Kraft Heinz: Making Correct Strategic Decisions

| About: The Kraft (KHC)


Brand building and innovation measures will augur well for its sales.

Stock warrants premium on relative valuation basis.

KHC is currently trading at a forward P/E of 20.7x, in contrast to its peers' average of 21x.

Kraft Heinz (NASDAQ:KHC) is an attractive investment prospect for long-term investors. The company has an impressive margin expansion story which will fuel its margin and EPS growth. Moreover, despite the ongoing sales volume pressures companies are facing in the industry, KHC has been registering better than expected sales volume. In the long term, the company's innovation efforts will support its revenue growth. And in the near term, its aggressive cost cut measures will support earnings growth. I think, given the company's disciplined and efficient cost saving measures, it will exceed its initial cost saving target. Going forward, the company will continue to enjoy margin expansion, and it is highly likely it will undertake another strategic acquisition in 2017 which will augur well for its top and bottom line growth, and as a result, the stock valuations will expand. The stock is trading at a forward P/E of 20.7x, in line with its peers' average of 21x.

Financial Performance and Catalysts

The company delivered solid financial results for 2Q16 by posting EPS of $0.85, beating the consensus estimate of $0.72. Also, the company's organic revenues experienced a decline of only 0.5%, better than analysts' expectation of a revenue decline of 2%. Moreover, the company increased dividends by 4.3%. Also, EBITDA for the quarter came out to be $2.10 billion, higher than the consensus estimate of $1.9 billion. During the conference call, the management signaled that EBITDA in the second half of 2016 would be lower than the first half the year because of normal seasonality, i.e. more low-profit margin meat. However, I think the synergies will offset the headwinds in the second half of the year. Also, commodity costs are likely to remain flat in the upcoming quarters which will augur well for its performance.

As packaged food companies are facing sales volume pressure due to a shift in consumer preferences towards organic and natural ingredients over proceeds and packaged food, KHC is working to alter its product portfolio to be consistent with consumer demand to support sales volume. Also, the company has scale and expertise to strengthen its product portfolio which will fuel its long-term growth. Moreover, the company is optimizing its supply to offer fresher products in the refrigerated category. KHC's efforts to improve the freshness of its frozen products would allow it to support sales volume and reverse market share losses, especially in the cheese category, including private label brands and Sargento.

In addition to innovation efforts, I think the company will actively look for more strategic acquisitions to address sales volume weakness. I do not believe KHC is done with merger and acquisitions yet. The company is likely to opt for strategic acquisition in 2017 and will try to acquire large food companies with strong brands, significant international footprint and inefficient cost structure. The company's acquisition strategy will be focused on generating merger and acquisition synergies and expanding its global presence, as currently almost 75% of its sales are generated from the U.S. market. The potential acquisition targets for KHC are Mondelez (NASDAQ:MDLZ), Kellogg (NYSE:K) and General Mills (NYSE:GIS).

Moreover, cost cuts will remain an important earnings growth driver in the upcoming years. KHC is aggressively making efforts to reduce its costs and expand margins, as it is operating with operational inefficiencies and excess capacity. The company's cost cuts are expected to result in profit margin expansion by 600 bps-700 bps in North America. The company targets to reduce costs by $1.5 billion per year by 2017 by optimizing supply chain and closing factories. Given the company's strong track record of disciplined cost savings, I think it will achieve cost savings of more than the initial target of $1.5 billion. However, in the near term, the company's performance will be exposed to supply chain transition risk. Consistent with its cost saving measures, the company has announced several manufacturing plant closures in the U.S. and shifting the production to remaining plants, which might impact its production in the near term; in 2Q16, the company faced supply chain problems which created shortages in Oscar Mayer and other products.

Valuation and Summation

KHC's brand building and innovation measures will augur well for its sales in the future. And if KHC experiences even a modest revenue growth in the upcoming quarters, it will positively affect its valuation. Moreover, the company has an attractive margin expansion story which will offset its sales volume pressure and fuel earnings growth in the near term. Also, I think, given the company's disciplined cost cut efforts, robust merger and acquisition strategy and innovation efforts, the stock warrants premium valuations in comparison to its peers; KHC is currently trading at a forward P/E of 20.7x, in contrast to its peers' average of 21x.

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.

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