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Stocks  | February 24, 2019

The Kraft Heinz Company (KHC) has been the bane of investor portfolios. After massively underperforming the major indices for the last five years, KHC decided that it wanted to give just one more extra blow to the dividend chasers.

The Board of Directors of The Kraft Heinz Company today declared a regular quarterly dividend of $0.40 per share of common stock payable on March 22, 2019, to stockholders of record as of March 8, 2019. This represents a reduction of $0.225 from the company's previous quarterly dividend of $0.625.

"We believe this action will help us accelerate our deleveraging plan, provide us strategic advantage through a stronger balance sheet, support commercial investments and set a payout level that can both grow over time and accommodate additional divestitures. By doing this we can improve our growth and returns over time," said Kraft Heinz CEO Bernardo Hees.

What Went Wrong

The Non-GAAP EPS miss of 10 cents was below the lowest of the analyst estimates. KHC was able to grow sales and adjusted for currency headwinds (stronger USD), the numbers on the top line were not bad at all.

However the adjusted EBITDA looked disastrous. The drop in adjusted EBITDA was almost completely focused in the US.

How did a consumer staple food stock miss so badly? Especially in a quarter where commodity prices were falling? The short answer was a complete lack of pricing power.

United States Segment Adjusted EBITDA decreased 16.3 percent versus the year-ago period to $1.3 billion, as the benefits from favorable key commodity costs and volume/mix growth were more than offset by a combination of lower pricing, higher costs net of savings, and investments to build strategic capabilities.

The other three regions were nothing exceptional, but adjusted for currency effects, they did relatively well. In fact, adjusted EBITDA would have been up in each of those regions had exchange rates been flat.

The Write Down of Epic Proportions

With investors reeling from a dividend cut and a gigantic miss, KHC dropped the third bombshell with a writedown of $10.4 Billion.

During the fourth quarter, as part of the Company's normal quarterly reporting procedures and planning processes, the Company concluded that, based on several factors that developed during the fourth quarter, the fair values of certain goodwill and intangible assets were below their carrying amounts. As a result, the Company recorded non-cash impairment charges of $15.4 billion to lower the carrying amount of goodwill in certain reporting units, primarily U.S. Refrigerated and Canada Retail, and certain intangible assets, primarily the Kraft and Oscar Mayer trademarks. These charges resulted in a net loss attributable to common shareholders of $12.6 billion and diluted loss per share of $10.34.

Now these losses don't change much except replacing the current useless goodwill number with a just about as useless, lower goodwill number. But it does speak volumes about the universally true, yet rarely accepted, fact. Companies almost always overpay for acquisitions. KHC overpaid and it is now writing down the value to what it should be. Remember this the next time you hear a company all excited about "growth" and "synergies".

A Compelling Valuation?

While the stock is out for pummeling as the markets open, it has at least on the surface, gone into "value" territory. Groupthink has pegged average estimates at $3.69, although we can bet that this number is being rapidly adjusted downwards and should move under $3.40 in the next month or so.

Even then, at 10X-11X earnings, for a consumer staple stock, surely we can argue for its "cheapness"? General Mills (GIS) trades at close to 15X. Kellogg (K) is also trading at a forward P/E of 14.5X. This should make us excited for KHC, no?

Maybe.

There are two ways to look at the cheapness of KHC and we will give you both sides of it. Yes, it is an iconic brand selling at a below market multiple. Yes, there is ketchup in the streets. Patient investors are likely to get 1-2% growth alongside a 5% dividend. While that may not be the best thing in the world, in a world where the 10 year Treasury bond yields 3%, it may be enough for some. Additionally, if you are a US dollar bear, the currency headwinds should become tailwinds in 2019 and KHC could surprise on the upside.

The other side of this is that the whole cheapness of KHC is an illusion via its extremely levered balance sheet. Here we show the debt to EBITDA of K and GIS, previously mentioned. We also threw in another company, Walgreens (WBA). While WBA is not remotely in the same segment as the first three companies, we put it there to show an example of a company that is trading close to the same earnings multiple as KHC. Note the leverage used by all four of them.

KHC on account of its higher leverage, deserves to be cheaper than K and GIS. How much is debatable, but 2-3 multiples is not too much in our view. Within the market you also have stocks like WBA which are growing at double digit rates, and still trade at an 11X multiple, while using less than half the debt of KHC.

So while KHC is cheap, no question, we would frame it in the proper context. In a market where we can get double digit growth and a growing dividend at 11X P/E multiples, while using half the leverage of KHC, is there a compelling reason to own KHC? Not yet.

Conclusion

KHC investors are obviously shell shocked today and they have our sympathy. We have recently run into multiple consumer staple products that have gotten hit hard and we did step up to the plate for this one. But KHC's US results look horrific. At Q4, 2018 run rates, KHC is on track for a sub $6.7 Billion in EBITDA.

Depending on where we see the stock opening, the EV to EBITDA would be under 12X. Definitely cheap, but we have seen cheaper and better in this market with good growth. Also with Debt to EBITDA jumping over 5X in 2019, don't expect any hikes any time soon, regardless of how much room you see on the payout ratio. While investors may also be worried about the SEC subpoena, we see this as immaterial to the issues at hand. Let the dust settle and then look for an entry.


A revolutionary initiative is helping average Americans find quick and lasting stock market success.

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