I can see why some investors would be tempted by Kraft Heinz (NASDAQ:KHC) at the moment. On its face, Kraft Heinz stock has a lot to like, and a reasonable “buy the dip” case.
The consumer giant owns a portfolio of iconic brands beyond its namesakes, including Planters, Philadelphia cream cheese, and Maxwell House. It should be a defensive business, an attractive attribute in a bull market about to enter its twelfth year.
Berkshire Hathaway (NYSE:BRK.A,NYSE:BRK.B), led by famed investor Warren Buffett, remains a major shareholder, and in fact helped lead the merger between Kraft and Heinz. And Kraft Heinz stock is cheap, trading at less than 10x 2019 adjusted earnings per share. It also provides an attractive dividend that yields nearly 6% at the moment.
But investors should look closer. It doesn’t take that much of a close look to see what’s wrong with Kraft Heinz and with Kraft Heinz stock. This looks like a value trap, a yield trap, and a stock that investors should avoid.
Kraft Heinz Stock Is Cheap
As far as the fundamentals go, it’s true that Kraft Heinz stock looks cheap relative to its earnings and its dividend. In fact, it’s the cheapest major food stock out there — and it’s not really close. Conagra Brands (NYSE:CAG), even after plunging this week following lowered full-year guidance, trades at almost 15x this year’s earnings per share. Campbell Soup (NYSE:CPB) has more than its shares of challenges, yet is valued at 19x the midpoint of its fiscal EPS guidance.
The dividend yield looks attractive too. Kraft Heinz’s 5.86% yield is the 14th-highest in the S&P 500. Index constituents with higher yields all have significant challenges, whether it’s traffic issues at Macy’s (NYSE:M) and Kohl’s (NYSE:KSS) or secular pressures on Ford Motor Company (NYSE:F) and Altria (NYSE:MO).
But in both cases, the fundamentals aren’t as attractive as they seem.
The Problems with KHC Stock
KHC stock does trade at a significant discount to the sector and the market as a whole. But it should trade at a discount.
Kraft Heinz is coming off a 2019 in which adjusted EPS declined 19% year-over-year. In conjunction with its fourth quarter earnings report last week, Kraft Heinz didn’t give specific guidance, a departure from its norm. But management said on the Q4 conference call that EBITDA (earnings before interest, taxes, depreciation and amortization) would decline again in 2020 after falling 14% in 2019.
EPS will fall. The current Wall Street consensus estimate projects a 20% drop, to $2.27. At that level, Kraft Heinz stock trades at a more reasonable 12x earnings and it’s too early to predict a return to growth in 2021.
Kraft Heinz’s debt load has to be considered as well. Based on guidance, net debt likely is over 5x 2020 EBITDA. That’s a concerning leverage ratio, and one that led Kraft Heinz debt to be cut to a ‘junk’ rating last week. On an enterprise value to EBITDA basis, which incorporates debt into the valuation, Kraft Heinz stock trades at over 10x. That’s a much smaller discount to other consumer food plays, most of which are driving at least some growth.
Declining earnings and heavy debt both suggest KHC stock should be cheap. And they color the dividend as well. Kraft Heinz already cut its payout last year. A company spokesman said last week there were no plans to do so again.
But the company has over $29 billion in debt to pay down. The current $2 billion in annual dividend payments potentially could be put to better use. And if earnings keep falling, Kraft Heinz may not have a choice but to slash its payout a second time.
The Bull Case
Investors can’t buy Kraft Heinz stock simply because it’s “cheap.” They have to believe in the potential for a turnaround.
On that front, there’s at least a case. But I’m skeptical it’s a good one. Kraft Heinz’s brands are well-known but they’re also under pressure. Grocers continue to push higher-margin private-label products. The likes of Velveeta and Kool-Aid have been shunned by consumers seeking healthier alternatives.
Kraft Heinz is trying to fix those brands, but it’s going to take time and money. As Dana Blankenhorn detailed on this site a year ago, it was aggressive cost-cutting by hedge fund 3G Capital that led to the current problems. Kraft Heinz increased near-term profits at the cost of the long-term health of its portfolio. It’s not the first time 3G’s strategy has failed: beer giant Anheuser-Busch InBev (NYSE:BUD) was also created via mega-merger, only to see its shares plunge and its dividend cut.
Kraft Heinz is trying to reverse field. The company is ramping marketing spend by 30% or more behind key brands. But I’m skeptical that’s enough. Millennials aren’t buying processed Velveeta ‘cheese’ or processed Oscar Mayer lunchmeat no matter how much money Kraft Heinz invests. The company can find some wins in condiments or smaller brands, but the world simply has changed. Kraft Heinz brands, for the most part, seem left behind.
If that’s the case, it’s simply impossible to own KHC stock. Declining earnings won’t support upside to the stock given the $29 billion debt load. There aren’t costs left to cut; if anything, spending has to normalize even beyond planned increases for 2020. The external environment remains difficult. Kraft Heinz stock does look cheap at first glance, but that’s hardly enough.
Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. He has no positions in any securities mentioned.