KHC - Kraft Heinz: Appetizing Dividends And Strong Upside Potential

2024-01-17 09:00:00 ET

Summary

• Kraft Heinz has seen a 16.5% total return since October, outperforming the S&P 500 index.
• The company is turning a corner with reinvestment in marketing and product innovation, leading to respectable bottom line growth.
• It's deleveraging its balance sheet, currently pays a well-covered dividend, and has announced a $3 billion share repurchase program.

It’s been a while since I last visited The Kraft Heinz Company ( KHC ) here in October with a ‘Strong Buy’ rating. With consumer staples being out of favor with investors at the time, the stock seemed like good value when market sentiment was working against it.

It appears that the market has agreed with my bullish stance and concerns around the newest class of weight-loss drugs and their potential impact to food companies may have eased. KHC has given investors a 16.5% total return since my last piece, besting the 10% rise in the S&P 500 ( SPY ) over the same time period. In this article, I revisit KHC and discuss why it remains a good bargain in a frothy market, so let’s get started!

Why KHC?

Kraft Heinz fits the mold of a company that has strong brands, with a number of household names that have earned the trust of consumers around the world, with 200 brands and a presence in 190 countries.

Despite having strong brands that’s been around for a long time, KHC has seen its share of struggles over the past decade as a result of underinvestment and relentless cost cutting. As a result, top-line growth has been underwhelming as consumers gravitated to KHC’s competitors.

However, it appears that the company is finally turning a corner, as reinvestment by management into KHC’s marketing, technology, and research and development into product innovation appears to be paying off. As shown below, KHC’s trailing 12-month revenue currently sits at the top end of its history dating back to 2016, and operating margin is also on its way up due to supply chain efficiency initiatives bearing fruit.

KHC was able to continue this trend in the last reported quarter, with organic sales growing by 1.7% YoY during the third quarter, driven by a respectable 8% increase in International Markets outside of North America, and North American sales being relatively flat at a 0.1% YoY decline.

Impressively, this is on the back of overall strong results in prior quarters as KHC saw 4.9% YoY organic sales growth in the first nine months of 2023, driven by 13% growth in International. As shown below, KHC’s growth is coming from key brands that resonate with consumers like Heinz, Kraft Mac & Cheese, and Philadelphia.

These results were driven by improving volume and market share across KHC’s categories. Plus, KHC’s realized cost efficiencies and pricing power drove adjusted EBITDA and EPS by an impressive 13% and 14% YoY during the last reported quarter. Profitability could also improve in the near-term, as management expects to achieve 4% COGS savings for the full year 2023. As shown below, KHC scores an A- grade for Profitability in the Consumer Staples sector, with EBITDA and Net Income margins that are more than twice that of the sector median.

Looking ahead to Q4 results and beyond, I would expect to see continued momentum around key brands, particularly in Emerging Markets, where KHC found plenty of success last year and in the cold cuts business that’s starting to gain share. Foodservice is another category that continues to shape the forward trajectory of KHC, as the low unemployment rate continues to spur consumers to dine out.

Management expects for the Foodservice category to grow in the low- to mid-teens for 2023 and 5% in 2024. As shown below, KHC’s Taste Elevation and Easy Meals are expected to grow market share for the full year 2023, and recent momentum around U.S. retail could help KHC to land flat from a share perspective for last year.

Risks to the thesis include a tough retail environment in the U.S. as market share growth for KHC has been about flat last year. This could spur aggressive promotions and cut into margins. However, the CFO reiterated that they aren’t going to sacrifice pricing for market share, as noted during the last conference call :

Look, we believe that for us to grow top line in a profitable sustainable way is critical. So, if in an event where industry is zero, I think that doesn’t change the game that we are trying to play. Because I don’t know if you are implying that we will start to go aggressive on promotions to try to get volume through market share in a productive and sustainable way. If that’s what you are asking behind your question, that’s not the game we are going to play. So, I will just say that our strategy continues to be the same, it’s working. And I think we feel that’s heading in the right direction. We don’t want to make a change in direction because of temporary situations in the industry.

Other risks include KHC’s slightly elevated leverage, with a net debt to TTM EBITDA ratio of 2.9x. It’s worth noting, however, that KHC has made great strides in deleveraging its balance sheet in recent years, and this is reflected by the 0.4x improvement in the leverage ratio of 3.3x at the end of 2022. Going forward, I would expect for the leverage ratio to trend toward the 2.5x level.

Meanwhile, KHC sports a healthy 4.3% dividend yield that’s well-covered by a 53% payout ratio. While dividend growth has been lacking, shareholders could see value realization from KHC’s plans to repurchase $3 billion worth of common stock between now and the end of 2026. Based on KHC’s current equity market cap of $46.2 billion, this equates to a substantial 6.5% of the current float.

Lastly, I continue to see value in KHC at the current price of $37.68 with a forward PE of 12.7, sitting below its normal PE of 14.6 over the past 10 years. Generally, consumer staples companies with strong brands trade at a long-term PE in the 18-20x range, and I believe that KHC has traded at a discounted over this timeframe due to perceived risks around its leverage, which it is bringing down.

Analysts expect long-term annual EPS growth in the 6% to 9% range starting in 2025, which combined with annual share buybacks (of around 2% of market cap) and the 4.3% dividend yield could result in solid annual returns in the 12% to 15% range from the current price.

KHC's valuation also remains at the low end compared to peers. As shown below, its EV/EBITDA of 10.1 is close to that of J. M. Smucker ( SJM ) and Conagra Brands ( CAG ), while being materially below that of Hormel ( HRL ) and Kellanova ( K ).

Investor Takeaway

Overall, Kraft Heinz has shown respectable performance in recent quarters and is poised for continued success in the future. Its key brands have resonated with consumers and its cost efficiency initiatives have resulted in solid growth in the bottom line. Additionally, KHC's focus on key segments such as Emerging Markets, cold cuts, and foodservice will likely contribute to its growth in the coming years.

While there are some risks to consider, such as a tough retail environment and slightly elevated leverage (which management has been bringing down), KHC's solid dividend yield and forward share buybacks make it an attractive investment opportunity with potential for strong annual returns. Considering all the above and the rise in valuation since I last visited the stock, I'm downgrading my rating from a 'Strong Buy' to a 'Buy'.

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