Kraft Heinz Stock At 2-Year High: Debt Is What Matters

Summary

• KHC is on an uptrend, but can it continue?
• The company generated 6.5% organic sales growth in 2020 as it rode pandemic tailwinds.
• The stock offers an attractive 4% dividend yield.
• I give my thoughts regarding forward prospects and the current assessment of the stock.
• I do much more than just articles at Best Of Breed: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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Kraft Heinz (NASDAQ:KHC) has experienced a resurgence over the past year and now trades near two-year highs. The company reported strong growth in 2020 and expects the growth to continue moving forward. KHC shareholders would welcome such a result as the company had been reporting declines in organic sales for each of the three years heading into 2019. The stock trades at less than 16 times forward earnings and a 4% dividend yield, suggesting there’s some value to the story. Investors should not ignore the significant debt load - KHC must deliver on growth expectations to make this investment story work. My current rating is hold as I am waiting to see how KHC performs following the pandemic.

Kraft Heinz Stock History

KHC has been a miserable stock to own since Kraft Foods and Heinz completed their mergers in July of 2015, as the stock is still less than half of what it was 5 years ago.

(Seeking Alpha)

While there was initial optimism for the Buffett-backed consumer goods giant, the stock began falling when top-line weakness led to material weakness in profitability. The financial weakness eventually forced KHC to cut its quarterly dividend by 36% to $0.40 per share in early 2019 - leading the stock to trade below $30 per share - more than 66% lower than its all-time highs. Will the tough times persist moving forward? Let’s do a deep dive to find out.

KHC Stock Forecast

In February, KHC presented at the Consumer Analyst Group of New York (CAGNY) Conference. There, the company gave a promising forward outlook for its business. Wall Street must have liked the presentation, as the stock is up nearly 15% since then.

Despite the stock falling amidst the pandemic stock market crash, KHC recovered to deliver strong results in 2020 with organic net sales growing 6.5% and free cash flow rising over 50%.

(CAGNY 2021 Presentation)

That is in stark contrast with the 2.2% organic net sales decline that the company reported in 2019. Sure, the company benefited from stay-at-home trends during the year. However, the company sees positive trends continuing this year as well - even as we move beyond the pandemic.

KHC, in its own words, owns a powerhouse portfolio of iconic brands.

(CAGNY 2021 Presentation)

The problem is that of underinvestment. In the past, analysts raved about KHC’s ability to derive operational efficiencies and that helped in part to justify the stock’s high valuation in 2016-2017, as investors were hopeful that potential acquisitions would be highly accretive to the bottom line. No significant acquisition took place but even worse, KHC started reporting financial weakness that seemed to be due to underinvestment in core businesses. This showed the double-edged sword of cutting costs: do it just enough, and it’s considered operational efficiencies but do it too much and it screams chronic underinvestment.

KHC has identified this problem and is focused on renovating its brands - 43% of its portfolio is slated to be renovated in 2021.

(CAGNY 2021 Presentation)

One area of investment is marketing - KHC aims to increase annual marketing expense by $100 million as compared to 2019 levels.

(CAGNY 2021 Presentation)

KHC is also getting smarter about marketing as it embraces social media advertising.

(CAGNY 2021 Presentation)

Other investments include improving production capacity and innovations such as producing its first-ever recyclable mac & cheese containers.

(CAGNY 2021 Presentation)

KHC believes that this is the turning point. Whereas the company saw organic net sales decline at a 1.3% compounded annual growth rate from 2017 to 2019, the company now believes it can achieve low-single digit growth moving forward.

(CAGNY 2021 Presentation)

In conjunction with the sales growth, KHC has also identified $2 billion in productivity efficiencies, including $1.6 billion planned through 2024.

(CAGNY 2021 Presentation)

Putting it all together, KHC anticipates that it can grow its bottom line by 4% to 6% annually with over 100% free cash flow conversion.

(CAGNY 2021 Presentation)

Is Kraft Stock Still a Good Stock to Buy?

In light of the promising outlook, is KHC a buy? That decision, in my opinion, depends squarely on KHC’s ability to deliver on its forward projections. Sure, the stock trades at 15.8 times forward earnings, which isn’t a commanding multiple. KHC traded at 25 times earnings in 2017 - if the stock can get up to 20 times earnings, then there’s a robust 30% upside when also accounting for the 4% dividend yield. The dividend appears well covered with a 63% payout ratio, but investors shouldn’t look only at P/E multiples or payout ratios to determine attractive value.

Investors shouldn’t ignore the ever-so-important impact of debt. Net debt stands at just below $25 billion - roughly 6 times 2020 free cash flow of $4.3 billion. KHC has brought leverage down from 4.4 times in 2019 to 3.7 times in 2020.

(CAGNY 2021 Presentation)

That’s squarely below KHC’s long-term target of less than 4 times and I don’t anticipate leverage rising too rapidly as we move beyond the pandemic. Still, it’s a sizable amount and KHC has a credit rating of BBB- or equivalent - the lowest rating still considered investment grade. Moody’s has stated that it may downgrade KHC if debt to EBITDA rises to 4.5 times or higher. If KHC can prove that it can grow its top and bottom line sustainably, then the stock will likely prove undervalued with potential for an upside surprise if it can gain credit rating upgrades. If, however, KHC returns to the secular declines of the past, then the stock will prove to be a value trap, as it may need to further reduce its dividend to pay down debt. Considering that KHC was reporting negative organic sales growth in the three years into 2019, I think that investors should wait to see if KHC can report consistent growth as we come out of the pandemic.

Conclusion

With shares trading at low earnings multiple and attractive 4% dividend yield, KHC may appear to be a solid dividend value stock. The company has given optimistic forward guidance that calls for a return to the consistent top and bottom line growth. However, investors should not ignore the high debt load - KHC must deliver on consistent growth for the stock to be a successful investment. If KHC can show robust growth, then there may be a considerable upside as the stock is re-rated towards 20 times earnings multiple. My current rating is hold.

Analyst’s 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.