KHC - Kraft Heinz: Inflation Aids But Volume Trends Are Concerning

2023-08-07 06:56:05 ET

Summary

• Kraft Heinz has experienced stagnating results and divestments hurting sales, with inflation impacting margins.
• The company's struggles can be traced back to a mega-merger nearly a decade ago, resulting in a significant decline in stock value.
• Despite poor volume trends and operational struggles, KHC has maintained stable debt levels and offers a 4.5% dividend yield.

In February of this year I believed that Kraft Heinz ( KHC ) has seen another lost year in 2022. This came after the company posted its annual results which revealed stagnating results, with divestments hurting sales, as inflation had an impact on margins.

While the outlook for 2023 remained uncertain, the bright news was that the more elevated pace of divestments appeared to be a thing of the past, with leverage firmly under control here. While the company has returned to growth in the first half of the year, this is entirely driven by pricing, with underlying volume trends being rather soft.

Nearly A Decade Of Struggles

Following a mega-merger between Kraft and Heinz which took place nearly a decade ago, back in 2015, we have seen a $100 stock at the time fall to levels around the $30 mark pre-pandemic. The impact of leverage, elevated pricing and cuts on R&D efforts have weighed heavily on the business and the share price performance.

Trying to address these issues, the company has divested the Planters Nuts business in a $3.3 billion divestment in 2021, as the company sold its cheese activities in a $3 billion deal as well.

Forwarding to early 2022, Kraft Heinz posted a 0.5% fall in sales to $26.0 billion for the year 2021, with EBITDA down 4% to $6.4 billion, adjusted EBITDA of course that is. Adjusted earnings per share rose by five pennies to $2.92 per share, as net debt of $18.4 billion by now had fallen to about 3 times EBITDA.

That picture was a bit incomplete, as the company originally guided for a low single digit decrease in comparable sales in 2022 with EBITDA seen down to $5.8-$6.0 billion, on the back of operational struggles and the impact of the divestments. With inflationary pressures increasing during 2022, the company hiked the sales volumes, while keeping the EBITDA and earnings metrics largely intact.

Believing that earnings power for 2022 could come in around $2.50 per share, a 16 times multiple at $40 per share in February looked quite reasonable, perhaps full. This came as underlying growth was not so good, as inflation resulted in sales growth but no underlying volume growth, while the company still torched along a net debt load equal to 3 times EBITDA, although that was largely in line with many consumer packaging peers here.

Note that 2022 adjusted earnings came in at $2.78 per share, but with GAAP earnings coming in at $1.91 per share, and I am not blindly accepting all the adjustments, as I worked with the $2.50 per share estimate.

With the pricing looking much more fair, with a lot of the re-rating done already, I felt that the risk-reward was not overly appealing at $40.

Cooling Down

Since February shares of Kraft Heinz have been trading in a pretty tight range, between $35 and $40 per share, with shares now trading at the lower end of the range.

In May, Kraft Heinz posted a 7.3% increase in first quarter sales, in part held back by divestments, with organic sales being up 9%. The composition of growth however has been really poor with pricing up 15%, while underlying volumes and mix were down by 5%, with consumers looking for cheaper alternatives, or consuming less.

The company grew operating earnings by 11% to $1.24 billion. Amidst fewer one-time benefits appearing on the bottom line, earnings rose by 5 cents to $0.68 per share, a number reported both on a GAAP and non-GAAP basis.

On the back of the relatively solid quarter, the company now saw 2023 earnings between $2.83 and $2.91 per share, adjusted earnings those are of course.

Second quarter sales showed the impact of lower inflation, with reported sales up just 2.6% to $6.7 billion, with organic sales up 4%. Pricing contributed 11% to growth, yet with inflation coming down on a sequential basis, it was disappointing to see a 7% fall in volume/mix. Promising was to see that the company saw margins improved a bit on the back of these trends, with adjusted earnings per share up nine cents to $0.79 per share.

The company reaffirmed the full year guidance, yet with adjusted earnings so far this year coming in eighteen cents ahead of last year at $1.48 per share, there seems to be room for upside surprises. Net debt is pretty stable at $19.0 billion, although that growing EBITDA numbers makes that leverage still comes in around 3 times.

And Now?

A 12-13% pullback in the time frame of a quarter is quite a bit for a consumer staple business like Kraft Heinz. The reason for that are not the headline numbers, as topline sales and earnings growth looks pretty decent, but the composition of growth is very poor, with second quarter volumes down as much as 7%. This brings the fear that the company cannot pursue prices hiked in the second half of the year, and that this will subsequently result in (renewed) margin pressure.

That being said, the investment thesis has been derisked quite a bit, as shares trade at 12 times adjusted earnings based on the full year guidance, and 14 times if we do not accept all the reconciliations made by management. Furthermore, leverage is under control, even as it is not rapidly coming down anymore, while a 4.5% dividend yield provides support and should be rather easy maintained by the company here.

A reason for the retreat in the share price is arguably the perspective of high inflation, which aided the business over the past year, yet is rapidly cooling down. More so, underlying (volumes) have seen much lower demand, as the observation that interest rates might be higher for longer, raise the bar as well. In fact, the current dividend yield actually trails risk-free rates by a small margin here.

Given this dynamic, I see appeal emerging again, and having traded in and out of the stock in the past, I am tempted to add to my current long position again in the lower thirties.

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