Business

KHC: Kraft And Heinz Merger Fails On Most Basic Metric

Summary:

  1. KHC failed to deliver against the most important financial objectives outlined at the merger: Free Cash Flow.
  2. The outlook for future performance is bleak: among the large cap global food companies, KHC has the worst performance, the weakest balance sheet and it is the most expensive stock.
  3. Engage in any M&A at this point is non-sense and can result in nothing but value destruction to shareholders.
  4. KHC target price is $36 per share.

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Catalysts:

1) Revenue continues to decline, 2) Margin continues to decline as KHC needs to increase investments in brands and products to face the industry challenges, 3) Investors push for greater transparency and stop accepting high non-recurring EBITDA and EPS adjustments into the reported results, 4) Net debt continues to grow increasing KHC cost of debt and the company faces a downgrade by credit agencies to high yield debt, 4) KHC cuts dividends to stop debt growth, 5) KHC overpays for an acquisition and either increases debt or dilutes existing shareholders issuing more stock, 6) Continued stock insider selling by 3G Capital, the management and possibly Berkshire Hathaway (which together own ~50%  of KHC shares). 7) Investors realize the high valuations that KHC stock trades both on absolute levels and compared to peers.


Mr. Warren Buffett at Berkshire Hathaway 2016 Annual Report:

“We have never, however, singled out restructuring charges and told you to ignore them in estimating our normal earning power. If there were to be some truly major expenses in a single year, I would, of course, mention it in my commentary. Indeed, when there is a total rebasing of a business, such as occurred when Kraft and Heinz merged, it is imperative that for several years the huge one-time costs of rationalizing the combined operations be explained clearly to owners. That’s precisely what the CEO of Kraft Heinz has done, in a manner approved by the company’s directors (who include me). But, to tell owners year after year, “Don’t count this,” when management is simply making business adjustments that are necessary, is misleading. And too many analysts and journalists fall for this baloney.”

Kraft and Heinz merger was announced in March 2015 and the deal closed in July 2015. Now, after 12 quarters of reported results as a fully integrated company, every thoughtful investor must perform a very critical analysis of the KHC stated objectives at the merger versus the delivered results, the changes in the key assumptions, and the outlook for the company going forward.

Unfortunately, a high-profile merger with enormous expectations to create long term shareholder value, so far has failed to deliver.

And more importantly, the outlook for future performance is bleak: among the large cap global food companies, KHC has the worst performance, the weakest balance sheet and it is the most expensive stock.

For the purpose of this analysis we will focus on some of the key financial objectives outlined in the KHC March 25, 2015 Investor Presentation: Creating a Global Food & Beverage Leader.

Reported Adjusted Results Metrics:

  1. Significant revenue synergy opportunity, with strong platform for international growth.
  2. Significant synergy potential – $1.5 billion in run-rate annual cost savings by 2017.

Free Cash Flow Metrics:

  1. Targeting $2 billion of debt pay-down within two years.
  2. Target net leverage of below 3.0x to be achieved in the medium-term.
  3. Maintain dividend per share, which is expected to increase over time.
  4. No share repurchases for at least two years following transaction close in order to accelerate deleveraging to our stated target.

Reported Adjusted Results Metrics:

1- Significant revenue synergy opportunity, with strong platform for international growth.

Organic sales growth is zero, actually it is more dramatic as annual sales since the merger fell 4.5% or $1.186 billion to $26.261 billion in the last 12 months.

Organic sales decreased 0.9% in the 1H 2018.

The changes in consumer tastes that make KHC products less popular has been greatly publicized, but the big problem is that these are structural rather than cyclical trends. The market has changed, and the company must adapt. These are not easy fixes and the efforts to introduce innovations in the portfolio that capture market growth has been too small or too slow to move the needle and offset declines at legacy products.

To put it simply: 1) the consumers today have a higher propensity to change their habits, specially to healthier options where KHC doesn't have a strong portfolio offer, and 2) the way that brands communicate with consumers has also changed dramatically: mass marketing is an animal going to extinction. And KHC has failed to create meaningful connections with consumers to drive sales growth.

As a consumer, when was the last time that KHC excited you with a product launch?

