Value Investment - KHC - Company to Watch in 2020
All comments and likes are very appreciated.
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Fair Value and Profit Drivers
After reviewing results through the first nine months of 2019, we're holding the line on our $50 fair value estimate for Kraft Heinz. We continue to expect sluggish top-line performance near term (which management has attributed to reduced inventory levels at developed market retailers and unfavorable promotional spend), with our forecast calling for a more than 4% reported decline this year. Further, we still anticipate cost pressures in manufacturing, packaging, and logistics and elevated investments behind its brands will eat into profits, and expect operating margins to hover in the low-20s. Our valuation implies fiscal 2020 price/adjusted earnings of 18 times and an enterprise value/adjusted EBITDA multiple of 14 times.
The question for Kraft Heinz Co. is whether new management can execute a turnaround. CEO Miguel Patricio has a marketing background; it remains to be seen if he can fix the company’s fundamentals in an industry struggling to reinvent iconic consumer brands to remain relevant.
A key tenet of Kraft Heinz's strategic focus has been on driving cost saves--targeting more than $1.7 billion in savings the past few years. Up until now, the bulk of these savings resulted from corporate workforce reductions (affecting about 4,900 employees, or 12% of its total employee base), a rationalization of its North American manufacturing network (with a net of six plants closed), and enhancements to its supply chain.
In line with our thinking, Patricio's early read on the business is that it's failed to pivot from one centered on intense cost-cutting (following the merger of the two businesses four years ago) to one anchored in rooting out inefficiencies and boosting brand investments. This aligns with our outlook, which calls for the firm to extract $2 billion by fiscal 2020 to fuel its brand spend in light of the intense competitive landscape; we anticipate 65% of its savings will drop to the bottom line, with the remaining 35% reinvested in marketing and research and development. In this context, we expect marketing and R&D will expand to nearly 6% of sales in the aggregate (versus less than 5% the last few years) over the course of our 10-year forecast. Further, we posit input cost inflation pressures are unlikely to subside (partly due to higher protein costs related to a reduction in the supply of hogs stemming from China's African Swine Fever and elevated transportation costs versus recent deflationary trends), which stand to eat into the firm’s margin trajectory. As such, we forecast operating margins will remain in the low-20s over our 10-year explicit forecast, generally in line with fiscal 2018 (but below its mid-20s peak in 2016 and 2017).
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While Kraft Heinz’s shares retreated at a high-single-digit clip following its fourth-quarter print, we don’t think there has been a material deterioration in the story over the past several months to merit such a pullback. Rather, we believe that under the direction of CEO Miguel Patricio (who joined the firm just more than six months ago from wide-moat Anheuser-Busch InBev) Kraft Heinz is stocking up on the ingredients necessary to strike up a more flavorful recipe for the long term (pivoting away from blindly rooting out costs, in favor of sustainable efficiencies, with the intent to funnel a portion of any savings realized to elevate the standing of its brands).
We attribute a portion of the market’s disfavor to the slight delay in the time over which the firm intends to convey the details of its strategic direction, which is now set for early May as opposed to March prior. However, the underlying premise behind this shift (affording the recently appointed head of the U.S., Carlos Abrams-Rivera, who joined Feb. 3 from Campbell Soup, time to reflect on the tenets of its approach and interject his perspective) seems reasonable. And despite this extended horizon, we don’t think the drive to incite change is on hold.
In the aggregate, we see little in the fourth-quarter results (a 2.2% decline in organic sales, a 20-basis-point shortfall in gross margins to 32.2%, and an 80-basis-point erosion in adjusted operating margins to 20.0%) or near-term guidance (suggesting pressure at the sales and profit lines is unlikely to subside in 2020, generally in line with our expectations) to warrant a material change in our $50 fair value estimate. Further, we’re holding the line on our long-term outlook, calling for 2%-3% annual organic sales growth long and operating margins remaining in the low-20s over our 10-year explicit forecast. We continue to posit patient investors should consider stocking up on this no-moat name, which trades 45% below our valuation.
Risk and Uncertainty
We think Kraft Heinz's intent focus on extracting significant costs (at the expense of brand spend) has resulted in the degradation of its brand intangible asset (eroding its brands and retail relationships). Further, attempts to extend the distribution of Kraft's products over Heinz's international network may continue to falter if efforts to tailor its mix to better align with local tastes and preferences prove insufficient.
We also surmise that consumers perceive a few of the categories in which Kraft competes--namely, cheese and packaged meats, which in the aggregate account for around one third of total sales--as commodified, implying purchase decisions are more likely to be based on price rather than brand. In addition, Kraft generates just over 20% of its sales from Walmart, and its bargaining clout could diminish as the base of retail outlets continues to consolidate and market share shifts to mass merchants and warehouse clubs at the expense of traditional grocery stores.
Bouts of unfavorable weather could place upward pressure on input prices for products such as dairy, coffee beans, meat, wheat, soybean, nuts, and sugar. In response to the rampant cost inflation in the cheese, meat, and coffee categories a few years ago, Kraft put through significantly higher prices, but was unable to fully offset the profit hit, given the lag in the benefit. Further, transportation and logistics costs have soared and show little sign of abating, which stands to crimp profit prospects across the industry.
Finally, even with a new management team at the helm, it is unclear whether the firm will be able to orchestrate sufficient change to bolster its financial performance. We think this sizable task could prove more challenging given the intense competitive landscape in which it plays, as it consistently goes to bat against other leading branded operators, private-label fare, and smaller, niche foes (which have proven more agile in their response to evolving consumer trends).
I and/or others I advise hold a material investment in the issuer's securities.
_________________________________________________________________________________________________________________
All comments and likes are very appreciated.
