Why Warren Buffett Bet Big On Kraft Heinz

| About: The Kraft (KHC)

Summary

Kraft Heinz is one of Berkshire Hathaway's largest positions and provides a good example of the types of businesses Warren Buffett likes to buy.

The company last increased its dividend by 4.5% but has room for potentially stronger growth rates as merger cost synergies and debt refinancing lift earnings over the next few years.

Is Kraft Heinz a buy for long-term dividend growth investors?

Kraft Heinz (NASDAQ:KHC) maintains a wonderful portfolio of brands, sells recession-resistant products, generates dependable free cash flow, and is taking steps to further bolster its margins and earnings.

These are many of the qualities I like to see for companies included in our Top 20 Dividend Stocks portfolio, so let's see if Kraft Heinz can make the cut.

Business Overview

Kraft Heinz is the fifth largest food and beverage company in the world. The company was formed in 2015 after Kraft Foods Group and H.J. Heinz merged together.

Heinz specialized in ketchup, sauces, meals, soups, snacks, and infant nutrition. Kraft Foods was one of the largest consumer packaged food and beverage companies in the country.

Kraft Heinz owns more than 200 brands that are sold in close to 200 countries. Some of its well-known brands include Kraft, Heinz, Oscar Mayer, Ore Ida, Velveeta, Capri Sun, Planters, Jell-O, Kool-Aid, Lunchables, Philadelphia, and Kraft Macaroni and Cheese.

Condiments and sauces accounted for 32% of the company's sales in fiscal year 2016, followed by cheese and dairy (15%), frozen and chilled meals (12%), ambient meals (10%), and infant and nutrition products (5%). Wal-Mart is the biggest customer at 20% of revenue.

By geography, Kraft Heinz derives approximately 76% of its revenue from North America, 10% from Europe, 7% from Asia Pacific, 3% from Latin America, and 4% from other countries and exports.

Business Analysis

The merger of Kraft and Heinz brought together two companies with complementary strengths and iconic brands.

Prior to the combination, Kraft was the fourth largest North American food and beverage company and maintained number one or number two market share positions in 17 core product categories, representing approximately 80% of the company's total sales.

Impressively, Kraft's products average twice the market share level of their nearest branded competitors.

Kraft's products were in 98% of North American households (an average of 10 Kraft brands per household), and the company reported 80% consumer awareness of the Kraft brand in 14 key international markets.

Heinz was more international with 60% of sales outside of North America and generated 25% of its sales in emerging markets. The business focused more on ketchup, sauces, meals, and snacks.

Heinz had products that maintained the number one or number two market share position in more than 50 countries. It was also the most profitable food company in the industry.

By combining forces (Heinz was doing $10 billion in sales and Kraft's annual turnover was $18 billion), Kraft and Heinz gained substantial scale in North American retail and foodservice markets.

As a result, management identified cost synergies of approximately $1.5 billion, driven by opportunities to rationalize manufacturing footprints, consolidate distribution, reduce headcount, and optimize marketing. The company expects to achieve these synergies by 2017.

Heinz's CEO Bernardo Hees now runs Kraft Heinz and was instrumental in helping Heinz improve its margins to lead the industry over the last few years.

He can now put some of his profit-improving strategies in place at Kraft to lift overall margins of the combined company - even if overall sales remain stagnant.

From a growth perspective, Heinz's international footprint provides a platform for Kraft to take more of its brands and products overseas.

The combined company also owns eight billion-dollar brands and five $500 million+ brands. Kraft Heinz can offer customers a broader range of products and solutions to gain shelf space and grow its foodservice business.

It can also use its strong brands to expand into adjacent product categories. The company is executing what it calls its "big bets" strategy to more rigorously test new product ideas with consumers before bringing them to market. Once a new product has passed the test, it is supported with heftier marketing spending.

Recent examples of Kraft Heinz's "big bets" are Heinz-branded mustard and barbeque sauce and Kraft's new mac & cheese, which does not use any artificial preservatives.

While the company invested $150 million in research and development last fiscal year, it spent more than three times that amount on advertising ($464 million).

Kraft Heinz is an extremely durable business because it sells essential products and continuously benefits from long-standing consumer recognition.

