Matt York/The Associated Press
The theory: As we approach the end of a business cycle and the economy slows, the winning stocks sell things that people can't do without, such as "consumer staples" like everyday food items.
With that in mind, we bring you the newly christened Kraft Heinz Co., which made its trading debut this week. It's the combination of the public Kraft Foods and Heinz, taken private in 2013 by the investing all-stars 3G Capital (sponsors of the Tim Hortons/Burger King merger) and Warren Buffett. It has passed Coca-Cola Co. as the third-largest food and beverage company in North America (behind PepsiCo Inc. and Nestle Foods Corp.), with $22-billion (U.S.) in sales, notes analyst Erin Lash of Morningstar. It also sports a dividend yield of nearly 3 per cent.
The 3G pedigree, though, is what has investors most excited about the combined company. Brazil-based 3G is a relentless cost cutter, having boosted profit margins at Heinz, Burger King and InBev, where it has a number of board seats. Kraft's recent lacklustre numbers present a similar opportunity, enthusiasts for Kraft Heinz stock say.
"3G's laser focus on cost savings and cash flow and its pragmatic approach to business makes this a must-own stock for consumer staples investors seeking growth in a structurally weaker environment," says analyst Robert Moskow of Credit Suisse. Jason English of Goldman Sachs says it "will prove to be the story of the decade in food."
It seems, however, that investors are already anticipating a fair amount of 3G magic at Friday's closing price of $77.31 (U.S.). The more reserved observers of the shares suggest that Kraft Heinz's apparently conservative guidance already incorporates most of the cost savings, so a hope for big, positive earnings surprises may go unfulfilled. The true promise of Kraft Heinz, they say, may require yet another acquisition.
Mr. Moskow notes that 3G's influence on InBev's 2008 purchase of Anheuser-Busch helped the St. Louis brewer add seven full percentage points to its operating margins. At Heinz, operating margins have risen from 15 per cent to 21 per cent in just two years as 3G cut the number of manufacturing plants by 17 per cent, eliminated less-profitable product lines, and implemented "zero-based budgeting" in which managers have to start from scratch in justifying their operating budgets each year.
"3G creates value by putting dynamic management teams in charge and instilling a culture of cost cutting that incumbent management teams can't achieve," Mr. Moskow says.
And Kraft, he says, is a perfect example of a company that couldn't achieve those results, as it has failed to take advantage of its scale, has excess capacity in its manufacturing system and has had "numerous product recalls and execution missteps" in recent years. Its "woeful" gross margin is five percentage points below peers and eight points below Heinz's despite greater annual sales. "The advantage of buying Kraft now is that the new management can quickly correct Kraft's mistakes and capture some early wins in cash flow and gross margin expansion."
The expectation is that 3G will find $1.5-billion in synergies with the merged company, but Mr. Moskow thinks that number will be roughly $300-million higher. When plugged into his earnings model, and combined with a projected forward price-to-earnings ratio of 24 (a 20-per-cent premium to food peers), he gets a target price of $85.
While many bulls point to projected cost savings, Mr. English of Goldman instead cites the potential for the new company's top line. His "outperform" thesis and $83 target price are driven by the belief that investors are "excessively cautious" about potential sales growth.
But the numbers at both Kraft and Heinz, pre-merger, actually do demand caution.
David Driscoll of Citigroup Global Markets Inc. has a "sell" rating on Kraft that carries over to the new concern. He notes that before the 3G deal, Heinz management suggested it could increase revenue organically (without acquisitions) by roughly 4 to 5 per cent, a slight boost from the 3-per-cent-plus numbers it posted in fiscal 2012 and 2013. But in calendar 2014, organic growth for Heinz was negative 1 per cent. Sales volumes were down almost 4 per cent in 2014 and 13 per cent cumulatively since 3G took over, Mr. Driscoll said.
"While some of the volume decline could be product rationalization, the declines are staggering – and far exceed anything else we see (or have ever seen) in the sector," he writes. "Does this signal what is ahead for Kraft? In our view, given what has happened at Heinz, there is increased revenue risk for Kraft post-deal – even though current top-line fundamentals pose their own risk."
Indeed, he says, Kraft is posting market share declines in categories that represent more than 65 per cent of sales, has declining volumes companywide, and has "no strategy for participating in the growing natural/organic segment," he says. Investors bid up Kraft's share price prior to the merger, he believes, in a "frenzy to invest with 3G, and a belief that eventually there is going to be another deal at this entity."
Ken Goldman of JPMorgan, who's neutral with a $71 price target, says he wants to be conservative on the cost-cutting expectations, but "we like the story for investors willing to wait a couple of years, when another deal may be likely, as per 3G's history."
Mr. Moskow of Credit Suisse says "3G thinks big and is not likely to be satisfied with Kraft and Heinz alone," and its partnership with Mr. Buffett's Berkshire Hathaway "gives it significant firepower to make acquisitions."
He names names that Kraft Heinz – with a market capitalization of $89-billion – may consider as targets: General Mills ($34-billion), Kellogg ($22-billion), and Mead Johnson Nutrition Co. (nearly $18-billion). The Kraft Heinz balance sheet "will be significantly stronger by 2017," he says, suggesting that may be when Kraft Heinz will pounce.
At that point, investors can once again salivate over potential 3G-inspired cost cutting – and likely pay a price for the shares that befits gruyère and cavatappi, rather than Kraft Dinner.
David Milstead