Kraft Heinz (NASDAQ:KHC) stock is still overvalued. Don’t try to catch this falling knife. Even though Kraft Heinz is down a lot since Feb. 13 — when it reported 2019 earnings — the free fall may not be over.
Why? The company insists on maintaining its $1.60 per share annual dividend. The reality is Kraft Heinz cannot afford this high level of dividend. It costs too much, especially since Kraft Heinz is laden with debt.
Here are the facts. Kraft Heinz has 1.2 billion shares outstanding. The dividend annually is $1.60. So the dividend requires Kraft Heinz to cough up $1.9 billion each year. Let’s call it $2 billion assuming some executives convert their options.
The problem is that Kraft Heinz had $28 billion in long-term debt at the beginning of 2019. Kraft Heinz has to get serious about paying it down. That means it needs to pay down $3 billion to $4 billion of debt a year.
Its banks don’t want Kraft Heinz to have a debt ratio of greater than say 4 times its cash flow. The cash flow measure is called EBITDA (earnings before interest, taxes, depreciation and amortization). Since Kraft Heinz made only $6.1 billion in EBITDA during 2019, the ratio stands at 4.6 times. That is too high.
Here is another way to look at the dividend dilemma at Kraft Heinz. If EBITDA doesn’t rise, debt needs to fall quickly to $24.4 billion (4 times $6.1 billion of EBITDA). It would need to magically erase about $4 billion in debt to get there.
But there is not enough free cash flow to pay down all of that debt. In fact, free cash flow during 2019 was just $2.8 billion. So after the dividend cost of $2 billion, there was only $800 million left to pay down $4 billion in debt. Those numbers don’t add up.
Kraft Heinz Upset the Ratings Agencies
As I noted above, those numbers don’t add up. That is, not without major asset sales. So, unsurprisingly, Kraft Heinz’s new management team is working on just that.
Management kept the dividend stable, made a big deal about it and sold off a bunch of assets to lower debt. But this upset the ratings agencies. They don’t like asset sales since they cut into the EBITDA-generating capability of the company.
Here is what happened. Kraft Heinz paid down about $2 billion of debt, selling $1.9 billion in assets to cover the debt reduction.
Moreover, management indicated that it is not going to cut the dividend during the Feb. 13 release.
Immediately Fitch cut its rating on Kraft Heinz’s debt to “junk” status. The agency lowered its rating to BB+ from BBB- on the company’s debt. Here is what Fitch said:
“Following Kraft’s commentary around 2020 operating headwinds and its commitment to maintain its dividend, Fitch estimates the company may need to divest up to 20% of its projected 2020 EBITDA to support debt reduction.”
Moreover, management indicated on its call that it expects EBITDA to fall by another $460 million during 2020. That will probably mean a similar fall in free cash flow.
KHC Dividend Yield Indicates the Market Expects a Cut
As it stands today, the dividend yield on Kraft Heinz stock is over 6.5%. That is an indication that the market expects management to cut the dividend.
If Kraft Heinz stock stays at this level, it means that the market thinks the dividend will be cut roughly in half. For example, at 80 cents per share, the dividend yield at $24 per share is just 3.3%.
That would be a normal dividend yield for a food company like Kraft Heinz. It also means the dividend would only cost $1 billion, instead of $2 billion.
This would allow the company to pay off more debt without having to sell assets. Those assets are needed to generate EBITDA to pay interest and debt service costs.
Besides, who wants to run a respected food company with “junk”-rated debt? Maybe management was just going through the motions of maintaining the dividend. Now they can claim that the market made them cut it.
Bottom Line on Kraft Heinz Stock
Like I said in the beginning, don’t try to catch a falling knife. If Kraft Heinz did not have so much debt, I would say stay with the stock. After all, the 6.5% dividend yield makes it look like a bargain.
But now, with the debt only falling slowly, expect the company to either dig in its heels on the dividend, or expect further asset sales. Either way, it’s a slow rot for Kraft Heinz stock.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here. The Guide focuses on high total yield value stocks. Subscribers get a two-week free trial.