KHC - 5%-Yielding Kraft Heinz Is A Top-Tier Recovery Stock

2023-11-11 23:10:29 ET

Summary

• Kraft Heinz is a strong recovery play in the consumer staples sector, with potential for stock price recovery.
• The company is facing inflation issues and a loss of pricing power but remains optimistic about its future.
• Kraft Heinz is gaining market share, improving efficiency, and has a healthier balance sheet, making it an attractive investment with potential for sustained dividend growth.

Introduction

I like the consumer staples sector a lot. Right now, I'm watching two groups of stocks in this sector. Companies with strong pricing power and consistent long-term outperformance and players that are struggling more with elevated inflation.

To give you an example, PepsiCo ( PEP ) is a company I would put in the first category. The Kraft Heinz Company ( KHC ) is in the second category.

Nonetheless, the second category isn't hopeless. The second category makes for terrific recovery plays, meaning stocks trading below their fair value with a high likelihood of a stock price recovery.

On September 7, I wrote an article titled Kraft Heinz: 5% Yield And Up To 40% Undervalued . Since then, the stock has returned 0.3%, beating the S&P 500 by 0.7 points.

These numbers aren't spectacular. However, they show that the stock has refrained from moving lower despite ongoing inflation issues, very poor consumer sentiment, and the belief that interest rates may remain higher for longer.

Earlier this month, the company reported its earnings, which underline my bull case. Although this corporation is suffering from elevated inflation and a loss of pricing power (lower volumes due to higher prices), it is upbeat about its future, expecting to regain pricing power through company initiatives.

In this article, I'll walk you through important developments and explain why KHC remains a fantastic recovery play in this sector.

So, let's get to it!

Light At The End Of The Tunnel

One of the biggest problems facing established consumer staple companies has always been inflation. In general, pricing power in grocery stores is low, with the ever-present threat from generic brands.

Periods of elevated inflation really test how strong certain companies and brands are. Companies in the snacking business often have better pricing power, as chips and related products are not that essential and are often protected by better brand awareness.

Kraft Heinz has top-tier products but limited pricing power.

In the third quarter, the company saw a 1.7% growth in organic net sales.

Price grew by 7.1 percentage points, offset by a 5.4 percentage point decline in volume/mix.

However, volume trends are expected to improve as the impact of pricing diminishes, with action plans taking effect.

Despite weak organic growth (with steep declines in volumes), the company was able to report 12.9% growth in constant currency adjusted EBITDA and 14.3% growth in Adjusted EPS.

When looking at the three pillars of growth, we see a solid performance.

• Foodservice Growth: Foodservice sales grew by approximately 9%, outpacing the industry, with a focus on driving growth through a Chef-Led model and prioritizing higher-margin spaces.
• Emerging Markets: Double-digit organic net sales growth continued in emerging markets, driven by a data-driven go-to-market model, leveraging the Heinz brand and expanding the food service business.
• U.S. Retail GROW Platforms: While overall North American organic net sales declined slightly, GROW platforms in the U.S. grew by 3.3%, with a focus on rebuilding profitability in the meats business.

Even better, on top of successful growth initiatives, the company is gaining market share.

Through comprehensive initiatives, including joint business plans, increased marketing investment by 25%, and targeted innovation efforts, the company has successfully reversed market share declines, particularly in categories like Cream Cheese and Cold Cuts.

Collaborative efforts with key retailers and a strategic focus on pricing and service improvements have led to a significant recovery, with Cream Cheese experiencing a 50 basis points share growth in October.

These category-specific actions align with the company's broader commitment to building market share, supported by a solid supply chain and a case-fill rate in the high 90s by the end of Q3.

The company also maintained a disciplined approach to promotions, reducing volumes sold on promotion in the U.S. by seven percentage points versus 2019.

Returns on investment improved by 15 percentage points, showing the effectiveness of investments in revenue management and technology.

Speaking of efficiency, the company continues to drive continuous improvement in its supply chain, pacing ahead of its gross efficiency target of $2.5 billion by 2027.

Despite inflation, the company is moderating and expects mid-single-digit inflation for the full year, with specific challenges in labor, tomatoes, and sugar.

A Better Outlook & Healthier Balance Sheet

One of the most important issues is balance sheet health. After all, due to balance sheet deleveraging, the dividend hasn't grown in recent years.

The dividend is currently stuck at $0.40 per share per quarter. This translates to a 4.9% yield, protected by a 53% earnings payout ratio.

In the third quarter, net leverage has been reduced to 2.9x EBITDA, reaching the long-term target of approximately 3.0x. This was supported by a free cash flow conversion rate of 68%.

Although it needs to be seen how high dividend growth will be, we're now very close to what could be a prolonged period of sustainable and regular dividend growth.

Kraft Heinz also hiked its outlook.

The outlook for organic net sales is at the low end of the 4 to 6% range, at approximately 4%. Constant currency-adjusted EBITDA guidance was raised to 5% to 7% growth.

The adjusted gross profit margin is expected to expand by 200 to 250 basis points. Adjusted EPS guidance was raised to a range of $2.91 to $2.99, reflecting 5% to 8% growth versus 2022.

This helps the company's valuation as well.

An Attractive Valuation

KHC is currently trading at a normalized P/E ratio of 11.2x.

• The five-year normalized P/E ratio is 12.8x.
• This year, EPS is expected to grow by 6.8%, which is well within the company's guidance.
• Next year, EPS is expected to grow by 1.5%, followed by 6.3% growth in 2025.
• While these numbers are obviously subject to change, they could help the stock return 15% per year through 2025 (including dividends).
• This theoretical performance is based on a return to a reasonable valuation and its expected growth rates.
• As we can see in the lower part of the chart below, current EPS expectations are either above or close to expectations from six months ago, showing that it has held up quite well in this economic environment.

While a 15% annualized return is not promised - especially not in this economic environment - it does show that KHC has a favorable risk/reward with 30% to 40% undervaluation.

Takeaway

Kraft Heinz, despite grappling with inflation, demonstrates a robust rebound.

Supported by growth in key areas and market share, KHC's strategic initiatives are paying off.

With a healthier balance sheet and an attractive valuation, the prospect of sustained dividend growth adds allure.

Meanwhile, the current undervaluation hints at a potential 15% annualized return, making Kraft Heinz a compelling choice for investors eyeing long-term gains and income.

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