Kraft Foods - A Word Of Caution On This Beloved Stock

| About: The Kraft (KHC)
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Summary

Shares of Kraft trade near their all-time highs.

As investors like the dividend and analysts anticipate operational improvements.

I continue to display caution given the leverage employed, sensitivity to rising interest rates, premium valuation and operational challenges ahead.

Shares of Kraft Foods Group (KRFT) continue to trade around all-time highs being aided by a reiteration of buy advice by analysts at Bank of America.

I can understand the reasons why analysts are optimistic on the prospects for the shares, but warn against too much optimism amidst the leverage, premium valuation, potential risk of rising interest rates and the operational challenges ahead.

Reiterating The Bull Case

Analyst Bryan Spillane employed by Bank of America, continues to be bullish on the prospects for Kraft Food's shares. Spillane maintains his buy rating on the stock, as the price target is raised by two dollars to $66 per share, suggesting roughly 10% upside from current levels.

Spillane anticipates that shares will outperform the peer group in the coming six months thanks to improved earnings quality starting in the final quarter of this year, as he expects that management might announce changes to its strategy in 2015, boosting the value of the firm.

The performance of Kraft into the final quarter and first half of 2015 is anticipated to improve on the back of price hikes which should allow gross margins to improve and have a positive impact on the bottom line. Just yesterday, Kraft announced that it is raising coffee cup prices by 9% at the end of this year. Combined with an increase in free cash flow conversion, Kraft's management could decide to return more cash in the form of dividends or share repurchases next year.

On top of these short-term anticipated margin achievements, Kraft is still in the early stages of a multi-year productivity increase program according to Spillane. This should allow the company to deliver on mid-single digit growth in earnings and dividends for some years to come.

Kraft's Difficult Operating Environment And Its Strategy

At the start of September, Kraft presented the difficult operating conditions in which the company operates, and how it targets to create value for its shareholders in this difficult environment.

Kraft is of course best known for strong brands like Jell-O, Kool-Aid, CapriSun, Velveeta and Philadelphia, among many others. While these and other brands can be found in nearly every North American household, it deals with rapid change in the market.

This includes the emergence of the Hispanic portion of the population, the millennials, pressure on spending power of lower and middle-class America, a focus on nutritional products and alternative distribution channels.

Even within the relatively stable supermarket environment, there are huge disparities seen between product categories with yoghurt, coffee and nuts being among the rapidly growing segments while sales of soft drinks, cereals, milk and ice cream are down in their double-digits.

To succeed in this environment Kraft has to change a lot of things in the way it used to run the business, including focusing on the reinvention of marketing, and continued investments back into the business. In terms of marketing, Kraft is already moving online to deal with the shift from TV advertising to mobile and online platforms.

At the same time the company is committed to the smart usage of data, even calling in the currency of the future, being crucial in the success in the future as it allows Kraft to offer personalized offerings for its clients.

The Long-Term Targets

Despite the challenges, Kraft remains upbeat about the long-term prospects of the business, assuming it can adapt to cater to customers' needs in the future as well.

The company aims to grow organic revenues by a rate equivalent or greater than the overall market, which should allow for operating income to rise in the mid-single digits. Earnings per share could even grow a little quicker, as the company targets to convert at least 90% of earnings into free cash flows.

This should allow the company to grow its shareholder payouts alongside operational growth, targeting dividend growth in the mid-single digits for years to come.

As The Results Currently Indicate Struggles

At the release of the third quarter results in October of this year, it was clear that Kraft is still struggling on an operational basis.

Total sales were up just 0.1%, although organic growth of 0.9% has been a bit better than the headline number. That said, this growth has been driven by an average price hike of some 2.1% with the mix and volumes being down by about 1.2%. Strength in the areas of refrigerated foods, as well as cheese, has been offset by a weak performance of the meals and desserts business.

Adjusted for the volatile impact of the mark-to-market of post-retirement pension plans, operating earnings were up in the single digits as the benefit from cost savings, efficiencies and lower marketing efforts outweighed selective commodity price inflation.

Leveraged Balance Sheet And A Premium Valuation

Overall Kraft is a stable business in what still is considered a traditional stable industry, allowing the company to operate with a great deal of leverage. While the company holds $935 million in cash and equivalents, it does have very sizable liabilities consisting out of $10.0 billion in traditional debt and another $3.6 billion in post retirement liabilities, as well as healthcare related liabilities, on its balance sheet.

Following traditional calculation methods, this yields a net debt position of little over $9 billion which is sizable but manageable in relation to the roughly $4 billion in annual EBITDA being reported, resulting in a 2.3 times leverage ratio. Including the other liabilities relating to pensions and healthcare, this ratio will jump to a 3 times leverage ratio. The steep and attractive quarterly dividend which yields nearly 3.7% is a key ratio why deleveraging is no easy task, with the company distributing roughly 65% of its net earnings per year.

Shareholders have to share the profits over nearly 600 million shares which at a price of $60 per share values equity in the business at roughly $36 billion, or the entire business at close to $45 billion when including traditional net debt.

At the current rate, Kraft generates sales of roughly $18 billion, EBITDA of some $4 billion and earnings of about $2 billion when being normalized for certain items. This results in a valuation at roughly 2.5 times sales, 11 times EBITDA and roughly 18 times earnings.

Searching For Growth

Kraft's financial performance, adjusting for the spin-off of Mondelez (NASDAQ:MDLZ) has been rather flattish in recent years, with sales hovering around the $18 billion mark over the past 4-5 years.

Adjusting for certain items, the company has not made any real progress in terms of profitability either, amidst a stable shareholder base. Despite this operational stagnation, shares are trading at the high end of the $45-$60 trading range in which shares have traded since the spin-off.

The reasons are of course the anticipated improvements by the analysts as well as the increase in overall valuation multiples across equity markets amidst a continued fall in interest rates. Following the plunge in sales, the dividend yield of Kraft looks very appealing to investors, coming roughly 150 basis points over ten year government bonds, while allowing potential growth as well.

Final Thoughts

Simply comparing the dividend yield of Kraft to risk-free securities and favoring such an equity investment based on superior yield and growth is dangerous as Kraft actually has quite some challenges ahead.

For starters is the sizable leverage position of the firm and changing industry landscape as has been discussed extensively before. This makes it that the company has to change and operate to the best of its capabilities to achieve its long-term targets.

That being said, Kraft will probably turn out to be a decent investment in the long run based on these observations. As long as investors realize that an investment is not risk-free, and that an unexpected jump in interest rates could result in a serious setback at some point on the road.

Consequently, I don't feel that the premium yield being offered and anticipated growth outweigh the potential for valuation contraction in case interest rates rise, or operational challenges might manifest themselves in a bigger way.

For those reasons I remain neutral at current levels, not sharing the bullishness displayed by analysts at Bank of America.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.