The Kraft Heinz Company (NASDAQ:KHC) can be best recalled through its core brands such as Oscar Mayer cold cuts, Heinz ketchup, and Kraft macaroni and cheese. The company has grown well through mergers and acquisitions and has been paying good dividends in the past but the management is facing problems with respect to organic growth. They are focusing on their core competence of acquisitions. After their failed attempt to acquire Unilever (NYSE:UL) last year, it seems that they might be eyeing PepsiCo (NYSE:PEP) or Mondelez International (NASDAQ:MDLZ). There has also been some recent insider buying at the low levels.
Our assessment of the company’s situation and the management strategy indicates that there might be a major acquisition coming up which will be a turning point for KHC and could provide an interesting upside to investors with a medium to long-term horizon.
KHC is the fifth-largest food and beverage company in the world and the third-largest in North America. The company has a vast variety of products in the segments of condiments, sauces, cheese, dairy products, beverages, coffee, meals, and so on. Some of the key brands in its portfolio are Kraft, Heinz, Oscar Mayer, Lunchables, Classico, Plasmon, Benedicta, Capri Sun, Golden Circle, Wattie’s, Glucon D, and Complan.
The company distributes its products not only through its own independent sales force but also through a wide network of distributors, brokers, and agents to various retail outlets, hotels, restaurants, hospitals, pharmacies, bakeries, and so on across the globe.
A Big Acquisition Coming Up?
KHC has a history of inorganic growth through mergers and acquisitions. In 2013, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) and 3G carried out an LBO (leveraged buyout) of H. J. Heinz Company and followed it up by merging the entity with Kraft to create one of the largest consumer goods players in the world. Ever since then, the management of the company has been heavily focused on M&A for the purpose of expansion. They made a bid of $143 billion in 2017 for acquiring UL but were forced to walk away from the deal after the UL management opposed the move.
If this deal had gone through, the company would have gone on to become a global consumer goods powerhouse. Currently, there is speculation that the management might bid for PEP or Mondelez International in the near future. As per Stifel analyst Christopher Growe, these two companies could be excellent potential targets for KHC as the management is expected to lead industry consolidation within the consumer packaged foods industry. After the Unilever bid, it is clear that the company is looking for a large-scale, transformational acquisition and buy growing brands and categories while also creating global cost synergies.
However, the big question here is – why is KHC so focused on acquisitions instead of organic growth? The common view is that the management is struggling to drive organic growth and this is also one of the reasons why the stock is available at a low price. In fact, in their recent coverage on KHC, Credit Suisse explicitly mentioned that organic growth is not an area of expertise of the management. The company is also struggling to drive product innovation and is facing strong competition from younger brands. Another factor that is impeding organic growth for KHC in developed markets is the fact that consumers are shifting to healthier foods.
The company’s results for the previous quarter were tepid as the revenues dipped marginally from $6.36 billion to $6.30 billion and the EBIT fell from $1.55 billion to $1.51 billion. The company continued to generate good free cash but the organic revenue growth is expected to be hardly 1% for the year as per analysts. On top of this, the management is also planning to dispose of its successful Indian malt drink brand named Complan. The sale might help improve the company’s cash flows and maintain a high dividend payout to investors.
Good Fundamentals And Some Insider Buying Too
From an investment perspective, the best part about KHC is the fact that all these concerns have already brought the stock price to a low. KHC has fallen by more than 25% since the beginning of the year which is quite high for any safe, low-beta, large-cap company. However, the fundamentals of the company are not too bad. As we see in the extract below, KHC has an RoE of 17.8% which implies that the shareholder value creation has been high.
This has been achieved as a result of a decent operating margin of 25.6%. The sales growth and the EPS growth over the past five years have been good but this is largely due to inorganic growth. The amount of leverage on the Balance Sheet is not too high with a long-term debt to equity ratio of 0.43. The company has been generous in their dividend payouts with a ratio of 27.2% resulting in a yield of more than 4%.
