Description

6 years ago, bedrock nailed a short pitch on KRFT, which at the time had recently announced a merger with Heinz. The new company, KHC, traded for 16-18x fwd EBITDA and the market was hoping for $8+bn in EBITDA after synergies. This was predicated on $27bn in revenue and 30+% EBITDA margins. Investors also thought they were buying a food M&A platform, run by 3G Capital, which would consolidate the fragmented CPG (and maybe HPC) industry. In early 2017, after successfully realizing substantial synergies from KRFT, KHC announced a bid to acquire Unilever. The bid was almost immediately withdrawn and since then KHC went from one of the most discussed to least discussed stocks in the market.

After the failed Unilever bid, KHC’s organic sales trends remained negative, but the market gave it a pass because investors believed that KHC was losing low margin sales in an attempt to improve margins. In 2018, the wheels came off, and the market started to appreciate that the 28-29% EBITDA margins of 2017/2018 was a high-water mark. As sales continued to decline, KHC’s margins declined from 29.2% in 2017 to 26.6% in 2018. In 2019, KHC’s CEO, Bernardo Hees stepped down. The dismissal was essentially an acknowledgement that KHC couldn’t buy companies, rip costs out of them, and repeat the process. A few months later, Kraft Heinz replaced its CFO, a terrible look in the midst of accounting errors and poor organic sales trends.

That brings us to today. Kraft Heinz is a $26bn sales CPG company predominantly based in US and Canada (80% of sales). At its core, CPG companies are a combination of brands + manufacturing scale + distribution. Kraft Heinz owns popular brands that are facing secular headwinds but still have a place in society. Lunchables and Oscar Meyer aren’t popular brands in NYC and LA, but across America these brands still resonate suburban and rural people. Management has broken the portfolio into 3 platforms: grow (50% of sales), energize (30%), and stabilize (20%) and in order to improve the company’s organic growth profile management has divested some low-growth assets such as the cheese business to Lactalis. This divestiture alone is 40bps per year accretive to KHC’s organic growth profile. Furthermore, KHC has divested some iconic brands and the valuations other companies are placing on these brands highlights KHC’s value. Earlier this year, KHC sold Planters to Hormel for $3.35bn or 3+x sales. For context, KHC right now trades for ~2.5x sales.

Though KHC’s brands face secular issues, KHC’s manufacturing and distribution scale is under appreciated. In 2018, a WSJ article on KHC, which was meant to portray the difficulty the company faces selling Bologna, highlighted the manufacturing capabilities of Kraft Heinz:

3G said the Kraft Davenport facility is at the center of its plans to prove it doesn’t just slash expenses, but that it also invests in brands.

Production moved 10 miles up Interstate 280 to a new, $225 million plant, where the first cold cuts rolled off the assembly line in June. The facility is the first U.S. plant 3G built from the ground up since the firm entered the food business with its acquisition of H.J. Heinz five years ago.

Gone are the elevators. Instead, conveyor belts whisk “stick meat”—macerated proteins stuffed into 6-foot-long casings—through processing rooms. New machines can handle 15,000-pound batches. Robotic arms pick up trays and place them in room-size ovens. Automated slicers deliver perfect 9-ounce portions that drop into plastic containers.

When it hits full capacity in a few weeks, the plant will be able to churn out 2.8 million pounds of sliced meat a week, about 17% more than the old factory, while employing 500 fewer people.

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This brings me to my punchline: 3G wasn’t completely wrong. Our field research suggests that CPG companies are terribly run and very bloated. What 3G got wrong was that they went too hard, too fast while the industry was grappling with secular threats due to brand fragmentation, digital advertising, and the infinite online shelf space. Today, under the leadership of Miguel Patricio, investors are paying very little for the call option that KHC can return to 2+% organic growth. Management’s focus is clear, KHC has created 3 Chief Growth Officer roles (US, Canada, and Intl) and interestingly none of the positions are held by Brazilians!

KHC can also accelerate growth through bolt-on M&A. The company’s net debt has shrunk from $30bn 2 years ago to $21bn today. A few months ago, management acquired Assan Foods in Turkey, “a rapidly growing sauces-focused business.” Nothing is going to happen overnight, but it seems like time is finally working for KHC with a new business paradigm focused on growth and a balance sheet that will enable M&A.

Valuation

KHC is a $45bn Mcap and $66bn TEV company that seems like an attractive long. The 3G halo bubble has burst, organic sales trends are beginning to stabilize, and the EBITDA margins have been reset and are currently 22-23%. We don’t think KHC will make anyones career, but expectations are low and investors should get an 8% FCF yield while they wait for growth. To put this in perspective, KHC’s FCF yield is 2x the US High Yield Index interest rate (~4.5%) while the earnings profile durability is more sustainable than it was a few years ago.

The big risk right now, along with many companies, is inflation. For FY21, gross cost inflation is expected to be 4-6% for KHC, but management is confident they can price for inflation. Last month, KHC’s CFO, Paulo, said:

We are very confident that we are going to have enough pricing and to offset the inflation we are seeing now. We are doing pretty much 2 things: we are implementing pricing and also promo optimization to manage this inflation.

We are actually -- when you look at our second half, we are expecting positive pricing in our P&L, even with the fact that we are lapping a very high pricing from prior year, as you mentioned, above 4% price we had in the second half last year and the fact that we are restoring some promotions.

So again, we are very confident that actually, by the end of the year, we will have implemented pricing and other revenue management initiatives to deal and to offset this inflation that we're seeing now and including the carryover of this inflation into 2022.

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Over the last 6 years, the company’s sales, profit margins, and fwd multiple have all de-rated and should be approaching a floor. If management is able to navigate the current inflationary environment, KHC is a lowish risk, double digit IRR based on a ~9% FCF yield and 1-2% organic growth. For the risk investors are taking, KHC will be a home-run investment (15+%) if the company can drive 2+% organic growth since the multiple will likely expand and margins will reverse their negative trend and start to improve. On the levered balance sheet, its possible KHC sports 5+% EPS growth.

Catalyst

FCF piling up is the catalyst