Kraft Heinz Shows Promise, But Wait For A Pullback

| About: The Kraft (KHC)

Summary

KHC advanced to near 52-week highest after beating EPS estimates in Q2.

Cost-cutting initiatives are paying-off.

Company can expand margins further, but investors should wait for a better entry point.

Shares of Kraft Heinz (NASDAQ:KHC) advanced 3.3% after the company reported its results for the second quarter. GAAP net sales increased 160% and GAAP operating income grew 268% driven by the merger between Kraft and Heinz and synergies. Organic sales (excluding the impact of foreign exchange and the merger) fell 0.5% as the negative impact of volume and mix more than offset a 1.6 percentage point increase in pricing. But despite the weak top-line performance, adjusted EBITDA increased 23.1% on the back of strong gains from cost saving initiatives. The stock now trades at a forward P/E of 27.4, and while we like the long-term outlook for steady growth and margin expansion, we think investors should wait for a pullback.

KHC is a respectable choice for defensive investors. The company has a portfolio of strong brands (such as Kraft, Oscar Meyer, and Kool-Aid) that give it pricing power over buyers, despite the retail industry being more concentrated than KHC's sector. Retailers rely on KHC's popular brands to drive store traffic, and this also limits access to distribution for other firms because retailers determine shelf space allocation based on market share and brand popularity. After the merger, KHC is the 3 rd largest food and beverage firm in North America after PepsiCo (NYSE:PEP) and Nestle, and the company's product breadth provides another advantage as retailers tend to consolidate relationships to include vendors they can trust to fill up a sizeable portion of their stores with a variety of items, rather than partner with a large number of less-proven suppliers and risk stocking issues. With think this bargaining leverage and market share stability will allow KHC to generate stable returns for investors over time.

KHC's focus on cost cutting is another reason for optimism. Management expects to cut $1.5 billion in expenses by 2017 through workforce reductions, plant shutdowns, and supply chain enhancements. The impressive adjusted EBITDA growth from the latest quarter was more-or-less solely a product of these initiatives, and we think margins can expand further. Rather than return extra cash to shareholders, we think KHC is smart to reinvest the savings in its business. Some of KHC's brands have come under threat in recent years, as increased competition has made it difficult for consumers to justify paying premiums for similar products. The company will have to innovate (either by enhancing existing products or introducing new ones) in order to drive growth in mature segments, and we expect R&D as a percentage of sales to increase 50-100 basis points in the coming years.

We expect KHC to generate average annual sales growth in the low-single digits, driven by a combination of volume and pricing. Earnings will outpace sales growth as KHC continues to realize synergies from the merger and implements new cost cuts. However, we urge some caution now that shares are trading close to 52-week highs. There are a number of risks to the outlook, including integration issues and an overextension of cost cutting efforts (to levels where it undermines performance). In addition, we think the US economy is weak, and this heightens the risk profile. A slowdown in income growth and consumer spending would encourage customers to trade down to cheaper brands and could potentially induce a wave of discounts and promotions across the sector.

Conclusion:

Despite weak top-line results KHC was able to beat EPS estimates thanks to significant productivity improvements. We believe the company is well positioned to grow margins over time, and view management's decision to reinvest savings to support sustainable growth favorably. But the company could run into difficulties if the US economy continues to slow, and at current prices, KHC's margin of safety is too small. Investors should wait for a pullback.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.