To fix sales growth the company needs to make big changes in the portfolio of products and communicate it with very creative and talented marketers.

Looking at industry competitors turn over and employee satisfaction data, it is clear that the culture created at KHC has failed to attract, retain and develop this type of talent to its ranks. Creative sparks and ideas must be unlocked and developed internally with guidance from leadership.

Attacks from competitors come from both spectrums: emerging brands and retailers private labels.

Another major disruption that challenges KHC is on the distribution channels.

Ecommerce: the shelf space is unlimited. Agreements with retailers are no longer significant entry barriers to competitors and this weakens KHC competitive advantages.

Amazon, traditional supermarkets online operations, and direct to consumer online sales are all viable options to the consumers.

This means that consumers have an increasing power of choice and brands must have attractive offerings and create meaningful connections to succeed.

Kantar Retail estimates that e-commerce today comprises just 2% of grocery sales, meaning there is plenty of room left for growth. It’s expected that 20% of all grocery sales, representing around $100 billion, will come from online shoppers by 2022, with 70% of shoppers purchasing some of their groceries on the web, according to data from the Food Marketing Institute and Nielsen.

The changes in the online space are also driving dramatic impacts to the traditional offline retail channels, where companies are acting fast to adapt.

This means that bricks and mortar retailers are:

1) Increasing the space that emerging brands have at theirs shelves. According to The Nielsen Company, US retailers are giving small brands double their fair share of new listings. The reason is twofold: retailers want small brands to differentiate their proposition and to drive their margins, as these small brands tend to be premium and rarely promote. As a consequence, small brands are capturing two to three times their fair share of growth while the largest brands remain flat or in slight decline.

2) Increasing their private labels offers in their quest for differentiation and traffic.

3) Becoming tougher with traditional trading partners such as KHC: they are pursuing more aggressive procurement strategies, including participating in buying alliances, getting tighter on SKU proliferation, decreasing inventory levels, and demanding more expensive supply chain services.

The impacts for KHC are dramatic as the company is losing importance, connection and leverage with both the consumers and costumers.

Sales will continue to decline if the company doesn’t act fast to adapt and face this uphill battle.

Reported Adjusted Results Metrics:

2- Significant synergy potential – $1.5 billion in run-rate annual cost savings by 2017.

Annual Adjusted EBITDA grew $1.051 billion since 2015 to $7.790 billion in the last 12 months.

The company claims to have delivered more than $1.7 billion of cumulative cost savings in the integration programs. This means that over the same period the organic EBITDA excluding the integration program gains fell $649 million, or 55% of the $1.186 billion drop in sales

In the 1H 2018, Adjusted EBITDA fell $140 million or 3.6% yoy.
And as KHC now expects more of a 50-50 EBITDA split to the year in 2018, instead of the second half skew that was previously talked, in 2H 2018 Adjusted EBITDA should fall at the accelerated pace of $252 million or 6.3% yoy!

On top of that, shareholders should be very concerned with the amount of non-recurring adjustments embedded in these Adjusted EBITDA numbers.
In fact, by the end of 2017 KHC did a post integration business update, and now with no reasonable justification non-recurring costs are climbing again in 1H 2018. At the same time that sales & EBITDA & margins are falling yoy!

KHC calls these adjustments many different names, such as: Integration and restructuring expenses, Merger / Deal costs, Amortization of inventory step-up, Unrealized gains / (losses) on commodity hedges, Impairment losses, Gains / (losses) on sale of business, Non-monetary currency devaluation, Equity award compensation expense (excluding integration and restructuring expenses) and Other pro forma adjustments.

But it must be clear that for the shareholders it really means one thing: KHC true reported results varies enormously versus what is stated as the adjusted results.

Non-recurring costs % of total Adjusted EBITDA and $ since the merger:

2015 FY: 49% at $3.3 billion

2016 FY: 14% at $1.1 billion

2017 1H: 10% at $392 million

2017 2H: 4.5% at $182 million

2017 FY: 7.2% at $574 million

2018 1H: 14% at $511 million (!)