Best Regards,
I0_USD_of_Warren_Buffet
_________________________________________________________________________________________________________________
Fair Value and Profit Drivers
After reviewing results through the first nine months of 2019, we're holding the line on our $50 fair value estimate for Kraft Heinz. We continue to expect sluggish top-line performance near term (which management has attributed to reduced inventory levels at developed market retailers and unfavorable promotional spend), with our forecast calling for a more than 4% reported decline this year. Further, we still anticipate cost pressures in manufacturing, packaging, and logistics and elevated investments behind its brands will eat into profits, and expect operating margins to hover in the low-20s. Our valuation implies fiscal 2020 price/adjusted earnings of 18 times and an enterprise value/adjusted EBITDA multiple of 14 times.
The question for Kraft Heinz Co. is whether new management can execute a turnaround. CEO Miguel Patricio has a marketing background; it remains to be seen if he can fix the company’s fundamentals in an industry struggling to reinvent iconic consumer brands to remain relevant.
A key tenet of Kraft Heinz's strategic focus has been on driving cost saves--targeting more than $1.7 billion in savings the past few years. Up until now, the bulk of these savings resulted from corporate workforce reductions (affecting about 4,900 employees, or 12% of its total employee base), a rationalization of its North American manufacturing network (with a net of six plants closed), and enhancements to its supply chain.
In line with our thinking, Patricio's early read on the business is that it's failed to pivot from one centered on intense cost-cutting (following the merger of the two businesses four years ago) to one anchored in rooting out inefficiencies and boosting brand investments. This aligns with our outlook, which calls for the firm to extract $2 billion by fiscal 2020 to fuel its brand spend in light of the intense competitive landscape; we anticipate 65% of its savings will drop to the bottom line, with the remaining 35% reinvested in marketing and research and development. In this context, we expect marketing and R&D will expand to nearly 6% of sales in the aggregate (versus less than 5% the last few years) over the course of our 10-year forecast. Further, we posit input cost inflation pressures are unlikely to subside (partly due to higher protein costs related to a reduction in the supply of hogs stemming from China's African Swine Fever and elevated transportation costs versus recent deflationary trends), which stand to eat into the firm’s margin trajectory. As such, we forecast operating margins will remain in the low-20s over our 10-year explicit forecast, generally in line with fiscal 2018 (but below its mid-20s peak in 2016 and 2017).
_________________________________________________________________________________________________________________
While Kraft Heinz’s shares retreated at a high-single-digit clip following its fourth-quarter print, we don’t think there has been a material deterioration in the story over the past several months to merit such a pullback. Rather, we believe that under the direction of CEO Miguel Patricio (who joined the firm just more than six months ago from wide-moat Anheuser-Busch InBev) Kraft Heinz is stocking up on the ingredients necessary to strike up a more flavorful recipe for the long term (pivoting away from blindly rooting out costs, in favor of sustainable efficiencies, with the intent to funnel a portion of any savings realized to elevate the standing of its brands).
We attribute a portion of the market’s disfavor to the slight delay in the time over which the firm intends to convey the details of its strategic direction, which is now set for early May as opposed to March prior. However, the underlying premise behind this shift (affording the recently appointed head of the U.S., Carlos Abrams-Rivera, who joined Feb. 3 from Campbell Soup, time to reflect on the tenets of its approach and interject his perspective) seems reasonable. And despite this extended horizon, we don’t think the drive to incite change is on hold.
In the aggregate, we see little in the fourth-quarter results (a 2.2% decline in organic sales, a 20-basis-point shortfall in gross margins to 32.2%, and an 80-basis-point erosion in adjusted operating margins to 20.0%) or near-term guidance (suggesting pressure at the sales and profit lines is unlikely to subside in 2020, generally in line with our expectations) to warrant a material change in our $50 fair value estimate. Further, we’re holding the line on our long-term outlook, calling for 2%-3% annual organic sales growth long and operating margins remaining in the low-20s over our 10-year explicit forecast. We continue to posit patient investors should consider stocking up on this no-moat name, which trades 45% below our valuation.
Risk and Uncertainty
We think Kraft Heinz's intent focus on extracting significant costs (at the expense of brand spend) has resulted in the degradation of its brand intangible asset (eroding its brands and retail relationships). Further, attempts to extend the distribution of Kraft's products over Heinz's international network may continue to falter if efforts to tailor its mix to better align with local tastes and preferences prove insufficient.
We also surmise that consumers perceive a few of the categories in which Kraft competes--namely, cheese and packaged meats, which in the aggregate account for around one third of total sales--as commodified, implying purchase decisions are more likely to be based on price rather than brand. In addition, Kraft generates just over 20% of its sales from Walmart, and its bargaining clout could diminish as the base of retail outlets continues to consolidate and market share shifts to mass merchants and warehouse clubs at the expense of traditional grocery stores.
Bouts of unfavorable weather could place upward pressure on input prices for products such as dairy, coffee beans, meat, wheat, soybean, nuts, and sugar. In response to the rampant cost inflation in the cheese, meat, and coffee categories a few years ago, Kraft put through significantly higher prices, but was unable to fully offset the profit hit, given the lag in the benefit. Further, transportation and logistics costs have soared and show little sign of abating, which stands to crimp profit prospects across the industry.
Finally, even with a new management team at the helm, it is unclear whether the firm will be able to orchestrate sufficient change to bolster its financial performance. We think this sizable task could prove more challenging given the intense competitive landscape in which it plays, as it consistently goes to bat against other leading branded operators, private-label fare, and smaller, niche foes (which have proven more agile in their response to evolving consumer trends).
I and/or others I advise hold a material investment in the issuer's securities.
_________________________________________________________________________________________________________________
All comments and likes are very appreciated.
Best Regards,
I0_USD_of_Warren_Buffet