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Kraft Heinz Tailors Its Menu to Prompt Sustained Growth and Steady Its Competitive PositionKraft Heinz Tailors Its Menu to Prompt Sustained Growth and Steady Its Competitive Position Erin Lash Sector Director Business Strategy and Outlook | by Erin Lash Updated Nov 25, 2020 Like its packaged-food peers, Kraft Heinz has benefited from consumers’ newfound penchant for eating at home, with 85% of its sales driven through the retail channel. In addition, we surmise that its performance has been aided as consumers and retailers opt for leading branded fare (like that in Kraft Heinz’s portfolio), in line with the gains in household penetration and repeat purchase rates to which Kraft Heinz alluded. However, we had believed the firm was charting a new course even before the onset of the pandemic, following the appointment of CEO Miguel Patricio in 2019. More specifically, we posit the firm's revised strategic playbook--pursuing sustainable efficiencies, elevating brand spend (marketing and product innovation), enhancing capabilities (category management and e-commerce), and leveraging its scale to more nimbly respond to changing market conditions--is prudent. As a part of this, we think Kraft Heinz has abandoned its profitability-at-all cost mantra in favor of driving sustained and profitable growth. And while the firm intends to realize $2 billion in efficiency savings through 2024, it appears to be doing so as an opportunity to free up resources to reinvest in its product mix rather than inflating profits. As such, we think the firm’s focus on fueling marketing spending and aims to get more mileage out of these investments are judicious--aided by its decision to narrow its stock-keeping unit count (down 20% in North America this year). In this vein, management targets a 30% increase in marketing investments over the next five years, which we think stands to support its brand mix and its retail relationships. This aligns with our forecast for marketing, research, and development to expand to more than 5% of sales in the aggregate over our 10-year forecast versus less than 5% the past few years. But even with this shift, we don't envision the blistering pace prompted by COVID-19 will extend longer term (with our forecast calling for organic sales to moderate from the midsingle digits to low single digits) as consumers work through their pantries and resort to away-from-home food consumption as social distancing mandates are eased. Economic Moat | by Erin Lash Updated Nov 25, 2020 We don't believe that Kraft Heinz’s intangible assets or scale warrant an economic moat. Our contention is supported by returns on invested capital (including goodwill) that have languished, falling short of our 7% weighted average cost of capital estimate each of the past four years. We attribute these lackluster returns to the prior management team’s decision to prioritize near-term cash flow at the expense of protecting its long-term competitive position. Since the tie-up in 2015, Kraft Heinz has operated as the third-largest food and beverage firm in North America behind PepsiCo and Nestle, boasting around $20 billion in sales on its home turf in 2019 (and about $25 billion on a consolidated global basis). The hallmark of the combination of Kraft and Heinz had resided in its ability to extract a significant degree of costs from its operations (with operating margins that now hover in the low 20s, materially above the mid- to high teens its peers boast). We don’t think this level of profitability evidences a scale edge but rather has been derived as it refrained from investing meaningful resources behind its brands. Investments in research, development, and marketing have amounted to just 4%-5% of sales annually at Kraft Heinz, generally lagging the mid- to high-single-digit levels at peers. Further, we don’t believe Kraft Heinz enjoys significant pricing power. As evidence, in its U.S. segment (around 70% of its consolidated sales base), Kraft Heinz volume has eroded more than 1% on average over the past four years, despite price holding about flat over the same time horizon. Further, some of the categories in which it competes--like packaged meats and cheeses, categories that account for around one fifth of its consolidated base, after excluding the pending sale of its natural cheese business--have become commodified, as consumers tend to consider price rather than brand when making purchase decisions. This is a particular challenge given that switching costs for the end consumer are essentially nonexistent in the consumer product industry. However, we no longer surmise that Kraft Heinz is anchored to its past and will part ways with less profitable (noncore) brands and businesses to the extent it affords an opportunity to invest additional resources behind its highest-return opportunities. Despite this, we aren't convinced these actions will manifest in a sustained improvement in its competitive position. Given that center-of-the-store grocery categories, such as simple meals