Kraft Heinz Will Have No Choice But To Cut Its Dividend
The list of issues that came up on Kraft Heinz's (KHC) August 8, 2019 earnings release is disturbing. But nothing is more important than what is now clearly apparent: KHC's free cash flow cannot support the $1.60 per share annual dividend. Before I get into that here are some of the other issues:
- KHC did not provide a cash flow statement, for either Q1 or Q2. There is no reference to any of the following items in its August 8, 2019, earnings release:
- free cash flow, capital expenditure, operating cash flow or cash flow from operations, free cash flow conversion, debt repayments, or asset purchases or sales (other than one item announced in the follow-up conference call with the CEO and CFO for $1.5 billion that was "completed");
- A document was filed on the SEC Edgar system on August 8, 2019, indicating that KHC would not be able to files its 10-Q quarterly reports (which include the cash flow statements) since it needs to ("i") "enhance its analysis of forecasted cash flows used in the impairment assessment, and ("ii") test the accuracy of forecasted cash flow allocations to specific brands. KHC got a waiver from its Senior Credit Facility holders to get this done by August 13, 2019. This is the third such waiver it has gotten from its creditors.
- Management is in such disarray it could not provide any formal guidance for 2019 other than to say that the second half is going to be a turnaround for the company.
The point about the 10-Q impairment testing is pretty disturbing. Not only did KHC make an additional write-down of $744 million for goodwill and $474 million for intangibles (for a total of $1.218 billion) during the first half of 2019, but this was on top of the $15.4 billion in write-downs (or what it calls asset impairments) that KHC announced in February 2019 for 2018. You can read my previous two articles about this, especially the one on June 4, 2019, "Kraft Heinz Is Still Overvalued: Wait For More Clarity." Something went wrong in the space of just 3 months, since KHC filed its belated 10-K for the year ending Dec. 31, 2018, on June 7, 2019, after its impairment methodology was already tested by auditors and the company internally. Here is what I surmise. Management was shocked by the dramatic downfall in sales of 5.47% in Q1 2019, and 4.25% in Q2 2019 on a YoY basis. Their internal forecasts of sales and cash flow were upended. They are worried about further sales declines, both from pricing failures and weak inventory in stores (i.e. demand for their brands is continuing to weaken.)
My Model Forecasts Free Cash Flow Will Be 19% Lower
Based on my model, which I partially shared in the previous article, I believe KHC's 2019 free cash flow will be no more than $1.42 billion. The dividend will cost $1.958 billion at a rate of $1.60 per share and with 1.224 fully diluted shares. There may be slightly fewer shares receiving the dividend, and we can't know this without the cash flow statement, but the point will stand: KHC can't afford the dividend. This can be seen in a snapshot of my model in the following two tables:
Source: Hake estimates, based on H1 results from KHC on Aug. 8, 2019
This model assumes that capex will need to be increased by KHC sometime during 2019 in order to make their brands more viable. I put this increase at 10%. In addition, the model assumes that cash flow from operations will decrease to 9.3% of sales from 9.8% last year.
Source: Hake estimates
This model also assumes that even with the announced asset sale of $1.5 billion of Indian brands, the debt repayments are only going to be 50% of what they were last year, or $1.34 billion. In fact, the CEO made a point on the conference call on August 8, 2019, to emphasize that KHC was not contemplating further asset sales, at least for the time being. Given that fact, the table in my model shows that there will still be a $379 million drawdown of cash, even after the reduced debt repayments for 2019 and the asset sale. KHC only has $1.1 billion in cash, so it can't keep on drawing this down just to keep the $1.60 dividend which costs $1.9 billion. So, in effect, without further asset sales, the dividend has to be cut.
My model for 2020 assumes there is a 25% dividend cut to $1.20. Here is how that looks:
Source: Hake estimates
This shows that at $1.20 per share, the dividend would cost $1.6 billion. Even though free cash flow will be lower at $1.3 billion, the difference would be made up by a $1.5 billion asset sale in 2020. Again this also assumes a 50% cut in debt repayments.
The banks who hold $30 billion in long term debt may not like this. They may want higher debt repayments, especially given that there was a second impairment charge done within six months of the first one. In that case, I can see no other way but for KHC to cut its dividend even great to below $1.20 per annum.
So, the bottom line is KHC will need to cut its dividend. When that happens the stock will fall further.
What is KHC Worth?
Assuming there is only a small dividend cut and using the 2020 forecasted numbers for KHC I derived a value of $28.77 to $29.65 per share. You can see this in the model below, which shows an adjustment for the EV/EBITDA metric, given that KHC has a higher EBITDA margin than its peers and a reduction for the FCF Yield comp metric, given that KHC has a lower FCF margin. Also, note that for the dividend yield metric I used the lower expected dividend divided by KHC's present 4.9% dividend yield. The reason is that if I suspected that even if the dividend is cut, the market would not allow the stock to be traded at the peer group dividend yield. The second potential value for the stock shown below at a $29.65 valuation per share, is if the dividend yield metric is not included.
Source: Hake estimate of true value, based on peer data from Yahoo! Finance
The bottom line is that the stock is not worth substantially more than where it is trading today (August 8, 2019). Given the risk of a dividend cut, a defensive investor would continue to watch the situation.
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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.