contracts, which will be critical in the packaged food wars that are expected to ensue in the next years of inflation. Having friends and contacts in China, with their repeated Covid lockdowns, the instant noodle market is doing very, very well right now according to them. We might expect macaroni and cheese (and other quick-prepare dry goods) to fill similar voids on shelves around the world.
The stock is cheap based on my analysis using EBIT instead of earnings per share in valuing a price target. The company is showing signs of an executable turnaround with increasing cash positions and decreasing total debt. The dividend is an especially big bonus and bonus if the company reverts to its previous dividend increases of 4% per year. Kraft Heinz is a buy for me at less than $48 a share.