At first sight, The Kraft Heinz Company (KHC -1.28%) appears to be a textbook case of how to conduct a successful large-cap merger. Shares are up more than 20% after last summer's unification, which was coordinated by billionaire Warren Buffett's Berkshire Hathaway and private-equity firm 3G Capital Partners. Over the last year, Kraft Heinz shares have doubled the greater S&P 500's gain of 13%.
The reality is slightly more complicated. Kraft Heinz has essentially performed in line with its greater peer group (packaged foods) over the last year. As interest rates remain low, many investors are looking at traditionally safer, low-volatility consumer-staples companies as income replacements. With its 2.7% dividend yield, Kraft Heinz yields more than the 30-year U.S. Treasury bond.
Provided interest rates stay lower for longer, Kraft Heinz should continue enjoying favorable valuations as income investors stretch for yield, provided the company can perform in line with its industry.
Could a recent lawsuit cost shareholders big-time?
One subset of operational risk is legal risk, which is loosely defined as financial or reputational loss arising from regulatory or legal action. With legal risk, not only is there a potential for a large cash payout, but the cost of defending the company in legal proceedings can be high.
Pinnacle Foods (NYSE: PF) recently filed a lawsuit alleging that Kraft Heinz's new line of Devour frozen meals "directly, deliberately, and blatantly" infringed on its Hungry-Man trademark by using a "confusingly similar" slogan.
The slogan in question? Devour's new tagline of "Satisfy Your Cravings" is similar to Hungry-Man's "Satisfy Your Craving." These three words -- the letter S excluded -- may cost Kraft-Heinz investors millions in legal fees and potential damages.
Even if Kraft Heinz is successful in this case or settles quickly, its Devour line of frozen single-serve meals may face bigger problems: changing consumer tastes.
The single-serve frozen-dinner market is under threat
The single-serve frozen-dinner market has struggled of late. It's a bifurcated market, with calorie-conscious dieters choosing Kraft-Heinz's Weight Watchers Smart Ones, Nestle's Lean Cuisine, and ConAgra Foods' Healthy Choice brands. On the other hand, brands like the aforementioned Devour and Hungry-Man are designed to tap into the, well, the hungry-man demographic that desires a robust meal at a fair price.
Consumer tastes have hurt sales of the latter brands, as concerns about ingredients and sodium content have shifted health-conscious consumers away, while cheaper substitutes from quick-service restaurants like the McDonald's "McPick 2 for $5" and Burger King "5 for $4" deals have proven successful among the hungry-diner set. Kraft Heinz CEO Bernardo Hees has noticed the transition and noted "consumption trends" as the company's biggest challenge.
The lawsuit may cost millions, but it's not a thesis-altering event
Last quarter Kraft Heinz's year-on-year revenue (last year's comparable includes unmerged companies) fell nearly 5%. In The Wall Street Journal, Hees specifically noted the Smart Ones brand of frozen meals as a reason for top-line weakness. The company's prescription for growth was to remove artificial ingredients from its macaroni and cheese and to introduce the Devour line of meals. While investors should monitor this case, it's not a thesis-changing event.
For example, for the first six months of 2016, frozen and chilled meals overall made up roughly 9% of Kraft Heinz's top line, and this was without the new Devour line of single-serve meals. Kraft Heinz continues to be a condiments- and sauce-driven company, with 25% of its revenue produced from this segment. Devour may be in a product category with considerable headwinds, but so are its competitors.
The biggest driver in this segment appears to be dividend yield; look for Kraft Heinz to perform in line with the overall industry, as yield hunters continue to look for above-average dividend payers in the traditionally safe consumer-staples space.