Over their corporate lives, Kraft and Heinz have spent billions of dollars on marketing to favorably alter consumers' awareness and perceptions of their products. As a result, the company can consistently raise prices without seeing a major impact on demand.

With products in virtually every U.S. household and leading market share positions across most core product categories, Kraft and Heinz are key vendors for the retailers that sell their products. They can also afford to invest in in-store displays, coupons, and rebates to help consumers buy more products.

As a result, it's hard for new entrants to take shelf space from these giants and convince consumers and retailers that they are better. They lack the capital for marketing, and building brand awareness takes a very long time.

Kraft Heinz's extensive distribution channels are another competitive advantage. As the company develops new products or acquires other brands, it can sell these new offerings to existing customers while improving their cost profile as they quickly scale. This helps the business respond to evolving consumer tastes to remain relevant.

Overall, the food and beverage industry possesses a number of characteristics that should help Kraft Heinz remain a major force for many years to come.

It's also comforting to know that demand for the company's products should continue following population growth over time - the industry's pace of change is gradual with no risk of obsolescence thanks to the non-discretionary nature of its products (people have to eat!).

Key Risks

Like all food and beverage companies, Kraft Heinz can be impacted by volatility in commodity costs. However, its pricing power helps mitigate this risk to a degree, and cost volatility tends to even out over longer periods of time.

The bigger risks to the company's long-term earnings potential are shifting consumer preferences for food and beverage products.

Simply put, consumers are increasingly aware of what they are eating and desire healthier all-natural foods. Organic offerings are taking over the shelves at many grocery stores, and some of the big brands don't carry as much trust with consumers as they used to because they are associated with unhealthy products loaded sugar, preservatives, and artificial ingredients. The rise of digital marketing has also made it somewhat easier for small brands to generate awareness more efficiently.

As a result, the door has been at least slightly opened for new entrants to establish themselves as the healthy, natural, and organic alternative to many of the incumbent big brands out there. In fact, according to IRI, more than $18 billion in industry sales have shifted away from large companies to smaller players since 2011.

From Jell-O to Koo-Aid, Oscar Mayer, and Mac & Cheese, Kraft Heinz certainly has a number of products that could be somewhat vulnerable to the health and wellness trend in the coming years.

Kraft Heinz is combatting this trend with its "big bets" strategy and by introducing new products free from preservatives and artificial ingredients. While it might not be the first mover to capitalize on evolving consumer preferences, the company's scale, extensive distribution channels, massive marketing budget, long-standing customer relationships, and shelf space should not be ignored.

As the company's balance sheet improves over the coming years, Kraft Heinz will also be in a good position to potentially acquire rising threats that can give it greater exposure to healthier products and brands.

Finally, it's worth noting that Kraft Heinz generated over 75% of its revenue from North America last year. With demand for food and beverages tracking population growth over time, the company's growth profile is lower than some of its peers that have greater exposure to emerging markets.

It's worth keeping an eye on the company's organic sales growth to see if it can continue squeaking out gains in light of its merger-related restructuring, concentration in the mature North American market, and shifting consumer preferences.

Dividend Analysis: Kraft Heinz

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Dividend Safety Score

Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Kraft Heinz's dividend is very safe. The company's strong Dividend Safety Score of 89 is driven by its reasonable payout ratio, healthy margins, recession-proof products, and dependable free cash flow.

Let's start with the company's dividend payout ratio. Analysts expect Kraft Heinz to earn $3.07 per share this year, and the company's annual dividend payout is $2.30 per share.

Dividing the company's dividend by its projected earnings yields a payout ratio of 74%. While this would be considered a relatively high and potentially risky payout ratio for many types of businesses, it is less of a concern for Kraft Heinz because demand for its products is so stable.

Given the amount of restructuring work and debt refinancing taking place at the company, it's not a bad idea to look at the company's projected payout ratio for 2017 as well.

Analysts are estimating that Kraft Heinz will generate $3.82 per share in earnings during 2017. The large increase from 2016 is driven by cost synergies and the company's refinanced balanced sheet (lower interest expense = higher earnings per share).

If the dividend were to remain at $2.30 per share, the company's payout ratio would fall to 60% in 2017, which is very healthy for a consumer staples business.