and baking offerings, had been losing out to consumers' desire to shop the perimeter of the store for some time in search of healthier fare (before the onset of COVID-19), we think that maintaining--or even increasing--brand spending will be crucial in sustaining brand awareness and securing a competitive edge. We view this as even more essential now, relative to several years ago, in light of the rise of the e-commerce channel that has enabled smaller, niche operators to gain a leg up in amassing proof of concept, as retailers aren't beholden to allocate their inherently limited physical shelf space to unproven suppliers. Further, because of the intensely competitive environment in which it plays (going to bat against other branded peers, lower-priced private-label offerings, and smaller, niche operators), we believe Kraft Heinz will ultimately ramp up its brand spending in order to stave off market share losses, even though this spending would hamper margin gains over time (if not fueled by efficiency savings). But if this plays out and the firm’s sales and share exhibit stabilization, we would consider re-evaluating our moat rating. Fair Value and Profit Drivers | by Erin Lash Updated Nov 25, 2020 After reviewing results through the first nine months of fiscal 2020, we aren't making any changes to our $48 fair value estimate for Kraft Heinz, which implies a fiscal 2021 enterprise value/adjusted EBITDA multiple of 14 times. We believe with shelter-in-place and social distancing initiatives, at-home food consumption should remain elevated in the near term, aiding firms like Kraft Heinz that sell the bulk of its wares through the retail channel (which we estimate at 85% of its total sales). However, we don’t expect this growth will persist at the same cadence, as consumers work through their at-home inventory and ultimately venture out to restaurants. We also expect competitive intensity could increase, especially against a more challenging macroeconomic backdrop. This aligns with management's newly minted long-term targets (launched along with the dissemination of its revised strategic playbook) for 1%-2% organic sales growth and 4%-6% adjusted EPS growth. As such, our longer-term forecast calls for around 2% annual sales growth and operating margins holding in the low 20s. Over the next few quarters, we expect increased demand and factors related to the coronavirus are likely to result in higher costs, particularly related to safety, logistics, maintenance, and labor. But despite these near-term costs, we’re encouraged by the firm’s commitment to investing behind its brands, even amid this uncertain climate (with a focus on marketing and media, which was up 40% between the second half of 2019 and the first half of fiscal 2020). And we don't believe these were one-off investments, with management calling for a 70% jump in spending between the first and second halves of 2020. We aren’t surprised that previously planned innovation is on hold as the firm focuses its manufacturing resources on supplying retailers with the most in-demand offerings in the near term, which we view as prudent. We believe this ability to reliably deliver product to store shelves during the current pandemic could buoy the company's previously impaired relationships with its retail partners. But to ensure this persists over a longer horizon, we think the firm will need to keep its foot on the gas. We forecast marketing, research, and development to expand to more than 5% of sales in the aggregate over our 10-year forecast versus less than 5% the last few years. Risk and Uncertainty | by Erin Lash Updated Nov 25, 2020 We think Kraft Heinz's intent focus on extracting costs (at the expense of brand spending) has resulted in the degradation of its brand intangible asset, eroding its brands and retail relationships. Even though concerns surrounding COVID-19 have jump-started consumption of its fare lately, we don't expect these gains will prove sustainable as consumers destock their pantries when the pandemic subsides. As such, we believe that consumers perceive a few of the categories in which Kraft competes--namely, cheese and packaged meats, which account for around one fifth of its consolidated base, after excluding the pending sale of its natural cheese business--as commodified, implying purchase decisions are more likely to be based on price rather than brand. In addition, Kraft generates just over 20% of its sales from Walmart, and its bargaining clout could diminish as the base of retail outlets consolidates and market share shifts to mass merchants and warehouse clubs at the expense of traditional grocery stores. Bouts of unfavorable weather could place upward pressure on input prices for products such as dairy, coffee beans, meat, wheat, soybean, nuts, and sugar. In response to the rampant cost inflation in the cheese, meat, and coffee categories a few years ago, Kraft raised prices but was unable to fully offset the profit hit, given the lag in the benefit. Further, transportation and logistics costs have soared and show