Kraft Heinz (NASDAQ: KHC) has been a near-perfect hedge for the S&P 500 since our last Kraft Heinz article: Renovation Before Innovation. In addition to outperforming the S&P 500, KHC paid dividends, so the total return for 1.5 years compounded 17.8%, versus 7.9% in the S&P 500. Not too bad, in our opinion.
Now that some investors are preparing for a possible recession, KHC, as a consumer staple stock, could be a good investment idea.
Kraft Heinz hasn’t been an investor darling in the past
Historically, Kraft Heinz has not been an investor darling since Kraft Heinz’s $63 billion mega-merger in 2015. The first restructuring program under the supervision of Brazilian private equity firm 3G Capital did not did not give the expected results. This caused the share price to drop more than 40% in 2018-2019. The share price has not recovered to date. After that, a new management generation with Miguel Patricio was appointed in July 2019 and the turnaround efforts look much better this time around.
Kraft Heinz management has structured the company into six product platforms and set goals such as grow, energize or stabilize for each of them.
Most products (64%) are in Growing up category, where the company aims for both organic and inorganic growth. Structuring the portfolio allowed company management to set clear goals for each category, while focusing their marketing efforts where it counts, avoiding wasted marketing dollars. The management prides itself on flattening the hierarchy and shortening the decision-making time, thereby putting the giant corporation on agile tracks.
Kraft Heinz announces acceleration
Last year, KHC’s organic growth was 1.8%, driven mainly by the international segment, where organic growth was 3.1%.
In his February 2022 CAGNY presentation, Kraft Heinz raised his long term growth forecast, which we see as a sign of management’s confidence in the success of its acceleration plan.
The company has exceeded analysts’ expectations over the past year and is set to announce its second quarter results in a few days. One of the things to watch would be whether management maintains its optimistic acceleration talk.
Kraft Heinz announced its second quarter results on July 27, beating analysts’ expectations on both EPS and revenue and boosted organic net sales for fiscal year 22 to a high number thanks to higher prices than society is able to pass on to consumers.
Management of a brand portfolio via M&A
In addition to organic growth, Kraft Heinz manages its brand portfolio through mergers and acquisitions. With Miguel at the helm, Kraft Heinz divested two businesses – Cheese and Nut Planters in 2020 for $3.2 billion and $3.35 billion, respectively. At the end of 2021, the company acquired 85% of Just Spices for a supposed valuation of $300 million. In this way, the company divested some of the slower growing businesses while acquiring a fast growing startup with the intention of rolling out Just Spices as an international brand.
Clean up the balance sheet
Proceeds from two large divestments were partially used to repay debt, which decreased by $7 billion (or 25%) from $28 billion at the end of 2020 to $21 billion at the end of 2021. In this way, Kraft Heinz retained its investment grade rating and reduced its net debt to 3x adjusted EBITDA.
Kraft Heinz through the lens of Porter’s Five Forces
If you look at Kraft Heinz’s Porter’s Five Forces strategy, being one of the largest packaged food producers in the world, the company has a relatively low bargaining power of suppliers: it procures huge quantities of raw materials and uses economies of scale. This is positive for KHC stock. In addition to this, Kraft Heinz hedged the prices of certain raw materials such as grains, oils and energy until the fourth quarter, which gives the company some stability in input prices and time to adapt to an inflationary environment.
As evidenced by Kraft Heinz’s second quarter results, the company is successfully passing on higher production costs to buyers, suggesting that the bargaining power of buyers is weak. This is somewhat contradicted by recent headlines, where Tesco (OTCQX:TSCDF) pulled KHC products like Heinz ketchup from their shelves in protest at price increases. The dispute has since been resolved, however, it shows that for Kraft Heinz, Tesco (and other supermarkets) is not just a rival with its private label products (the threat of substitutes), but Tesco also improves the bargaining power of buyers, which is negative for Kraft Heinz.
consumer packaged goods Industry rivalry is quite high, which is illustrated for example by KHC’s net profit margin of less than 5%. At the same time, most of its competitors, such as General Mills (GIS) and Hormel Foods (HRL), have net profit margins above 10%. Kraft Heinz aims to realize gross efficiencies of $2 billion, which will be used for margin improvement.
Dividend discount model
KHC has a long history of paying dividends. The current payout ratio is just under 60%. Accordingly, we estimate the fair value of Kraft Heinz shares using the Dividend Discount Model (DDM).
Kraft Heinz has paid $0.4 in quarterly dividends, or $1.6 per year for the past 4 years. The current dividend yield is 4.4%. Seeking Alpha analysts estimate that dividends could grow at a moderate growth rate of 2% in 2023 to reach $1.63. We use this assumption in our DDM.
Return required: We use a risk-free interest rate of 2.77%, an equity risk premium of 5.69% and a beta for the stock.
Beta picks: Usually we take a 5 year monthly beta for the title. However, as we noted earlier, over the past 1.5-2 years there has been essentially a very weak correlation between the KHC and the S&P 500, resulting in a beta of 0.08, whereas at Over the past five years, the monthly beta was 0.85. In our evaluation of KHC stock using DDM, we decided to deviate from using a 5-year beta and use a 3-year beta instead, as that is the when the company’s turnaround was launched, a new CEO appointed and the COVID-19 hit among other things. . We believe the three-year beta (0.46x) better represents KHC’s correlation to the market.
Having a beta of 1 means that the stock essentially moves as much as the market. Having a beta of less than one means that in the scenario where stock markets are expected to fall due to a sell-off in a recession, the price of a low-beta stock will decline less over the period.
The required rate of return for KHC would be 2.77% + 0.46 * 5.69% = 5.39%. You may wonder if the required rate of return is too low, but this is due to the low beta and diversification benefits of KHC stocks.
D1 = $1.63 (expected dividends in 2023)
g = 2% (long-term growth rate)
r = 5.39% (required rate of return)
Result for price: $1.63/$0.0339 = $48 per share, 29% upside at the current share price.
Note on required return: You may notice that the required return we use for KHC is just over half that used for PRU (10.6%) in our previous article. Even though both are mature companies that pay dividends. The only reason behind this is that the beta of PRU is triple that of KHC.
If you use 10% as the required rate of return, the fair value of KHC stock will be reduced to $20.4/share. So, as you can see, the estimate of fair value per share is highly dependent on your required rate of return.
In our view, Kraft Heinz has undergone a major transformation over the past few years.
It’s in the right industry – Consumer Staples for the recessionary environment.
Management raised both its guidance for FY22 and long term growth targets, which is quite a statement for a giant like Kraft Heinz.
The stock has outperformed the market for the past 1.5 years since we tracked it and provided excellent coverage for the S&P 500.
We remain bullish on the stock and estimate the fair value of KHC stock using DDM at $48, suggesting upside potential of 29% from the current stock price.