Is now a good time to buy Kraft Heinz (NASDAQ:KHC) stock? After the company’s credit was downgraded and it issued a weak earnings report, things don’t look so good for the iconic food maker. But Kraft Heinz stock sells at a discount to its processed and packaged foods peers. Given the company’s many established brands, in theory Kraft Heinz stock could be a great contrarian play.
On the surface, the shares look like a bargain. But in reality, the company could now be a classic “value trap.” With its management wedded to the concept of cost-cutting at all costs, the company’s stable of brands have been starved of marketing dollars. Cutting costs works in the short-term. However, the value of Kraft Heinz hinges on the value of its brand portfolio.
A turnaround could be on the horizon for the company. But, in the meantime, Kraft Heinz stock could fall further. Consequently, the shares are a sell at the present time.
What Hurt Kraft Heinz?
Kraft Heinz is a prime example of what happens when companies focus on cost-cutting above all else. In other words, zero-based budgeting can only take them so far. But that was Kraft Heinz’s go-to approach. It’s the calling card of 3G Capital, the Brazilian private equity firm that teamed up with Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A BRK.B) to acquire HJ Heinz in 2013.
It’s fair to say that Berkshire was more of a silent partner in the deal. The real “sweat equity” came from 3G’s adept utilization of zero-based budgeting (“ZBB”). ZBB is cost-cutting on steroids, helping to fatten the bottom line even if the top line is on a diet. But over the long-term, it may not be the key to creating shareholder value.
3G and Berkshire merged Heinz with Kraft Foods in 2015. Since 3G could use ZBB to trim Heinz’s fat, Kraft Heinz’s operating margins. could be meaningfully raised. But over time, ZBB went from being on a sensible diet to a starvation diet. Reduced investments in its brands lowered its top line. Despite its high margins, sagging sales translated into lower profits, sending Kraft Heinz stock down more than 60% since the merger.
Changing tastes and demographic trends don’t help, either. As InvestorPlace columnist Josh Enomoto wrote in his Feb. 18 column, millennials are less enthralled by brand-name cheese and deli meats and are more willing to buy store brands. In addition, processed food products are losing popularity. In an age of “plant-based diets” and “whole foods,” where do cheese products fit into the equation?
Value Stock or Value Trap?
Compared to its peers, Kraft Heinz stock is cheap. With a forward price-earnings (P/E) ratio of 11.9, and an enterprise value/EBITDA (EV/EBITDA) ratio of 9.2, Kraft Heinz’s valuation metrics are lower than those of its main competitors:
- Campbell Soup (NYSE:CPB) has a forward P/E of 19.2 and an EV/EBITDA ratio of 16
- Conagra Brands (NYSE:CAG) has a forward P/E of 15.7, and an EV/EBITDA of 12.3
- General Mills (NYSE:GIS) has a forward P/E of 15.8, and an EV/EBITDA of 12.6.
- Mondelez (NASDAQ:MDLZ) has a forward P/E of 22.4 and an EV/EBITDA of 19.5
Yet there’s good reason for the valuation discrepancy. Not only are Kraft Heinz’s sales sagging, but its balance sheet faces headwinds as well. Credit Rating agency Fitch recently downgraded its debt to “junk” status. Fitch’s rationale? Diminishing EBITDA, along with Kraft Heinz’s refusal to cut its dividend.
Kraft Heinz has $29.9 billion of debt against around $6.6 billion of trailing 12-month EBITDA. And with its EBITDA expected to decline again this year, more of the company’s cash flow will be used to pay interest. In theory, Kraft Heinz could reduce its debt load by selling assets. But, despite a desire to sell brands like Maxwell House and Breakstones, there are few takers.
With material asset sales unlikely, Kraft Heinz stock needs a true turnaround to move the needle. But this time, the key to such a turnaround isn’t cost cutting or deal making. It needs to increase the sales of its current products. But what’s Kraft Heinz’s game plan for growing its top line? The company has delayed the announcement of its turnaround plan until May.
In the meantime, all we can do is speculate about the company’s turnaround prospects. New talent at the helm of the company could result in success, given CEO Miguel Patricio’s marketing-focused background. Yet it remains to be seen whether the company’s long-term revenue trends can be reversed.
Kraft Heinz Stock Could Easily Head Lower
Floundering in a runaway bull market, Kraft Heinz, in theory, should be a great contrarian play. Yet there’s little reason to buy the shares, even at their current price level. The company’s valuation multiples are lower than its peers. But there’s a strong rationale for this discount.
In short, Kraft Heinz needs to raise the sales of its current offerings. But it remains to be seen whether its new, marketing-focused management can adapt the company’s old-school food products to changing tastes and preferences.
The bottom line is that Kraft Heinz stock is a sell. While it’s a value stock on paper, in reality it’s more of a value trap.
Thomas Niel, contributor to InvestorPlace, has been writing single-stock analysis for web-based publications since 2016. As of this writing, Thomas Niel did not hold a position in any of the aforementioned securities.