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About a year ago, I concluded that I was slowly developing a taste again for shares of Kraft Heinz (NASDAQ:KHC). This came even as 2021 has been an uneventful year, with divestments resulting in a meaningful reduction in leverage again. With leverage ratios under control, a resulting 12-13 times earnings multiple looked compelling, even as the operating performance remained lackluster.
A Quick Recap
Following its ill-advised mega merger in 2015, Kraft Heinz has been overleveraged as a near $100 stock at the time and fell to the $30s at the outset of the pandemic. The pandemic actually provided a lifeline to the business, resulting in stronger demand for food (amidst hoarding), lower interest expenses and offered the potential to divest some assets at reasonable prices. Following a $3.3 billion divestment of the Planters nuts business in 2021, leverage came down to about 3 times.
That divestment was announced just after the release of the 2020 results, a year in which the pandemic fueled a 5% increase in sales to $26 billion, with EBITDA up to $6.7 billion, earnings reported at $2.88 per share, and net debt down $2 billion to $25 billion. Modest improvements in profitability and lower absolute debt levels made that leverage ratios fell to 3.7 times.
Besides the Planters deal, there was the Cheese divestment which reduced leverage by another $3 billion. Pegging earnings power close to $2.75 per share pro forma for the deals (although accompanied by a much lower GAAP number), leverage would be addressed in a huge way, albeit aided by the pandemic. Through 2021, the company managed to reduce net debt towards $22 billion as operating performance was pretty flat, not too bad following tough comparables versus the pandemic.
At $35, valuations were non-demanding, yet a 4.6% dividend yield started to look a lot safer albeit that the business still has a real positioning issue at hand, making me upbeat on the cheapness, although the operational performance was not too convincing.
Stabilization
A year since voicing this cautious, but an underlying upbeat tone on the company, shares have been trading range bound between $35 and $45 over the past year, currently exchanging hands at $40 per share.
Early in 2022, Kraft Heinz posted a 0.5% decline in full year sales to $26.0 billion as adjusted EBITDA fell 4% and change to $6.4 billion, with adjusted earnings per share up five pennies to $2.93 per share. The gap with GAAP earnings was huge at $0.82 per share, as net debt has been cut to $18.4 billion, just below 3 times EBITDA now.
Following divestments, Kraft Heinz saw a low single digit decrease in comparable sales for 2022 with adjusted EBITDA seen between $5.8 and $6.0 billion, hinting towards some margin pressure. Following inflationary pressure in the first quarter, the company hiked the sales guidance, keeping the EBITDA range unchanged.
From hereon things got a bit tricky. Second quarter sales fell 1% on a reported basis, but organic sales rose 10%, the result of a 12% price hikes offsetting 2% organic volume declines. Despite a low double digit increase in sales, the pricing action was not sufficient to halt EBITDA declines. This resulted in the company hiking the organic sales performance, yet keeping the EBITDA range intact. Net debt actually rose to $19.4 billion, mostly amidst poor working capital cash flow conversion.
Third quarter sales even rose 3%, as the composition of the sales growth was disappointing amidst inflationary pressures. For the quarter, prices rose 15%, in part offset by a near 4% decline in volumes. Strong pricing makes that the EBITDA guidance was adjusted to $5.9-$6.0 billion, with net debt stable around $19 billion.
To date, adjusted earnings per share are down 10% to $1.93 per share, making a $2.50 per share run rate realistic for 2022. In the meantime, the gap with GAAP earnings keeps narrowing, and the adjustments are “cleaner” involving fewer cash outflows.
2023
2022 has been a tough year amidst raging inflation which hurt margins, in part because volumes came down as well. Higher prices furthermore resulted in poor working capital conversion, which made that leverage has not really come down anymore.
Right now, it has been a combination of a higher share price and lower earnings per share which increased the earnings multiple to about 16 times here, quite a re-rating, as leverage remains stable around 3 times. To create appeal here, inflation needs to come down as growth could return this year.
This could happen as no recent divestments have been announced as subdued inflation might allow for margin and thus an earnings recovery, as such a situation results in solid cash flow conversion. That is the roadmap for the company this year, but inflationary trends are still hard to read into.
Given all of this, I must say that the risk-reward appears to have gone backwards a bit, although it is comforting to see that the company has fixed interest rates for its debt. Amidst all this, I am turning a bit more cautious here, as the road to a real recovery still takes a long time.
