It has been two years since Kraft Heinz (KHC) consummated its merger, in a deal which received the vote of confidence from the Oracle of Omaha. Ever since shares have traded in a $70-100 range, and currently exchange hands at levels around the $80-mark. Investors are counting on the spotless execution, driven by the ruthless managers of 3G Capital and value being created from further deal-making. That is no easy task as the attempt to buy Unilever (NYSE:UL) (NYSE:UN) backfired, while many companies in the industry are coming under pressure.
These pressures include a change in consumer's preferences towards healthier foods, shift to online meal-kit delivery companies, as well as pressure from retailers. These distributors have seen their margins come under pressure from low-price German competitors and the Amazon.com (NASDAQ:AMZN) effect, of course. Lack of growth, already sky-high margins and an above-average leverage ratio make it hard to find drivers to create value from here, as Kraft Heinz's equity already trades at premium multiples.
How Is The Merger Going?
Kraft Heinz does not appear to be able to escape the pressures which the rest of the industry is facing as well. Organic net sales were down by 2.7% in Q1 of this fiscal year, driven by the shift of Eastern. Disappointing is that second-quarter organic sales were down by 90 basis points, even as the company should benefit from the shift of the holiday. The decline in sales was split pretty evenly between pricing and volume/mix effects.
While the company is happy with the sequential improvement in momentum, you can hardly say that it is seeing real momentum on its top line. Even as sales are sluggish, you have to give the company credit for its margin performance as operating earnings were up 17% to $1.92 billion. That is an incredible result on sales of $6.68 billion, for margins being equal to 28.8% of sales! Adjusted EBITDA was flattish at around $2.10 billion, for margins of 31.5%.
As a result of the solid execution, adjusted earnings came in at $0.98 per share for the quarter, as the GAAP earnings number was just four cents lower. For 2016, the company posted adjusted earnings of $3.33 per share and an adjusted EBITDA number of $7.8 billion. In the first six months of this year, adjusted earnings so far run $0.24 per share ahead of the results posted last year. This makes a $3.80 adjusted per share number look realistic for this year.
The improvements in earnings are driven by lower costs related to the integration of the merger, as well as the fact that the company no longer has to pay dividends on its preferred stock. While GAAP earnings are up significantly, adjusted EBITDA is flattish so far this year. Using the $3.80 per share number, with shares trading at $80 per share, Kraft Heinz trades at 21 times earnings.
How Much More Financial Firepower?
Kraft Heinz's balance sheet requires some attention. The company reports $119 billion in assets, but $104 billion is comprised out of goodwill and other intangible assets. The company holds just $1.5 billion in cash and operates with $31.1 billion in debt. While the company does not have massive post-retirement liabilities, as these modest liabilities are largely offset by corresponding assets, net debt of around $30 billion is quite substantial nonetheless. With adjusted EBITDA coming in at $7.8 billion a year, leverage ratios approach 4 times. That high leverage multiple, lack of top-line sales growth, a 21 times earnings multiple, and already sky-high margins make it hard to see drivers to create shareholder value from here.
The 1.23 billion outstanding shares value equity of the business at around $100 billion, or the business at $130 billion if net debt is included. Given the leverage employed already and the steep multiple at which the stock trades, any deal will most likely involve a large equity portion. Following a near 20% pullback from the highs earlier this year, I think that it might be less likely that major deals will be completed from here onward at this valuation.
While some consumer staples businesses have seen a deterioration in their valuation multiples, names like Campbell Soup (NYSE:CPB), Hormel (NYSE:HRL) or Kellogg (NYSE:K) face real positioning issues. At the same time, better positioned companies like Unilever have seen a huge run in their share price already on the back of the interest of Kraft Heinz.
Investing alongside 3G and Warren Buffett is a desirable opportunity for most investors. On the other hand, no one can escape the power of gravity. The simple truth is that Kraft Heinz is quite leveraged and is not posting any sales growth as the valuation is quite steep.
The real question is how much more money in terms of margins can be squeezed out of the business. Margins in the high-twenties are unheard of in the industry. Many other, and sometimes even larger peers, are happy if they post operating margins of 15% on sales. Furthermore, many companies are facing struggles as retailers are scared of the Amazon effect and impact of Aldi and Lidl aggressively expanding into the US. Notably, Kraft Heinz has a large exposure to North America, a market which so far has been largely immune from this competition.
While I think that Kraft Heinz has very powerful margins and ruthless execution, which warrants premium margins, it is hard to sustain these margins in a more transparent world. If we would simply imagine that margins might fall to 20% in the long term, which remains a very impressive result, operating profits could fall to $5.5 billion on a pro-forma basis.
With interest charges running at $600 million a year, and applying a 30% tax rate, net earnings might come in at just $3.4 billion a year, for an earnings number of close to $2.75 per share. Such earnings potential does only warrant a $50 per share valuation, not to mention the exploding leverage ratios in that scenario as well. The company furthermore does not have many levers to pull in order to reduce its net debt load, with dividend payouts currently running at $3 billion a year.
Part of the current high valuation is driven by the hopes of another large deal in which Kraft Heinz can use its expensive stock to deliver on some synergies. That said, if the company is happy to use stock as a currency, it does not make it particularity attractive to buy for you as an investor. Conversely, if shares dip, deals become less compelling, certainly as the balance sheet cannot carry a lot of additional debt on top of the current leverage employed already.
As a result, it remains very easy for me to pass up on the opportunity to invest alongside these world-class investors. Not only have shares not gone anywhere over the past two years, the prospects for future returns are very modest in my eyes, as I would not be surprised to see shares trade at lower levels in the coming year. Like many of its peers, Kraft Heinz might see pressure on its margins and sales as well in a very difficult operating environment.
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.