Kraft Heinz had a rough day, to say the least. Let’s briefly recap:
- The company’s EBITDA of $1,699MM missed estimates by ~11% (consensus was $1,906MM)
- Their new 2019 outlook called for $6.4BN of EBITDA compared to consensus estimates of $7.4BN
- There was an SEC subpoena into their procurement area
- The company cut its dividend by 36%
- The took a large impairment charge of $15.4BN related to Kraft Natural Cheese, Oscar Mayer cold cuts, and the Canadian retail business
Oh and Warren Buffet, a 27% owner of Kraft Heinz, said he wouldn’t buy more and probably paid too much for the business.
Yikes. No wonder the stock was down ~28% on the day. Being a contrarian investor though, do we buy now that there is blood (er, ketchup?) in the streets?
Unfortunately, I don’t quite yet think we are being compensated well enough for the risk. It is close, but the risk of rising inflation, new competition impacting CPG companies, and changing tastes has clearly impacted the business (and resulted in the miss and guide down).
Impairment and Financial Controls
The HUGE, but non-cash, impairment is something the headlines are grabbing. I’m less bothered by the impairment (is anyone actually shocked that Oscar Mayer cold cuts value has gone down?) and more bothered that this did not come up earlier. Each year, companies must test their assumptions on goodwill to see if it should be impaired. That test occurs in Q2 for Kraft which means they didn’t do it then and waited a couple more quarters to break the news. Perhaps they really didn’t change their assumptions until now, but more likely, I think some of their financial controls need improving.
Indeed, KHC has had issues in the past on this including issuing a non-reliance letter on its previously issued financials relating to the cash flow statement and maintained a material weakness in internal controls over financial reporting. This isn’t too rare, to be fair, but the CFO is a 29 year old so… do you feel comfortable with that? Especially with the new SEC investigation?
To be clear, I think Kraft Heinz is a good business and is supported by solid brands behind both companies. I would be a buyer KHC if it hits the right price. However, from a valuation standpoint, there’s not enough cushion built into the price today to weather more bad news. I generally use a 10% forward FCF yield to gauge this as a general proxy for when bad news is really priced in, though it can differ depending on the business. I would say given KHC is a strong business, I’d buy before it got to that level.
If the average S&P500 company trades at a 5% FCF yield, or 20x FCF, then you can see that KHC looks pretty good trading around 13x FCF. However, if you think you need a 10% FCF yield to buy the stock then that means it has further to fall — to $27 which is ~23% more downside.
Said another way, let’s say you think KHC should trade at a 6.5% FCF, a modest discount to the S&P500 especially when considering KHC is 4.3x levered. That is 18% upside from today’s levels, which is good, but not enough in my view for the risk.
There could be upside from improved sentiment and the sale of two businesses they announced on the call to pay down debt, but I think more likely than not, it will be bad news for the next two quarters. Without any positive catalysts, the stock likely drifts lower.