Total since 2015 = 21% at $5.5 billion

Reporting this level of non-recurring adjustments 12 quarters after the merger closed is unacceptable!

Especially considering that these adjustments have already exceeded by far the expected integration non-recurring costs of $1.9 billion. More details on this can be obtained at KHC 2Q 2018 10K, page 11: Integration Program and page 28: Segment Adjusted EBITDA. And 2017 10Q page 27: Adjusted EBITDA.

Large non-recurring adjustments are blurring the analysis of the true organic performance of the company.

And this brings us to the next point:

Free Cash Flow Metrics:

  1. Targeting $2 billion of debt pay-down within two years.
  2. Target net leverage of below 3.0x to be achieved in the medium-term.
  3. Maintain dividend per share, which is expected to increase over time.
  4. No share repurchases for at least two years following transaction close in order to accelerate deleveraging to our stated target.

The company has clearly failed to achieve the Free Cash Flow objectives outlined at the merger. Adjusted EBITDA is not moving together with Free Cash Flow.

And Free Cash Flow this is the most import metric that shareholders should be concerned with.

Pay-down debt is not refinancing the debt!

In fact, the debt is growing at alarming levels: since the merger the net debt grew $2.070 billion to $31.2 billion in Q2 2018.

What matters for shareholders is Free Cash Flow and this is a gap of $4 billion versus the merger expectation of decreasing net debt in $2 billion.

Today net debt to EBITDA is 4.2x versus the merger net leverage target of below 3.0x to be achieved in the medium-term.
KHC’s current cost of debt is extremely attractive at 3.7%.

Over the next quarters with the leverage getting closer to 5x net debt to EBITDA, the cost of debt should increase to be aligned with a BB rated debt.

BB debt current spread over treasury is 2.25% (source: ICE BofAML US High Yield BB Option-Adjusted Spread), as KHC cost of debt gets closer to this the company will increase its interests costs in $530 million per year!

Important to mention that this spread is at historical lows, and the average since 1997 is 3.7%. At these normalized levels KHC would have an increase in interests costs of $1.025 billion per year!

KHC’s Free Cash Flow generation is not enough to maintain the current dividend payout.

In 2017 KHC net debt grew $1.711 billion to $30.326 billion, while the company paid $2.888 billion in dividends. This means that the Free Cash Flow gap was 59% of the dividends.

And in the 1H 2018 KHC net debt grew $877 million to $31.203 billion in just 6 moths, while the company paid $1.659 billion in dividends. This means that the Free Cash Flow gap was 53% of the dividends.

We expect that KHC net debt will grow at least $1.1 billion per year maintaining the current dividend payments of $2.5 per share ($3.050 billion per year).

In other words, KHC should cut dividends at least 36% to $1.6 per share in order to stop debt growth! This assumes that EBITDA will stop falling yoy, clearly not an easy goal to achieve.

With that said, obviously there is no excess cash to repurchase shares.

But is it even a good idea to repurchase KHC shares?

What is KHC fair value?

It might be shocking to say it, but for a company that structurally decreases sales and EBITDA yoy the fair value is a moving target to zero, destroying shareholder value year after year.

Once big and mighty companies can also disappear if they fail to adapt. This is the capitalism happening in the US.

But first, let’s look at valuation multiples:

Mr. Buffett recently stated in an interview that:

"I THINK IT'S VERY HARD TO OFFER A SIGNIFICANT PREMIUM FOR A PACKAGE GOODS COMPANY AND HAVE IT MAKE FINANCIAL SENSE. THE PACKAGED GOODS BUSINESS MAKES HIGH RETURNS ON TANGIBLE ASSETS IT HAS, BUT IT IS A TOUGHER BUSINESS THAN IT WAS TEN YEARS AGO AND THE STOCKS ARE HIGHER THAN THEY WERE TEN YEARS AGO."

In fact, KHC stock is extremely overvalued, and even Mr. Buffett seems to agree.

10 years ago, Kraft, Heinz, and all of their peers traded very consistently between 9-11x EV/EBITDA. In a much more promising scenario with more organic growth opportunities than these companies have today, and surely more solid balance sheets (0-3x net debt/EBITDA).