An interesting observation in the above extract is the positive number in the Insider Transactions section. It is clear that the management has been buying shares of KHC at the current low and are expecting that an upcoming acquisition will unlock the true potential value of the stock. The current Price to Earnings ratio of the stock is also low at 18.7 if we compare it to KHC’s peer group.
There Might Be Some More Buying But The Real Value Lies In An Acquisition
KHC recently touched its 52-week low in May when the price fell to $54.11 and the general view was that the stock had bottomed out. It was reasonable to believe that despite all the red flags associated with the company, a valuation of $54.11 was the lowest that the share price could go. The stock has begun its upward movement since then and there has been no stopping it so far.
When we analyze the viewpoint of analysts following the stock, we see a very large spread in the range of target prices. 20 out of the 22 analysts following the stock are bullish with the highest target price being $85 and the lowest being as low as $50.
For carrying out our valuation and determining an appropriate target price, we will adopt a fundamental approach and use the Sales multiple and the Price to Earnings in order to forecast KHC’s valuation. If the management is able to announce even one relevant acquisition by the end of the year, the stock price is bound to appreciate through multiples expansion.
We have assumed a total revenue of $27 billion with a Net Income of $11.33 billion for the coming year which is a marginal increase of 3% over the current levels and is fairly reasonable based on industry numbers. If we apply a Price to Sales multiple of 3.7 and a Price to Earnings multiple of 8.7 to these numbers, we come up with a target price of $80 for 2018.
In order to re-verify our price target for KHC, we have gone ahead and analyzed the candle chart of the stock and determined the levels of support and resistance. As we can see in the extract below, the sluggish organic growth is clearly reflecting in the downward trajectory of the stock over the past two years.
Source: Yahoo Finance
The recent sell-off which took place around the beginning of 2018 seems unjustified as it brought KHC to unreasonably low valuations and it is likely that fresh buying might push it higher. The stock faces its first resistance at the level of $81 which is also a critical resistance as per the Gann’s Square of Nines indicator. The management might have to produce a stellar result with good organic growth dispelling investor concerns in order to break this resistance.
Another possible means would be a big acquisition that unlocks the potential value of the stock. Given the management’s strategy of inorganic growth and the recent insider buying, there is a reasonable chance that the latter might be true and that the company might initiate M&A-related talks very soon. We would stick to a target of $80 which is marginally below the resistance level, for a 12-month horizon.
The valuation and projected price of KHC in this article are purely based on our analysis and are specific to the date of the analysis i.e. 23rd June 2018. We must emphasize that it is dependent on a number of factors – KHC’s successful identification of potential acquisition targets, the success of acquisitions, value unlocking perceived by the market resulting in incremental buying, strong quarterly results, and so on.
While we are reasonably confident of our price projection, our analysis cannot be directed to providing any assurance about the achievability of the projected price. There is a possibility that the actual price of KHC’s stock is different from the projected price as a result of unexpected events and circumstances e.g. a failed acquisition, poor post-merger integration, lack of synergies from a future acquisition resulting in value destruction, the management being unable to acquire another company or grow organically, a change in the core KHC management, changed investor perception regarding KHC and the food and beverages sector, and so on. It is important to keep an eye on the latest news associated with KHC for upcoming acquisitions as well as the latest earnings results.
KHC has created a fair amount value for long-term investors over the years. The management’s incompetence to overcome the threats of competition and generate organic growth in a constantly evolving consumer goods market is indeed a cause for concern. However, on the positive side, they are focusing on what they know best – acquisitions. The fundamentals of the stock are reasonably strong too and the insider buying at current levels is an encouraging sign.
Even with Warren Buffett leaving the Board, there is a reasonable chance that the team will be able to dispel the concerns regarding KHC’s growth with a big acquisition very soon. The dividend yield of KHC is over 4% at current levels which makes it even more attractive. Overall, we are reasonably optimistic about KHC and we believe that an acquisition in the coming 12 months could unlock some value for investors holding the stock. Our price target for the following 12 months is $80 and we believe that it is reasonably achievable if the management creates a positive catalyst in the form of a high-quality acquisition.
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.