By The Valuentum Team
Being the fifth-largest food and beverage company in the world comes with its advantages, including a collection of strong and household brands. In addition to the two in its namesake, other brands under the Kraft Heinz (NASDAQ:KHC) umbrella include Capri Sun, Classico, Jell-O, Kool-Aid, Lunchables, Maxwell House, and the list goes on and on (Ore-Ida, Oscar Mayer, Philadelphia, Planters, etc.) What a excellent collection of diversified food and beverage product brands and a distribution network to boot, both speaking to sustainability of the enterprise for many years to come, something that surely attracted Warren Buffett to this investment proposition.
But an investment in Kraft Heinz comes with some "hair" on it. Though management is working to deleverage its balance sheet and has outlined plans to reduce leverage to under 3 times EBITDA in the "medium" term, it's flat-out difficult to ignore its massive financial obligations at ~$30 billion (long and short term debt) as of the latest update and on a net cash basis. Increased retail competition is also weighing on the food and beverage giant's organic growth prospects, with the pace of internal expansion falling into negative territory more recently. In light of these dynamics, Kraft Heinz is overpriced, trading at ~30 times our 2016 earnings estimate of $2.70 per share, arguably a ridiculous price in light of its massive net debt position.
In any case, we're not expecting Kraft Heinz to converge to a more reasonable valuation until the next economic/credit downturn when better capital allocation dynamics are considered. Until then, we think most investors in Kraft Heinz will take comfort in Warren Buffett's backing (Berkshire Hathaway is a holder), but we think the company has a lot of work to do to satisfy investors over the long haul, especially if organic sales continue to disappoint and multiple compression ensues. It's hard for us to get excited about Kraft Heinz as valuation simply matters. Let's continue to explore its candidacy as a investment idea, however.
Kraft Heinz's Investment Considerations
• On an asset base of more than $120 billion, Kraft Heinz generated a total profit to shareholders of just $2.46 billion in 2014 and 2015 combined. Though adjusted EBITDA marks came in much better, the company is not making the best use of its asset base, which includes a goodwill and intangible balance of over $100 billion. Shares trade at a substantial premium to peers.
• On a fundamental basis, we love Kraft Heinz. The tieup created a global food and beverage giant, combining two household names with iconic, global brands. Kraft alone has #1 or #2 positions in 17 core categories, and Heinz itself has products with top share in over 50 countries.
• The marriage of Kraft and Heinz will offer the combined company enhanced scale in North America, present cost efficiency and synergy opportunities to the tune of ~$1.5 billion, and aid in international expansion endeavors by leveraging the geographic presence of Heinz. The deal closed in the second half of 2015, and management continues to actively integrate the processes of both companies.
• Though the combined entity's EBITDA and cash-flow generation is robust, Kraft Heinz does have a material debt load. Management is committed to an investment-grade capital structure and plans to increase the dividend over time, but net-debt-to EBITDA marks are elevated. The company is targeting net leverage of below 3x in the near term.
• Part of the reason why Kraft Heinz trades at a very lofty price compared to its intrinsic value is in part due to the company's partners, Warren Buffett's Berkshire Hathaway (NYSE:BRK.B) and 3G Capital. Buffett alone brings with him quite an investor following.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Kraft Heinz's 3-year historical return on invested capital (without goodwill) is 5.6%, which is below the estimate of its cost of capital of 8.2%. As such, we assign the firm a ValueCreation™ rating of POOR.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. On the prospect of improving fundamentals, we give Kraft Heinz a neutral Economic Castle rating.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Kraft Heinz's free cash flow margin has averaged about 2.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company.
We think Kraft Heinz is worth $60 per share with a fair value range of $48.00 - $72.00.
The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 3.2% during the next five years, a pace that is lower than the firm's 3- year historical compound annual growth rate of 63.8%. Our model reflects a 5-year projected average operating margin of 24.5%, which is above Kraft Heinz's trailing 3- year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years and 3% in perpetuity. For Kraft Heinz, we use a 8.2% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $60 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Kraft Heinz. We think the firm is attractive below $48 per share (the green line), but quite expensive above $72 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Kraft Heinz's fair value at this point in time to be about $60 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Kraft Heinz's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $74 per share in Year 3 represents our existing fair value per share of $60 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Berkshire Hathaway is included in Valuentum's Best Ideas Newsletter.