KHC situation today is very challenging with:

1) Peak EBITDA margins after a cost cutting program that many would argue that went too far and now the company needs to increase investment behind the brands and products to face the industry challenges.

2) Organic sales is falling and it is very hard to see it reversing.

3) The company has a very leveraged balance sheet with 4.2x net debt to EBITDA, and at the same time that organic EBITDA is falling the net debt is growing at least $1.1 billion per year to sustain the current dividend payout. The longer it takes to be addressed, the worse it gets.

4) Acquisition targets valuations are extremely high and Mr. Buffett acknowledges that it is very hard to offer premiums and make financial sense.

We must also make it clear that a true industry consolidator must be able to deleverage the balance sheet decreasing the debt that financed the acquisition, before engaging in the next acquisition. KHC net debt today in fact is $2.070 billion higher than it was when Kraft merged with Heinz, at a frightening $31.2 billion and 4.2x net debt to EBITDA. And growing at least $1.1 billion per year to sustain the current dividend payout.

Engaging in any M&A at this point is non-sense and can result in nothing but value destruction to shareholders.

KHC stock should trade at a discount versus 10 years ago valuations, it is shocking to see it today at 13.8x EV/EBITDA 2018.

At 10x EBITDA 2018 KHC stock target price = $36.

It must cut dividends at least $0.90 to $1.60 per share to stop debt growth. At $36 KHC dividend yield is 4.5%, what some would argue that it is still expensive for a company with falling organic EBITDA.

Once more to make it clear: if KHC doesn't turn around the portfolio and find organic growth it is a moving target to zero, destroying shareholder value year after year.

It is impossible understate how challenging this is, but to give KHC the benefit of the doubt and make a straightforward analysis let’s consider that KHC is able to execute extremely well and achieve 2% sustainable sales and EBITDA growth.

So At $36 KHC stock trades at 4.5% dividend yield, and assuming a 2% dividend growth the expected shareholder’s total annual return is 6.5%.
With US 10-YR Treasury at 3% and historical equity risk premiums between 3.5% and 5.5% this is also very clear the $36 target price is generous to reflect historical high valuations and low risk aversion.

Another important analysis is comparing KHC versus the major peers in 3 key metrics that shareholders should be very focused: Net debt to EBITDA, Organic Sales Growth and Free Cash Flow Yield (Free Cash Flow / Market Cap).
These metrics are very useful to understand the sustainable total return to the shareholders, and it also shows how overvalued is KHC stock, even compared with peers trading at historically high valuations.

Net debt to EBITDA 2018:

KHC: 4.2x

Nestle: 1.6x

Coca Cola: 2.5x

Pepsi: 1.7x

Unilever: 2.3x

Mondelez: 3.5x

Organic Sales Growth:

2017         1H 2018

KHC:             -1%            -0.9%

Nestle:          +2.4%        +2.8%

Coca Cola:   +3%           +5%

Pepsi:           +2%           +2.5%

Unilever:      +3.1%         +2.5%

Mondelez:    +0.9%         +2.9%

Free Cash Flow Yield:

2017       1H 2018

KHC:            2.3%         1.1%

Nestle:         3.4%         1.2%

Coca Cola:  2.7%         1%

Pepsi:          4.5%.        0.1%

Unilever:     4.2%         1.4%

Mondelez:   2.5%         1%

On top of these fundamental challenges outlined here, we notice with big concerns that 3G Capital and the management sold a significant number of shares recently.

It was widely publicized that Mr. Buffett decided to step down from KHC board of directors "as he decreases his travel commitments". Berkshire Hathaway is clearly a long-term oriented investor, that have the patience to wait for long term value generation projects to unfold.

But with all the challenges that KHC faces, a big question mark is what is this long-term value generation project? The food industry changed dramatically in the past few years, and KHC is not keeping up with the challenges.

Only very few stocks qualify to be long term holdings at Berkshire Hathaway and KHC situation reminds us of Mr. Buffett timeless wisdom:

"Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."

We would be pleased to see Mr. Buffett divesting his 325,442,152 shares at this overvalued stock soon and preserving Berkshire Hathaway dollars.


Sources:

Article by Value Investor