Large food and beverage companies are simply resilient. For example, Heinz has been in business for more than 140 years and grew its sales each year during the last recession. People must continue to eat and drink regardless of how the economy is doing.

Not surprisingly, these companies generate excellent free cash flow. Established brands are cash cows, and Kraft and Heinz both have long track records of generating consistent, growing free cash flow.

Thanks to its stable business model and pricing power, Kraft and Heinz earn high and stable operating margins, which is often the sign of an economic moat.

Heinz in particular is notable because it had the highest profit margins in the industry prior to its combination with Kraft. As Kraft Heinz continues realizing cost synergies from the merger, its strong profitability should be further reinforced.

Kraft Heinz KHC Dividend Stock Analysis

Source: Simply Safe Dividends

The main knock against the company today is its balance sheet, which maintains a significant amount of leverage.

The company's net debt / EBIT (earnings before interest and taxes) ratio stands at 5.8x, which means that Kraft Heinz's total book debt could be covered with cash on hand plus 5.8 years of EBIT. I prefer a much lower ratio (e.g. less than 2.0x for most types of businesses), and it appears that Kraft Heinz agrees.

The company's management team said it expects to reduce $2 billion of debt by July 2017 to bring its net debt / adjusted EBITDA ratio below 3x over the medium term.

Furthermore, Kraft Heinz is set to reduce its interest expense as early as this summer when it refinances its $8 billion of preferred shares with investment grade debt.

The preferred shares pay Warren Buffett a 9% interest rate ($720 million per year) and originated from the 2013 deal Warren Buffett participated in to take Heinz private with 3G Capital. As part of the deal in 2013, Kraft Heinz could redeem the preferred shares at a premium once three years had lapsed.

Refinancing the notes will result in higher free cash flow from the interest expense savings, and it's worth noting the Kraft Heinz still maintains an investment grade credit rating, albeit at the lowest tier possible to remain investment grade.

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Source: Simply Safe Dividends

Overall, Kraft Heinz appears to have one of the safest dividends in the market. The company's payout ratio is healthy and improving, it sells recession-resistant products, free cash flow generation is very consistent, and the balance sheet will look better over the coming years.

Dividend Growth Score

Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Kraft Heinz has a Dividend Growth Score of 55, which suggests that its dividend growth potential is about average.

Kraft Heinz continued Kraft's quarterly dividend payment of 55 cents per share following the merger in mid-2015.

Since then, management has raised the dividend by 4.5% to 57.5 cents per share and expects to continue growing the dividend over time.

Prior to being taken private in 2013, Heinz had increased its dividend for nearly 10 consecutive years. Kraft has raised its dividend every year since 2013 but is a long ways away from joining the Dividend Aristocrats list.

From merger integration work to debt refinancing, there are a number of moving parts at the company right now.

As a result, I expect dividend growth to remain around 4% for the next year or two. Beyond that, I think Kraft Heinz can continue growing its dividend at a mid-single digit clip (e.g. 4-6% per year).

Valuation

Shares of Kraft Heinz trade at a forward-looking P/E ratio of 27.5, which appears expensive.

However, given the amount of merger integration work and debt refinancing in the works, it's worth looking further ahead to 2017. Using consensus earnings estimates, Kraft Heinz trades at a 2017 P/E ratio of 22.1.

Pairing the stock's relatively high valuation multiples with its 16% price surge year-to-date, it's hard to make a compelling argument that the stock is at an attractive entry point today.

Over the long term, it seems reasonable that Kraft Heinz can generate earnings growth of 4-6% per year. Demand for its products should follow population growth, and the company has some operating leverage in its model to increase earnings somewhat faster than sales.

Under my assumptions, the company appears to offer total annual return potential of 7-10% per year (2.7% dividend yield plus 4-6% annual earnings growth).

Conclusion

Many of Warren Buffett's holdings are characterized by strong brands, essential products, and dominant market share positions, so it's no surprise why he was excited to own Heinz and Kraft.

While the stock doesn't appear to be offering much value today, the underlying business will likely remain a dominant force in the food and beverage industry for many years to come. I will keep Kraft Heinz on my watch list as I wait for a more attractive entry point.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.