It’s never good when a company announces a $15.4 billion non-cash impairment charge. It’s a sign business is not going as planned. On Feb. 21, Kraft Heinz (NASDAQ:KHC) announced such a charge, sending Kraft Heinz stock down 27% in a single day of trading.
If you’ve owned Kraft Heinz stock since the end of 2017, and still hold, your paper losses are closing in on 60% … an awful feeling for any investor.
I haven’t written a lot about Kraft Heinz in recent months. While I knew things weren’t going well at the company, or in the entire processed and packaged foods industry for that matter, I had no idea that it was this bad.
Yes, people are trying to eat better, but there are still a lot of people buying Oscar Mayer hot dogs and Kraft macaroni and cheese dinners. A 60% haircut over 14 months seems like an overreaction, but Mr. Market is going to do what it wants when it wants. There’s not much we can do about that.
Back in April 2017, I included Kraft Heinz in a list of ten stocks to buy for the next decade. Of the ten stocks, only KHC is in negative territory after 22 months, averaging a 43% total return with Blue Buffalo getting acquired in April 2018 by General Mills (NYSE:GIS), hence the number nine in the title.
That is good news.
The bad news is that an IP reader saw my article at one point and picked KHC out of the crowd, prompting the individual to send me a course-worded email on the news.
In this business, there’s nothing worse than hearing about losses. You only want gains and wins. We all know that doesn’t always happen. I feel terrible, but it’s time to move on.
After some reflection, I’ve come up with seven reasons why contrarian investors might want to buy Kraft Heinz stock.
Note: If you’re not prepared for more potential losses, do not even consider an investment.
As you probably know, Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) is the largest shareholder in Kraft Heinz with 26.7% of its stock, slightly ahead of private equity firm 3G Capital, Buffett’s partner in the Kraft Heinz acquisitions, at 23.9%.
Both lost billions on paper as a result of the impairment charge. Buffett has admitted that they had made two mistakes with Kraft Heinz. First, they overpaid for Kraft and secondly, although he feels they didn’t overpay for Heinz, they acquired $100 billion in tangible assets between the Heinz deal and the Kraft merger, making today’s changing packaged foods industry a much more difficult operating environment than when they did the merger in 2015.
The good news is that Buffett has said he isn’t going anywhere. The bad news, at least so far, is that he hasn’t shown any enthusiasm for raising his stake or buying out his private equity partners.
My gut tells me that will change if its stock price falls into the $20s.
Warren Buffett’s a loyal partner. Since the impairment charge news, he’s been very complimentary of his 3G partners.
While Lemann might be smart about business, 3Gs infatuation with zero-based budgeting, where every expense must be justified each year, has focused the company on cost-cutting instead of innovation. That has led to old and tired brands unable to compete with smaller, more customer-friendly brands.
If 3G were to sell their stake to Berkshire and Buffett brought in a new management team focused on innovation, there’s no reason why its stock couldn’t move back into the $40s.
It probably won’t happen but it should.
Current Kraft Heinz CEO Bernardo Hees is a 3G guy. He has worked for 3G businesses ever since graduating from college and is still a partner of the private equity firm despite his day job running the company.
Trained as an economist, he’s a numbers guy. Before becoming the CEO of Heinz in 2013, he ran Burger King Worldwide for four years. Before that, he ran 3G-owned businesses in Latin America.
Burger King is hardly the same business as Kraft Heinz, but good CEOs can transition between industries and sectors. Cost cutters, not so much.
Crain’s Chicago Business contributor Joe Cahill wrote an interesting article in November about Kraft Heinz needing a new CEO long before the impairment charge. I couldn’t agree more.
“Hees needs to bolster product development and marketing capabilities, while reorienting company priorities toward growth after instilling an overriding zeal for cost containment,” Cahill wrote. “At the same time, he has to convince Wall Street that investing in growth won’t erode the industry-leading profit margins that set Kraft Heinz apart from industry rivals.”