little sign of abating, which stands to crimp profit prospects across the industry. Finally, even with a new management team at the helm, it is unclear whether the firm will be able to orchestrate sufficient change to bolster its financial performance. We think this sizable task could prove more challenging given the intense competitive landscape in which it plays, as it consistently goes to bat against other leading branded operators, private-label fare, and smaller, niche foes, which have proved more agile in their response to evolving consumer trends. Stewardship | by Erin Lash Updated Nov 25, 2020 As shown in its languishing returns and declining sales trends, we believe Kraft Heinz's past management prioritized near-term cash flows and outsize profitability at the expense of its long-term competitive position (as it has failed to direct sufficient resources to support its intangible assets). Returns on invested capital (including goodwill) have been in the low single digits on average the last three years, below our 7% cost of capital estimate. While Kraft Heinz has alluded to the merits of upping its brand spending, we've yet to see tangible proof it is willing to sacrifice profits to do so over a longer horizon. As such, we believe Kraft Heinz's stewardship of shareholder capital is Poor. Further, we're not fans of the company's controlled structure--3G and Berkshire Hathaway each own around one fifth to one fourth of the outstanding shares. Still reeling from the unfavorable headlines resulting from its fourth-quarter 2018 earnings announcement surrounding a profit contraction, a Securities and Exchange Commission investigation into its procurement accounting, and a reduction in its quarterly dividend to $0.40 per share from $0.625, Kraft Heinz announced a change in leadership. Bernardo Hess was replaced as CEO at the end of June 2019 by Miguel Patricio, who had spent the prior two decades at wide-moat AB InBev, serving as president of Asia from 2008 to 2012 and chief marketing officer from 2012 to 2018. In a shift from its past organizational structure, Patricio does not have an affiliation with 3G (which acquired Heinz in 2013 and orchestrated the merger between Kraft and Heinz in 2015), and based on his rhetoric since assuming the top spot, we think he is working to instill a larger commitment to reigniting sales by fueling further investments behind its brands (with a focus on innovation that aligns with evolving consumer trends and marketing its new fare), in line with our expectation for Kraft Heinz’s brand spending to tick up to a mid-single-digit range over our 10-year explicit forecast. Although Kraft Heinz under the ownership of 3G Capital has epitomized extensive cost-cutting, we don't think such actions will persist in a similar fashion going forward. Patricio has repeatedly emphasized that he has the green light from the board to implement significant strategic change as a means to drive sustainable and profitable growth. Beyond its priorities for cash within its existing operations, a significant amount of attention continues to center on Kraft Heinz’s appetite for a deal and where its interests might lie, particularly after its thwarted bid for Unilever in early 2017. However, building on the previously announced sales of three Indian brands, its natural cheese business in Canada (for around $1.8 billion in the aggregate), and most recently, its natural, grated, cultured, and specialty cheese business to Groupe Lactalis for $3.2 billion, we expect management could look to continue parting ways with less profitable. We think these efforts could serve to focus its resources (both financial and personnel) on the highest-return opportunities. Further, the firm seems intent on reducing its debt load with the proceeds from these initiatives, which we perceive as prudent, given that debt/adjusted EBITDA stood at 4.8 times at the end of 2019, with aims for leverage to approach 3 times over the next few years (which strikes us as reasonable). The ongoing investigation into its procurement practices (which resulted in the delayed filing of its fiscal 2018 10-K and its first-quarter 2019 10-Q) led Kraft Heinz to restate earnings between fiscal 2016 and fiscal 2018. The identified misstatements related to the timing of previously recognized vendor agreements, supplier rebates, incentive payments, and pricing arrangements. This builds off its announcement in February 2019 during which it reversed previously recorded savings of $25 million in the fourth quarter of 2018. Despite filing its 2018 10-K (although delayed), the SEC investigation is still ongoing. Even though this issue doesn’t appear to be pervasive, amounting to just around $200 million in adjustments in aggregate (resulting in a less than 1% change to annual earnings per share each of the three years based on its preliminary estimates), relative to its cost base of $12 billion spent annually excluding key commodities, we believe this issue supports our Poor stewardship rating. |
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