The Earnings Report
The earnings report
that triggered the stock price collapse, for Kraft Heinz Co (NASDAQ: KHC), was released on February 22, and it contained bad news on many fronts:
- Flatlining Operartions: Revenues for 2018 were unchanged from revenues in 2017, but operating income dipped (before impairment charges) from $6.2 billion in 2017 to $5.8 billion in 2018; the operating margin dropped from 23.5% in 2017 to 22% in 2018.
- Accounting Irregularities: In a surprise, the company also announced that it was under SEC investigation for accounting irregularities in its procurement area, and took a charge of $25 million to reflect expected adjustments to its costs.
- Goodwill Impairment: The company took a charge of $15.4 billion for impairment of goodwill, primarily on their US Refrigerated and Canadian Retail segments, an admission that they paid too much for acquisitions in prior years.
- Dividend Cuts: The company, a perennial big-dividend payer, cut its dividend per share from $2.50 to $1.60, to prepare itself for what it said would be a difficult 2019.
While investors were shocked, the crumb trail leading up to this report contained key clues. Revenues had already flattened out in 2017, relative to 2016, and the decline in margins reflected difficulties that 3G faced in trying to cut costs, after the deal was made. The only people who care about impairment charges, a pointless and delayed admission of overpayment on acquisitions, are those who use book value of equity as a proxy for overall value. The dividend cuts were perhaps a surprise, but more in what they say about how panicked management must be about future operations, since a company this attached to dividends cuts them only as a last resort.
The Value Effects
With the bad news in the earnings report still fresh, let’s consider the implications for the story for, and the value of, Kraft Heinz. The flat revenues and the declining margins, as I see them, are part of a long term trend that will be difficult, if not impossible, to reverse. While Kraft-Heinz may have a quarter or two with positive blips, I see more of the same going forward. In my valuation, I have forecast a revenue growth of 1% a year in perpetuity, less than the inflation rate, reflecting the headwinds the company faces. That downbeat revenue growth story will be accompanied by a matching “bad news” story on operating margins, where the company will face pricing pressures in its product markets, leading to a drop (though a small and gradual one) in operating margins over time, from 22% in 2018 (already down from 2017) to 20% over the next five years.
The company’s cost of capital is currently 6%, reflecting the nature of its products and its use of debt, but over time, the benefits from the latter will wear thin, and since that is close to the average for the industry (US food processing companies have an average cost of capital of 6.12%), I will leave it unchanged. Finally, the mistakes of the past few years will leave at least one positive residue in the form of restructuring charges, that I assume will provide partial shelter from taxes, at least for the next two years.
The good news is that, even with a stilted story, Kraft Heinz has a value ($34.88) that is close to the stock price ($34.23). The bad news is that the potential upside looks limited, as you can see in the results of a simulation that I did, allowing expected revenue growth, operating margin and cost of capital to be drawn from distributions, rather than using point estimates.
The finding the value falls within a tight range, with the first decile at about $26 and the ninth at close to $47 should not surprise you, since the ranges on the inputs are also not wide. As an investor, here are the actions that would follow this valuation.
- If you owned Kraft Heinz prior to the earnings report (and I thankfully did not), selling now will accomplish little. The damage has been done already, and the stock as priced now, is a fair value investment. I know that 3G sold almost one quarter of its holding in September 2018, good timing given the earnings report, but any attempts to sell now will gain them nothing. (I made a mistake in an earlier version of the post, and I thank those of you who pointed it out.)
- If you don’t own Kraft Heinz, the valuation suggests that the stock is fairly valued, at today’s price, but at a lower price, it would be a good investment. I have a limit buy on the stock at a $30 price (close the 25th percentile of the distribution), and if it does hit that price, I will be a Kraft Heinz stockholder, notwithstanding the fact that I think its future does not hold promise. If it does not drop that low, there are other fish to catch and I will move on.