If a business journalist could see the forest from the trees, as Buffett recently quipped, why couldn’t Hees?
A new CEO with real packaged foods experience would be a nice start to turning around Kraft Heinz.
Reversion to the Mean
On this one, I’m probably grasping at straws.
Reversion to the mean theorizes that stock prices generally tend to return to their historical average or mean. Since the merger in 2015, KHC stock has traded between $70 and $100; that’s 31 months before moving lower.
That said, reversion to the mean doesn’t always occur, and when it does, it often has more to do with improving business conditions than any historical trend.
The question aggressive investors ought to be asking themselves: Is this a shift in the norm for Kraft Heinz, which means a $32 share price is fully justified or is this an abnormally low level for KHC stock?
If Buffett is not buying more stock, it’s possible he feels $32 isn’t the bottom. It’s also possible he doesn’t want to make a bad situation worse by increasing Berkshire’s stake at a time when the future is unknown.
If you own KHC stock, you might want to pray for reversion to the mean.
There’s one constant with 3G companies: They tend to have large amounts of debt.
Take Restaurant Brands International (NYSE:QSR), the owners of Burger King, Tim Hortons and Popeyes quick-service restaurant chains. 3G hold 43% of the voting shares in the Toronto-based company. It has $11.8 billion in total long-term debt to just $913 million in cash. That’s a lot of debt for a franchise business.
As the global economy slows, the winning stocks will be those that have strong balance sheets. I wouldn’t characterize Restaurant Brands’ as such.
As for Kraft Heinz, it has $30.9 billion in long-term debt and just $1.1 billion in cash. Its debt represents 79% of its market cap, a relatively high level. However, as Buffett has acknowledged, the company has significant tangible assets that it could divest to other private equity firms, reducing the amount of leverage to its balance sheet.
After all, if private equity could bring Hostess Brands (NASDAQ:TWNK) and the Twinkie back to life, it’s possible some brave souls could do the same with some of Kraft Heinz’s brands.
In early January, Kraft Heinz completed its $200 million purchase of Primal Kitchen, a maker of healthy condiments, sauces, salad dressing and snacks. The business operates under the company’s Springboard platform, which includes some up-and-coming food brands disrupting the industry.
Last October, Kraft Heinz announced it was buying Ethical Bean, a Canadian coffee brand that meets a high standard of environmental and social stewardship. Although Ethical Bean is a company with less than $10 million in annual revenue, Kraft Heinz sees an opportunity to grow it.
These are the kind of stealth-like acquisitions it should have been doing from the get-go.
While they’re not massive deals of the Unilever (NYSE:UN) ilk, they give the company a more contemporary vibe, and that’s vital if it wants to deliver shareholder value in the future.
From little acorns do mighty oaks grow?
Reinvest in Business
This final point is vital to Kraft Heinz’s future. It must be apparent to Buffett and 3G at this point that cost-cutting is not the answer.
Between 2014 and 2017, Kraft Heinz increased its operating margin by 840 basis points to 23.5%, prompting most, if not all packaged food companies to adopt some form of cost controls. However, you can only cut out so much fat before your business starts to flatline.
“Savings can only go so far in boosting margins,” stated Just-Food.com contributor Dean Best recently. “Over time, sustainable sales growth is needed, too. And Kraft Heinz has not been able (or, some would say, willing through investment in its brands) to consistently grow its top line, either on a reported or an organic basis.”
Investors, worried that Kraft Heinz will be unable to reignite sales growth, have exited the building. It is going to take 12-18 months to regain investor trust and confidence.
If it wants to stop the bleeding from its share price, it’s essential that it delivers some coordinated growth strategy to the markets before summer gets rolling. If it doesn’t have the attention of investors by June, I could see it drop into the $20s.
Divestitures such as Maxwell House and Planters are welcome. However, if it doesn’t come with a plan for growth, a cleaner balance sheet won’t save its stock price.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.