Kraft Heinz Has A 5% Dividend Yield But I'm Staying Away

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About: The Kraft Heinz Company (KHC), Includes: CPB, MDLZ, UL
by: Dividend Power

Summary

Kraft Heinz Company has a dividend yield of ~5% due to a declining stock price but the dividend is not growing much.

The company has successfully increased operating margins to the mid-20s since the merger.

The company has not had much success generating organic sales growth and only recently focused on brand investment.

Kraft Heinz has a High Yield but Little Dividend Growth

The Kraft Heinz Company (KHC) has a dividend yield of nearly 5% but I’m not a buyer until the dividend’s growth rate increases. The company has one of the highest dividend yields of any consumer staples company, which is a defensive sector and thus many small investors seeking income and dividend growth may consider buying this stock. But from my perspective as a small investor the dividend has only been growing at a low single-digit rate and the payout ratio is near 70% based on adjusted earnings and even higher based on diluted earnings. Despite the high yield this is not an attractive combination for a dividend growth investor. Furthermore, the company is struggling to deliver organic revenue and EPS growth, which is not something one likes to see as a dividend growth investor. In addition, the company may attempt another acquisition, which could possibly increase debt or dilute existing shareholders further limiting my interest.

Merger and Current Business Structure

Kraft Heinz is a consumer staples company that was formed through the merger of Kraft Food Group and H. J. Heinz Company completed in 2015. Note that Kraft split from Mondelēz International (MDLZ) in 2012. KHC is now reportedly the third largest food and beverage company in the U.S. and the fifth largest one in the world. The motivation for the merger was a larger company with higher efficiencies, lower costs and increased margins. In this context the company seems to have succeeded since operating margins are now in the mid-20s and thus higher than many other consumer staples companies, which typically have margins in the mid-to-high teens.

Kraft Food Group and H. J. Heinz Company Merged in 2015

Kraft Heinz Merger Source: entrepreneuer.com

The company is controlled by 3G Capital who owns about 23.9% of the company, Warren Buffet owns another 26.7%, management owns 0.2% and the remainder of the company is publicly traded. This structure essentially gives 3G Capital voting control of the company. Note that Buffet used to be on the company’s board but resigned earlier this year. The company organizes itself into three global brands that are Kraft, Heinz, and Planters. But at the same time the company also confusingly organizes its businesses in five global platforms of condiments & sauces, cheese, nuts, meals, and baby food plus food service.

Kraft Heinz has over 200 processed food and beverage brands and many are well known by consumers in the U.S. Eight of its brands have over $1B+ in sales, which are Kraft, Heinz, Oscar Meyer, Philadelphia, Lunchables, Maxwell House, Velveeta and Planters. Five of its brands have between $500M - $1B in sales, which are Kool-Aid, CapriSun, Cracker Barrel, Jell-O, and Ore-Ida. The company has many more brands with less than $500M in sales.

Kraft Heinz BrandsKraft Heinz Brands Source: Kraft Heinz Fact Sheet

Although Kraft Heinz operates globally it derives roughly 70% of its sales from the U.S. and almost 80% of its sales from North America as seen in the chart below. The relatively limited international sales are both a weakness and an opportunity. It is a weakness since the company’s results will be strongly correlated to North America and a slow down in that region will greatly affect the company and further there is little global diversification. But it is an opportunity in that there are many prospects for global expansion.

Kraft Heinz Company’s Global Sales Footprint

Kraft Heinz Global Sales Footprint Source: Kraft Heinz Post-Integration Update Presentation

Dividend Growth and Safety

KHC’s dividend yield is greater than that of the S&P 500 and many other consumer staples companies and thus has drawn interest from those seeking income. But the dividend is not growing significantly. The annual dividend is currently $2.50 per share and at the closing stock price of $50.73 on November 2nd the yield is 4.93%. The current payout ratio is ~70% based on an adjusted EPS estimate of $3.55 (same as in 2017). Table 1 below shows the dividend yield and payout ratio of KHC and several other consumer staples companies. Clearly the dividend yield is higher than many other companies in the same category. Currently, the payout ratio for KHC is not excessively high but it is greater than many other companies in the consumer staples category.

Table 1. Dividend Yield and Payout Ratio of Some Consumer Staples Companies

Company

Dividend Yield

Payout Ratio

Kraft Heinz (KHC)

4.93%

70.4%

Mondelēz International (MDLZ)

2.48%

41.7%

J. M. Smucker (SJM)

3.22%

40.0%

Hershey (HSY)

2.73%

51.2%

Campbell Soup (CPB)

3.80%

53.9%

Unilever (UL)

3.43%

63.2%

Kellogg (K)

3.56%

50.2%

Source: DP Research, Google Stocks, Seeking Alpha

However, the dividend is currently not growing much. The chart below shows the dividend since 2012. The dividend increased significantly in 2013 but since the merger in 2015, the one year growth rate is ~3.1% CAGR and the 3-year growth rate is ~4.9% CAGR, which is not really high enough to get the interest of many dividend growth investors. The company has typically increased the dividend in Q3 of the calendar year. But note that the quarterly dividend will not be increased in 2018 although the annual dividend will have increased by $0.05 from 2017. This is a deceleration in the dividend growth rate and from my perspective an indication that dividend growth is not a priority for management.

Kraft Dividends Since 2012 and Kraft Heinz Dividends Since 2015

Kraft Heinz Dividend Source: DP Research, Seeking Alpha

Let’s assess why the dividend growth rate is so low and at the same time examine the safety of the dividend in terms of EPS, FCF, and debt since the merger. The payout ratio is probably higher than desired for many small investors focused on dividend growth and income. Kraft Heinz reports both basic/diluted EPS and adjusted EPS due to one time charges related to the merger, tax reform and other items. The company had an adjusted EPS of $3.33 in 2016 giving it a payout ratio of ~71% and it had an adjusted EPS of $3.55 in 2017 giving it a payout ratio of ~69%. But the payout ratios were higher at ~84% and ~76%, respectively, based on diluted EPS. In 2018, the payout ratio through Q3 2018 is ~70% on an adjusted EPS basis of $2.67 and ~97% on diluted EPS basis of $1.94.

In context of FCF the dividend is not well covered. In 2016, Kraft Heinz generated operating cash flow of $5.24B and had capital expenditures of ~$1.25B giving it a FCF of ~$3.99B but the dividend cost the company ~$3.76B. In 2017, the company generated $527M in operating cash flow and had capital expenditures of ~$1.22B giving it a FCF of -$690M. Note that capital expenditures increased from ~$648M in 2015 to the current levels due to higher investment by the company. The dividend cost the company ~$2.89B that year. The short fall was met by increasing debt.

Kraft Heinz has higher debt and increased interest expense as a result of the merger limiting its ability to increase dividends. The balance sheet indicates ~$3.37B in cash and only ~$2.74B in short-term debt at the end of Q2 2018. Long-term debt was, however, ~$28.33B at the end of Q2 2018. Short-term and long-term debt increased significantly from 2015 to 2016 due to the merger of Kraft and Heinz. Total debt has not decreased much since then. In addition, the company’s interest expense increased due to higher debt and is currently ~$1.23B annually. Although the total debt level is high due to the merger, the company is able to meet its current obligations. But note that the average interest rate is increasing most likely due to refinancing at higher rates. In 2016, interest expense was ~$1.13B and total debt was ~$32.4B for an average interest of ~3.5%. But in 2017 the average interest was ~4% implying that the existing debt is costing the company more.

Sales and EPS Growth Struggles

Since the merger, Kraft Heinz has in general struggled to deliver organic revenue and EPS growth that in turn limits dividend growth. These struggles have continued in the most recent quarter. The company recently reported on Q3 2018 results and organic sales grew at 2.6% YoY basis. But the company needed to drop prices -2% to boost sales 3.8% in the U.S and similar dynamics occurred in Canada and Europe, Middle East & Africa regions. Only the Rest of the World region had solid growth in volume and pricing as seen in Table 2 below. Note that the stronger U.S. dollar had a negative effect on net sales. But the company’s largest market is North America and net sales are down in aggregate in this region for the nine months through September 2018 as seen in Table 3 below.

Table 2. Kraft Heinz Sales Growth Rate for Q3 2018 YoY Basis

Geographic Region

Net Sale (%)

Currency (%)

Acquisitions and Divestures (%)

Organic Net Sales (%)

Price (%)

Volume/Mix (%)

United States

1.8

0.0

0.0

1.8

-2.0

3.8

Canada

-5.6

-4.2

0.0

-1.4

-1.5

0.1

Europe, Middle East & Africa

-3.3

-1.9

-2.0

0.6

-0.7

1.3

Rest of World

9.9

-9.4

6.8

12.5

6.2

6.3

Kraft Heinz

1.6

-1.6

0.6

2.6

-0.9

3.5

Source: Kraft Heinz Q3 2018 Update

Table 3. Kraft Heinz Sales Growth Rate for Nine Months To September 2018 YoY Basis

Geographic Region

Net Sale (%)

Currency (%)

Acquisitions and Divestures (%)

Organic Net Sales (%)

Price (%)

Volume/Mix (%)

United States

-1.2

0.0

0.0

-1.2

-0.3

-0.9

Canada

-0.9

1.3

0.0

-2.2

-0.3

-1.9

Europe, Middle East & Africa

6.5

5.1

-1.3

2.7

-0.7

3.4

Rest of World

7.8

0.0

0.4

0.3

0.5

-0.2

Kraft Heinz

0.7

0.0

0.4

0.3

0.5

-0.2

Source: Kraft Heinz Q3 2018 Update

Although organic sales grew in the quarter the company experienced a YoY reduction of diluted and adjusted EPS between Q3 2017 and Q3 2018 as seen in the chart below. Diluted EPS was down -$0.26, a -34% reduction. Similarly, adjusted EPS was down -$0.05, a -5% reduction. For the nine months through September 2018, diluted EPS was down -$0.50, a -20% reduction. Much of the reduction in EPS this quarter was reportedly due to increased expenses from investment in brands, high input costs and freight costs, and high overhead costs leading to a drop in margins by 480 bps to 21.4%. Note that some consumer staples companies with strong brands are passing on higher costs and sometimes they have done so at the expense of volume but maintaining margins. But more commodity-like products such as cheese, packaged meats, nuts, packaged coffee, etc., may not have significant pricing power limiting the ability to simultaneously maintain margins and increase net sales.

Kraft Heinz Diluted and Adjusted EPS for Q3 2018 and for Nine Months To September 2018

Kraft Heinz Q3 2018 Diluted and Adjusted EPS Source: Kraft Heinz Q3 2018 Update

Organic Growth or Acquisitions is The Question

It is not clear if the company has shifted to generating organic sales and EPS growth from existing brands or will focus on another acquisition. An acquisition would add debt and possibly dilute existing shareholders by issuing stock, which in context of a small investor focused on dividend growth is not desirable. Since the merger, cost cuts and efficiency improvements have increased margins to the mid-20s but sales growth has generally been negative. The recent focus on brand investment has generated organic sales growth but at the expense of margins. But at the same time, Kraft Heinz tried to acquire Unilever plc (UL) in February 2017 for $143B but the attempt failed since UL was not interested. There were also news articles reporting that KHC would try to purchase Campbell Soup (CPB) but this company is still controlled by the founding family making an acquisition more difficult.

In any event, Kraft Heinz indicated in their Post-Integration Update in February 2018, “Size matters relatively less than skill, speed” and discussed brand building through innovation, renovation and investment suggesting a focus on their existing brands. But at the same time in a May 2018 interview the CEO indicated that they “…like businesses with synergies that you can capture and then reinvest” suggesting that they would try future acquisitions. If Kraft Heinz attempts another acquisition it is unlikely that it will be a large one like the attempt for UL without Buffet’s support. But a medium size acquisition is much more feasible and possible but with only ~$3.37B in cash on hand any deal would need to be financed with debt and equity.

Conclusion

Since the dividend is not growing much, it is clear that much of the increase in yield is due to decline in the stock price since the 2015 merger. The stock price peaked in February 2017 and is down about -48% since then and it is down roughly -34% YTD. Furthermore, the stock price dropped about -9.7% on Friday, November 2nd after the company reported Q3 2018 results. Although I do not expect much dividend growth in the future, I also do not believe that the dividend will be cut in the near future. Based on trends since the merger, I expect the payout ratio on an adjusted EPS basis to be maintained at ~70% limiting future dividend growth. Despite the high yield I am not a buyer of KHC at the current stock price due to low expectations of higher dividend growth and the possibility of a future acquisition that would add to existing debt.

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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.