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Is Kraft Heinz Stock a Buy?

By Leo Sun - Apr 21, 2020 at 11:20AM

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The packaged foods giant is generating strong sales throughout the pandemic -- but its margins aren’t improving.

Earlier this year the future looked bleak for Kraft Heinz (KHC 1.31%). The packaged foods giant was struggling with decelerating sales growth, contracting margins, big writedowns on its top brands, a dividend cut, and an SEC probe regarding its accounting methods.

Kraft's high debt levels and constrained cash flows also didn't leave much room for the company's new CEO, Miguel Patricio, to launch aggressive turnaround efforts. The outlook was so dim that 3G Capital, the company's second-largest shareholder, dumped 25 million shares last September to reduce its stake to about 20%.

A shopper puts a bottle of ketchup into a shopping basket.

Image source: Getty Images.

But as the COVID-19 pandemic spread across the U.S., consumers stocked up on packaged foods and lit a fire under Kraft's core business. In early April, Kraft estimated its Q1 organic sales would rise about 6%, marking its first quarter of organic growth in five quarters. It expects its total sales to grow 3%, as the strength of its packaged foods segment offsets the "significant declines" in its food service business.

Kraft expects higher expenses to prevent its adjusted EBITDA and EPS from rising alongside its revenue, but its stock still rallied 30% over the past month as investors cheered the improvements. Yet its stock remains down nearly 70% over the past three years -- so is it finally safe to buy shares of this beaten-down packaged foods company?

Reviewing Kraft Heinz's biggest problems

After Kraft merged with Heinz in 2015, its management focused heavily on cutting costs instead of buying new brands or launching fresh marketing campaigns. As a result, Kraft Heinz lost fickle consumers to healthier and private-label brands. Under former CEO Bernardo Hees, Kraft cut its prices to stay competitive, but that strategy merely dented its margins and failed to revive its organic sales growth.

Metric

Q4 2018

Q1 2019

Q2 2019

Q3 2019

Q4 2019

Organic Sales Growth (YOY)

2.4%

(2.8%)

(0.3%)

(1.1%)

(2.2%)

Adjusted EBITDA Margin

24.7%

24%

25%

24.2%

23.9%

YOY = Year-over-year. Source: Kraft Heinz quarterly reports.

Those failures led to a $15 billion writedown on its top brands and a dividend cut last February. Miguel Patricio, who took the helm last July, tried to divest some of Kraft's weaker brands, but no buyers showed up.

Baked macaroni and cheese.

Image source: Getty Images.

Patricio then declared that Kraft would continue Hees' "zero-based" budgeting strategy, which cuts costs across its existing segments to free up more cash for new initiatives. He also renewed Kraft's marketing efforts for its classic brands, like Heinz ketchup and Kraft macaroni and cheese, to win over new consumers, and launched new direct-to-consumer options.

Kraft ended last quarter with $2.3 billion in cash and equivalents, but it was still shouldering $28.2 billion in long-term debt. Kraft has enough cash to pay off the $1 billion in debt that matures within a year, and it expects to generate enough free cash flow to cover its forward dividend yield of 5.5% -- but it still doesn't have much room for big acquisitions or aggressive marketing blitzes.

The economic downturn could help Kraft Heinz

Prior to the pandemic and the economic downturn, Kraft struggled with waning interest in its aging brands. However, its first-quarter forecast indicates that cash-strapped consumers are buying its non-perishable goods again.

Last month General Mills (GIS 0.45%) issued guidance for 1%-2% organic sales growth for fiscal 2020, although it warned the COVID-19 impact remained "uncertain". Nonetheless, Kraft and General Mills are both generating fairly stable sales growth throughout the crisis -- and a recession could boost sales of their cheaper products as shoppers avoid pricier brands.

But is it the right time to buy Kraft Heinz's stock?

Kraft's stock trades at just 13 times forward earnings, which is significantly lower than General Mills' forward P/E of 18. However, Kraft trades at a lower valuation because it faced more headwinds than General Mills, which expanded with big acquisitions, protected its margins with price hikes, raised its dividend, and avoided accounting scandals.

The COVID-19 crisis is temporarily boosting Kraft's packaged food sales, which should offset its loss of food service revenue from restaurants and other businesses, but it probably won't meaningfully boost its earnings or free cash flow -- which are more essential to its long-term turnaround efforts.

Kraft's outlook won't improve until it offsets its higher operating costs with its rising revenue. But if Kraft reveals some progress during its upcoming Investor Day in early May, it might be the right time to accumulate some shares of this battered stock. Until then, investors shouldn't assume Kraft Heinz is out of the woods yet.

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Stocks Mentioned

Kraft Heinz Intermediate Corporation II Stock Quote
Kraft Heinz Intermediate Corporation II
KHC
$38.64 (1.31%) $0.50
General Mills, Inc. Stock Quote
General Mills, Inc.
GIS
$75.79 (0.45%) $0.34

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