Where Will Kraft Heinz Be in 5 Years?

Will the ketchup and macaroni maker be left behind by shifting consumer tastes?

Leo Sun
Leo Sun
Jul 6, 2019 at 9:03AM
Consumer Goods

Kraft Heinz (NASDAQ:KHC) has struggled since its public debut in 2015. The packaged foods company, which was created from the merger of Kraft and Heinz, struggled with sluggish sales and contracting margins as shoppers gravitated toward healthier products and cheaper private label brands.

Earlier this year, Kraft Heinz hit a multiyear low on a triple whammy of bad news. It took a $15.4 billion writedown on its Kraft and Oscar Meyer brands, disclosed an SEC probe into its accounting practices, and slashed its dividend. Even Warren Buffett, who oversaw Kraft and Heinz's merger, subsequently admitted that Berkshire Hathaway "overpaid" for its 27% stake in the company.

Baked macaroni and cheese.

Image source: Getty Images.

Kraft Heinz's near-term outlook is bleak, but the stock also looks cheap at 10 times forward earnings with a 5% yield. Let's gaze further into Kraft Heinz's future to see if the packaged foods giant will recover over the next five years.

Understanding Kraft's main predicament

After Kraft merged with Heinz, the new company's management mostly focused on cutting costs instead of investing in new products, acquisitions, or ad campaigns. As a result its organic sales flatlined. Kraft tried to offset that slowdown by slashing prices, which boosted its sales but reduced its margins.

Metric

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Organic sales

(0.6%)

(1.5%)

(0.4%)

2.6%

2.4%

Adjusted EBITDA margin

29.3%

28.5%

29.5%

25.3%

24.7%

Source: Kraft Heinz quarterly reports. Year-over-year growth.

Kraft Heinz's strategy was notably different from General Mills' (NYSE:GIS) approach, which used major acquisitions and price hikes to offset lower shipments. General Mills' strategy enabled it to generate stable organic sales growth as its margins expanded, but Kraft's strategy caused it to slide down a slippery slope of fading earnings growth.

Moreover, Kraft's focus on cutting costs after the merger (which reduced the combined company's headcount by about 28%) likely affected its internal accounting controls. That's probably why Kraft subsequently admitted that it misstated its cost of products sold for four straight years. The overall impact was minimal, accounting for less than 1% of its cost of products sold each year, but it raised serious questions about the management's competence.

Kraft Heinz recently hired Miguel Patricio, a former Anheuser-Busch InBev (NYSE:BUD)executive, as its new CEO, but this new leader -- who previously resurrected InBev's struggling Chinese business -- faces an uphill battle.

A shopper puts a bottle of ketchup into a basket.

Image source: Getty Images.

What should investors expect from Patricio?

Patricio was most recently InBev's chief marketing officer, and he revived the company's Chinese business by promoting its flagship Budweiser brand as a premium product, while expanding local brands like Harbin.

This indicates that Patricio will likely ramp up Kraft Heinz's marketing efforts, seeking to pitch some of its aging products as premium brands in order to boost its gross margins again, and eventually acquire higher-growth brands while divesting lower-growth ones. We've already seen Kraft take a few steps in that direction. It recently sold its Canadian cheese business, and it's shopping around its Ore-Ida potato products and Plasmon baby food brands.

Yet Patricio, who took over on July 1, recently told The Wall Street Journal that Kraft won't sell any brands or make any quick acquisitions in the following months. Instead, Patricio wants Kraft Heinz to focus on cutting costs in certain areas to free up more cash for fresh marketing campaigns -- especially for its flagship ketchup brand.

However, Kraft Heinz's latest rebranding campaigns -- which include a "salad frosting" for kids (which is just ranch dressing) and a redesigned "Edchup" ketchup bottle from singer Ed Sheeran -- seem more like gimmicks than game-changing moves.

Kraft's long-term debt, which stood at $30.8 billion at the end of 2018, will also limit Patricio's ability to fund new R&D efforts and marketing campaigns. $10.3 billion of that total, excluding capital leases, matures within the next five years -- a daunting figure for a company that finished 2018 with just $1.1 billion in cash and equivalents.

A tough balancing act

The next five years will be crucial for Kraft Heinz's survival. It must stop sacrificing margins to boost sales, weed out weaker brands, invest in innovative products and fresh marketing campaigns, and reduce its massive long-term debt.

If Kraft Heinz can pull off that tough balancing act, its stock might recover. But if it fails to accomplish just one of those goals, its brands will continue to lose relevance in the crowded packaged foods market as its debt overwhelms its cash flow.