Should I Buy Kraft Heinz Co (KHC) Stock?j

Kraft Heinz 4Q 2018 Results

On the fateful day of 21 February 2019, Kraft Heinz reported their fourth quarter and full year 2018 results. Kraft Heinz is behind popular brands such as Kraft, Jell-o, KoolAid, Maxwell House, Stove Top, Planters and more.

Here are some summary pointers:

• Net sales grew by 0.7% to USD $6.891 billion
• Costs savings fell below targets
• non-cash impairment charges of $15.4 billion caused by certain reporting units, primarily U.S. Refrigerated and Canada Retail, and certain intangible assets, primarily the Kraft and Oscar Mayertrademarks.
• Fourth Quarter sales in the United States, Canada, EMEA and the rest of the world were disappointing
• Net debt to equity is 58.2%.
• The dividend is cut by 30% to deleverage the balance sheet
• U.S. Securities and Exchange Commission started investigating Kraft Heinz’s accounting policies, procedures and internal controls.

As a GIM investor, here is my take:

• If a company is unable to grow its revenue (top line) by more than 5%, why would I consider to buy the shares? A business value grows as it earns more profit.
• Looking at this ratio “Goodwill + Other Intangibles / Total Assets”, it is a jaw-dropping ratio of 83%. If 83% of my company’s total assets are not in hard-asset but based on figures which could be easily be adjusted by accounting assumptions, isn’t that frightening? On top of that, if the brands continue to deteriorate, will there be further write-downs in those goodwill and other intangibles? 

Part 1: Shareholders 3G Capital Berkshire Hathaway

Berkshire and 3G Capitals owns 26.7% and 22.1% of KHC — respectively. The deal was made in 2015.

3G Capital is a Brazillian investment firm, managed by Jorge Paolo Lemann. I think they are great people and they’ve really delivered fantastic results for its shareholders. 3G is known widely for their ability to cut costs for its investees. They helped Burger King to a turnaround in a stellar way, then helped Burger King merge with Tim Horton’s and Popeye’s. As a result, the companies that 3G invest… turn out to be leaner and profits start to rise.

And I understand why they have to do it. For mature industries, it is hard to grow especially when you’re a big giant. Cost-cutting to promote efficiency is one of the popular ways in these situations.

They do that by embracing zero-based budgeting. It means that every new expense has to be justified. 3G installed the new CEO Bernard Hees and many expenses were eradicated.

source: chiefexecutive.net

Staff were made redundant, corporate jets were sold and staff perks such as refrigerators stocked with snacks were removed. Just imagine how employees would feel about it? The morale would drop. From my personal sources, McDonald’s stopped using Heinz Ketchup in 2013 when CEO Bernard Hees took over Heinz.

Using Morningstar, you can see that its operating margin expanded from 14.4% (2015) to 25.8% (2017). It’s remarkable.. but it might come at the expenses of their employees’ welfare.

As a GIM investor, here is my take:

• While cost-cutting is something that boosts the profits considerably, there are certain limits to it. It’s like, you can cut your fats but you still need a skeleton to function.
• Cost-cutting may have trade-offs such as lower staff morale, lack of R&D budget, and staff overwork. I think it’s hard to balance reducing expenses versus investing for growth.
• My preference would be growing your sales faster than your expenses growth.
• Think about as an individual, to save more money, you need to spend lesser. But that’s miserable because it means you can’t afford to spend on your favourite shopping and food. So instead of focusing on cost-cutting/saving more money, focus on growing your sales/income.
• There is a limit to how much you can cut costs, but the limit to how much you can grow your sales are far wider.
• Cost-cutting is probably the shortcut way to grow your profits. Useful in the short-term but highly fatal in the long-term.
• It is one thing to invest in a company where management has experience only in cutting costs, and another thing to invest in a company where the management has a wonderful track record in building brands.

Part 2: Warren Buffett’s Remarks

Key Takeaways:

1. He won’t buy more or sell Berkshire’s stake in Kraft Heinz
2. Greater pressure coming from Amazon.com Inc, Walmart Inc and Costco Wholesale through their private brands.
3. Despite thinking that he has purchased a solid brand (Kraft Heinz) which millions of money is spent on advertising and promotions, newer brands are gaining momentum and customer awareness faster. It caused disruptions and worries among the top incumbents.
4. I think not only Kraft Heinz is affected, Campbell Soup as well. The packaged food industry is undergoing some changes.

Part 3: Valuations

While the earnings are a bit fuzzy at the moment, I do think there is a very simple way to value companies like Kraft Heinz. 3 – 4 months ago, I did a similar valuation method for Genting Malaysia. It’s called Price-to-Book value.

Back in Nov/Dec, Genting Malaysia reported an impairment loss.

Genting Bhd swung to a third-quarter net loss of RM275.8 million –  its first quarterly net loss in 10 years – versus a net profit of RM190.04 million a year ago, no thanks to an RM1.83 billion impairment loss on its 49.4%-owned unit Genting Malaysia Bhd’s (GENM) investment in the promissory notes issued by the Mashpee Wampanoag Tribe.

source: https://www.theedgemarkets.com/article/genting-swings-first-quarterly-loss-decade-impairment-loss

Looking at it, I believe a business like Genting Malaysia should trade above book value simply because [1] its brand has value and certain recognition [2] they have the only casino licence in Malaysia. The book value was MYR $3.10. At the point when I saw it, the price fell to RM $2.88. The P/B is 0.93x.

There is no way it should stay this valuation because of the factors I mentioned above. As of 1st March, it closed at RM $3.44. A 19.4% gain in 3 months. Not too bad! I told this to my friends and all of them resonated by taking action.

While both of them was affected by impairments, the profile of Genting Malaysia and Kraft Heinz is very different. Genting Malaysia has virtually no competition in Malaysia’s casino, they are the only player. Genting has a negative cash conversion cycle and the net debt is 7.4%. Its goodwill ratio of the total asset is 14.2% — far lesser than KHC’s 83%.

Kraft Heinz faces competition from other players. The names are Kellogg, General Mills, Nestle and others. It is definitely not an apple to apple comparison because of the profiles and fundamentals of the company.

If Price-to-book ratio, KHC’s latest book value of US $42.45 and the closing share price is US $32.40. This gives us a P/B of 0.76x.

If you ask me where the margin of safety lies, given both Genting Malaysia and KHC is at P/B 0.76x, I would choose to buy Genting Malaysia anytime. I am not sure how to think about KHC’s price to book. But I suppose at 0.76x, the risk should be rather minimal.

Everything looks bleak now. I am also not sure whether there would be another round of impairment write-down, should their brands deteriorate further. If so, a lower P/B is required. Anyway, what most people do not realise is KHC owns several brands which could be sold to interested parties. This helps them in deleveraging and having a focused portfolio.

Conclusion

For valuations, there is no exact science on how we do our assessment. For me, I chose to ignore the profits and focused on the book value which is really simple. Looking at how things are developing, I think P/B 0.85 should be reasonably comfortable for KHC.

Taking 0.85 / 0.76 -1, the upside is 11.8%.  I think there is a chance to make 9-12% gain in the share price in the next 2 – 3 months. KHC is not my cup of tea because I don’t like companies that grow via cost-cutting. Secondly, after making 9-12%, can this company grow continuously for the next 5 – 10 years? The future looks uncertain.

My personal preference is to buy small, focused companies that are managed by visionary, hungry entrepreneurs whose products are adding value to the world. I am looking for 5 – 10x gain in companies I invest.

I hold no responsibility for my research and I am not a licenced financial advisor, so please do your due diligence.