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Stocks  | February 28, 2019

When Things Don't Go As Planned

On March 25, 2015, working with Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B), 3G Capital, a Brazilian private investment group, announced that it would merge Kraft with Heinz, the condiment and canned foods giant it acquired with Mr. Buffett in 2013.

The combined company was "expected to have a market value of more than $80 billion," but four years later, Kraft Heinz (KHC) is valued at half of that level, and as a result, the company's debt looks problematic to the market.

Balance Sheet

One key observation about the company's balance sheet is that the majority of assets are comprised of goodwill and intangible assets:

As of December 30, 2017, 87 percent of the company's total assets were comprised of goodwill and intangible assets and following the recent impairment charges related to goodwill and intangible assets, the ratio had dropped to 83 percent as of December 29, 2018. This is not favorable.

On the other hand, the company's liabilities are all too tangible:

As of December 29, 2018, the company's total debt balance exceeded $31 billion, and the company has not been able to de-lever its balance sheet as planned despite aggressively cutting costs since the merger:

In other words, the company's total debt is nearly twice as large as its tangible assets, and this is what gave investors a heart attack last week.

Credit Rating

Following the merger, Standard & Poor's assigned a BBB- corporate credit rating, which is only one notch above a junk rating, to the combined company.

More recently, Standard & Poor's had upgraded the company to BBB, but following the earnings announcement (and a few surprises), Standard & Poor's revised the company's credit rating outlook to negative. The credit rating agency added that it could downgrade Kraft Heinz if its business continues to falter or if its credit ratios don't improve. The rating could also be lowered if the ongoing SEC investigation uncovers material accounting misstatements, internal control problems, or other accounting irregularities.

The company's investment-grade credit rating is critical for its ability to execute its industry consolidation strategy, so let's take a closer look.

Interest Coverage

The following graphs illustrate that the company's trailing-twelve-month operating income has declined, primarily due to a decline in gross profit margin and gross profits:

I explained last week that the company's profitability had suffered a margin contraction in the United States due to "lower pricing, higher costs net of savings, and investments to build strategic capabilities."

The company's interest expense, however, continues to inch up:

The company's creditworthiness has deteriorated recently primarily due to lower profit margin and secondarily due to the non-cash impairment charge.

Critical Metric

Moody's noted on February 26 that:

The ratings could be downgraded if operating performance deteriorates further, or the company pursues a major debt-financed acquisition or shareholder friendly initiatives. Specifically, debt/EBITDA sustained above 4.5x could lead to a downgrade.

The following section was included in the company's earnings presentation:

The mid-point of the company's expected adjusted EBITDA range divided into its total debt balance results in a "debt/EBITDA" ratio of 4.89 times.

In order to reduce this ratio below 4.5 times, as prescribed by Moody's, the company must reduce its total debt balance to $30 billion and improve its adjusted EBITDA to $6.7 billion.

The alternative could stall the company's long-term plans.

Bottom Line

The company's stock price has now been slashed by one-third in three days, and the primary culprit is the prospect of the company losing its investment-grade credit rating, which is critical for the success of its long-term strategy.

I expect management to focus on improving the company's financial health de-levering the balance sheet throughout 2019, either through disciplined cost control and/or selling off assets, before continuing with its long-term strategy of industry consolidation in late 2020 and beyond.

Lower balance sheet leverage would be welcomed by investors, and any news to that end would likely boost the stock price.

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