KHC - 3 Reasons To Buy The Kraft Heinz Stock

2023-08-04 11:45:54 ET

Summary

• Kraft Heinz is down by 13% this year but we think its prospects could possibly change.
• FCF generation looks poised to improve even as inventory normalization deepens.
• KHC has been showing an increased cadence of efficiency savings and this is reflected in the pace of EBITDA growth over sales growth.
• Forward valuations look cheap and the risk-reward on the charts look attractive.

Introduction

In 2023 so far, the stock of the multinational food company- Kraft Heinz ( KHC ), has proven to be a disappointment of sorts, delivering negative returns of -13%, even as its peers from the staple space have managed to deliver marginal positive returns.

After an underwhelming first seven months of the year, we think KHC could possibly turn out to be a more fruitful pick at these levels. Here are a few reasons why we’re optimistic about the stock at this juncture.

FCF Generation Is Looking Up

For long periods, KHC’s FCF (Free cash flow) generation wasn’t in a good place, but it looks like the tide has begun to turn. In H1, FCF was up by over 200% YoY, although the weak base effect played a part, and we think there’s still ample scope for further improvement ahead as the FCF yield is still below par.

Last year, to cope with supply chain uncertainties, KHC attempted to build a large buffer of stocks which impacted the cash position. This is reflected by the inventory turnover ratio which had dropped to 1.7x from the normal average of 2.1x.

This has been one of the main drivers for boosting the number of days tied up with working capital cash conversion. Normally it’s only around three days or so, but in recent quarters it has been in double-digits (although Q2 witnessed some sequential progress).

Those key working capital ratios will likely mean-revert in the quarters ahead, and KHC management is on record stating that they have a “very robust plan to bring the inventory down to levels before”, with the intention to get turnover ratios back to the pre-pandemic range.

On the Q2 call , management did also confirm that H2 would see an increased cadence of promotions in selected categories which could serve as an important catalyst for inventory corrections. Increased promotions will also help dampen the pressure on the volume front, a metric which has been worsening sequentially, mainly on account of Kraft Heinz’s premium pricing (see image below):

Some investors may be worrying about what fresh promotions could do to the margin picture, but it’s also important to consider that KHC will likely be very disciplined in their promotions, and so far, their data-driven promotion strategy in the North American markets has already been quite fruitful from an ROI perspective, relative to the pre-pandemic era. Besides, on account of seasonality , margins should still hold up pretty well in H2 (particularly in Q4) even with slightly higher promotions.

All in all, coming back to the original point of inventory rationalization, this will certainly help speed up the FCF conversion levels (FCF as a function of adjusted net income) from sub-50% levels to levels of 75-80% by the end of this year. As FCF picks up, there’s an outside chance that we even get a hike in dividends, as management doesn’t seem too keen to buyback shares.

Given The Ongoing Operating Improvements, Valuations Look Cheap

Value-conscious investors could also likely make a beeline for KHC stock at these levels, as the narrative here looks quite enticing when you consider the degree of improving operating leverage that the business has been generating recently, largely on account of pricing and efficiency gains. In Q1, the pace of YoY EBITDA growth was 1.41x the level of YoY sales growth, but this picked up even further in Q2 to 2.3x.

For the uninitiated, KHC has been reaping the fruits of an ongoing efficiency program. Initially, the company was only hoping to generate over $400m of gross savings per annum, but they’ve stepped on the pedal and hope to increase the runrate to $500m per annum.

All in all, given the improving operating dynamics, we think it’s a good opportunity to pick up KHC when it is trading closer to the lower-end of its 5-year EV/EBITDA trading band (also 7% cheaper than the long-term average multiple).

It isn’t just the EV/EBITDA metric, even from a forward P/E angle (based on the FY24 EPS), KHC offers good value at these levels, trading at a 9% discount to its long-term average.

KHC has also been paying quarterly dividends for 10 years now, and at the current price level, you could lock in a yield of 4.5%, almost 40bps higher than what you normally get from this counter.

Favorable Risk-Reward On The Charts

If one studies KHC's weekly price imprints over the last two years or so, we can see that the stock has been leaving traces in the shape of a wedge pattern. Currently, it appears that the broad trading range is between the $35 to $44 levels. Given where KHC's stock is currently perched, and looking at those two boundaries, it's fair to say that the reward-to-risk equation for a long position looks very attractive at these levels. Even if you have a conservative trading mindset, and only consider intermediate pivot points, you could maybe also use the downward-sloping resistance (which has been in play since last May) as an exit guidepost.

Then it's also worth considering how KHC is positioned relative to other value stocks from the S&P500. The chart below suggests that KHC could potentially work as a suitable rotation play for investors fishing for good value opportunities in this space. Currently, the relative strength ratio of KHC versus the value stocks of S&P500 is around 25% off the mid-point of its range, and we may see some mean-reversion closer to those levels.

For further details see: