Bought Kraft Heinz Stock On Expectation Of Recession In Next Few Years

About: The Kraft Heinz Company (KHC), Includes: KMB, LMT, PG
by: Zoltan Ban

There is no way of pinpointing an economic downturn with absolute accuracy, most often most of us only realizing it occurred in hindsight.

I bought Kraft Heinz stock recently given my belief that there are very good odds of a recession in next three years, making it a good bet for next five.

With a dividend of 4.9%, thanks in large part to much market negativity around the stock in the past year, which led to a steep decline in value, it's attractive.

While there is no rush in my view, I thought this is definitely a good entry point for Kraft Heinz (KHC) stock, so I made my move. As I pointed out already, the first time I covered this stock back in September, my time horizon for owning some defensive stocks going forward is about five years. In other words, I expect a recession to start at some point in the next three years, last for perhaps two years, while the early stages of recovery should happen in about five years or so, at which point it will likely be time to look at selling. I looked at a number of other companies which I deemed to have potential for resilience in the face of what I perceive to be a near certain bet on a coming recession in the coming few years. In the past few months I also looked at Procter & Gamble (PG), Lockheed Martin (LMT), and Kimberly Clark (KMB) as potential candidates. I might still choose another from this list later on, if I deem any of them to offer a good entry point, as I did with Kraft Heinz. Or perhaps I will choose from a large number of other potential candidates. For now, Kraft Heinz makes the most sense, as I intend to explain in this article.

The dividend is very attractive at this level.

The market mood has soured on this stock, with its current level being almost half of what it was at its peak in 2017.

Kraft Heinz stock chart Source: Kraft Heinz.

As we can see, this year so far, it has been an almost uninterrupted move down for this stock, and given some of the recent results and overall financial situation of the company, it should not come as a surprise. A current P/E ratio of only 6 suggests that the market is pricing in further declines in profitability going forward. The net earnings drop in the last quarter, compared with the same quarter of last year was indeed steep, with $630 million in profits, compared with $944 million in the third quarter of 2017. Revenues actually increased by about 1.5% during the same period, therefore it is definitely an issue of lower profits on operations. The cost of sales increased by almost 5%, which explains to a great extent the overall drop in profits. There are also other factors, which I tend to deem as being negative, such as growing interest costs which increased to $327 million in the latest quarter, from $306 million in the same quarter in 2017. The resulting effect the decline in its stock value on its dividend offer is that it became a very attractive 4.9% currently.

Kraft Heinz could impress market, precisely because expectations have become so low.

While there may be a few more disappointing quarters down the road, I personally think that there are plenty of opportunities for Kraft Heinz profitability to improve on the back of perhaps continued growth in revenue, while the cost of goods sold might just stagnate, or even decline. Input costs, such as soft commodities, packaging materials or energy prices will all decline in the event of an economic downturn. In fact, such costs could already decline next year even in the absence of weakening consumer demand. The current trade war situation is leading to lower soft commodity prices, given the targeted approach of trade partners towards tariffs on US agricultural exports. Other than that, we have lower oil prices lately, which tends to be deflationary across the board.

It would not take a great deal of improvement for the current unpleasant slide in profitability to be stemmed. Reason for this is that it is simply one of those situations where most factors which pushed profits down thus far, likely played themselves out. Cutting prices to maintain sales will not go on forever. The increase in cost of sales will not outpace sales volumes forever. Kraft Heinz might see a significant increase in sales in the event of a recession, leading to job losses and lower household incomes. Those who may feel less confident about their continued employment tend to cut back as well. Kraft Heinz does cater to the cost-conscious grocery buyers, so an increase in consciousness in this regard should help it.

Likelihood of recession in next few years.

From my perspective, given that I do expect a recession in the next three years or so, I do prefer to be invested in a stock like this one and collect the dividends, rather than risk getting caught in highly cyclical stocks, and only see the recession in hind-sight, after the damage is done. The way I see it, most cyclical stocks may only have another 10-20% upside at best, or perhaps not even that, while staying in means assuming a risk of losing perhaps 30-40%, or even more, depending on the severity of the economic downturn. In other words, the potential risk no longer justifies the potential reward at this point.

While I recognize that this move might turn out to be early, once viewed in hind-sight, and there may be some factors which might further push the ultimate point when this trade will pay off further into the future, I personally think that it will ultimately pay to make this trade. The recent announcement coming from the G20 in regards to the trade war being put on hold, with China apparently agreeing to some concessions is the perfect example of an event which might temporarily make investors, which are already pivoting towards defensive investment options, feel like they are taking the wrong approach. Thing is that aside from the trade war, there are so many other potential factors that can now drag down the performance of the stock market, that any such moments are likely to be very temporary in nature.

We have the prospect of rising interest rates, which is a real and immediate problem, given that low interest rates in the US and throughout most of the world's economy have been arguably the main driving factor behind the global economic recovery since 2009. Higher interest rates cannot but stifle growth going forward, and it is not the only factor which may do so. The effects of the recent Trump tax cuts are also starting to wear off now, with much lower growth rates forecast going forward, while its legacy is a ballooning deficit situation. The August CBO forecast suggests that while growth will exceed 3% this year, next year we will likely see a slowdown to 2.4% in the US economy. That is before factoring in any unpleasant surprises, such as an intensification in the trade war, which could become an all-out economic war or an intensification in the EU ideological civil war which now seems to be unfolding.

The CBO also projects an arguably unhealthy deficit path, which in my view could leave the US vulnerable in the event that the trade war becomes an all-out economic war. As I pointed out in a recent article, a combination of rising oil prices, which could tie the hands of the Federal Reserve and China perhaps together with a number of other actors deciding to massively sell US bonds, while the Federal Government is also running up debts at an increasing rate could lead to a US bond rout. Such a severe hit to the US bond market could forever harm America's status as a safe haven investment destination. As things stand right now, the deficit will be about a trillion dollars next year, which will already be a massive volume of paper entering the bond market, with things looking even worse thereafter.

CBO deficit projection Source: CBO.

Given already massive deficits, an act of massive dumping of US debt paper on to the market, while the Federal Reserve may find its hands tied due to inflation fears, would most likely lead to a severe cutback in government spending, which will trigger a massive recession.

Of course, there are those who believe that such a scenario could not come to pass, because shale oil is there to make sure that oil prices will not spike again. I personally think it is a mistaken assumption. There is always a chance that Saudi Arabia and Iran will come to blows, in which case they will target each other's oil industry, as well as shipping through the Persian Gulf. There is also a chance that Russia will for the first time use oil as a weapon if we back it into a corner, with all the antagonism that is being whipped up lately. It might be the case that it may do so in coordination with China, if animosities continue, where one cuts back on oil production, while the other starts dumping its massive bond holdings.

Even without such geopolitical events, we should keep in mind that while shale oil production gains have been impressive and continue to be impressive, it may not be enough to cover global demand growth, as well as perhaps a coming declines in production in conventional on-shore and off-shore fields, where investment has been lacking since 2014. This lack of investment may start to take its toll on production right about now, or perhaps within a year or two. I also think that shale production growth may start to slow in about a year or so.

The scenario I highlighted here is just one of many that threaten the economy in coming years. There is also the possibility of a non-event scenario, where the US and global consumers simply run out of steam, start spending less, leading to some loss in employment prospects, in turn giving rise to consumer confidence declining, further depressing demand. The trend can just feed on itself.

US consumer confidence chart Source: Trading Economics.

At this moment there is no definite sign that consumer confidence is weakening, but we will most likely only realize that we have seen a peak and we are in decline in this regard in hind-sight, after it leads to an economic downturn.

It is because there is really no way to pinpoint the event, with only hindsight telling us it happened, that we are left with no choice but to guesstimate, based on odds, driven by risk prevalence and gravity scenarios, which in my view at this point are shifting the balance towards odds of another recession within the next three years being rather high. If I am right, Kraft Heinz is likely going to be a very good bet for the next five years, relative to the overall market, which is why I decided it should be my first investment as I pivot towards more defensive stocks in the next year or so.

Disclosure: I am/we are long KHC. 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.