Miguel Patricio has hurdles to navigate after taking CEO job in July

Miguel Patricio has hurdles to navigate after taking CEO job in July

Investors shunned Kraft Heinz stock last Thursday (8 August) and analysts warned would-be buyers to stay away in the short term after another dismal set of financial results and an additional US$1.2bn write-down. Simon Harvey presents what you need to know.

Investors most be wondering how far into the abyss Kraft Heinz shares can slip after another dismal set of financial results and little indication of when the ketchup to snacks and cheeses maker will emerge from the trough it is presently in.

If a 19% drop in six-month group profits before tax was not enough to deter would-be share buyers, a 15% decline in its largest US market (70%) and a US$1.2bn write-down to add to the $15.4bn in February surely sealed the nail in the coffin. Even millionaire co-owner Warren Buffet has conceded he overpaid for H.J. Heinz before its was merged with Kraft Foods Group four years ago in a deal worth $45bn, one his fellow shareholder Jorge Paul Lemann at 3G Capital recently described as a "failure".

While currency valuations and M&A contributed more than half to the 5% decline in Kraft Heinz's six-month sales, one suspects the issues run deeper, with the likelihood of further impairment charges no doubt key on investors' minds. Although finance chief David Knopf said both the top- and bottom-line should be better in the second half, he pulled the earnings guidance, adding to the uncertainty. And the level of declines across all the results and regions will surely have markets guessing as to how long before newly-installed chief executive Miguel Patricio can turn the business around.

It's not been a happy start at the helm for the former marketing executive at brewing giant Anheuser-Busch InBev and the instigation of a "comprehensive review to develop a new strategic agenda for the next three to five years" suggests more pain to come in the short term.
 
Like many global food powerhouses, Kraft Heinz is grappling with the rise of more consumers seeking alternative and more healthy-eating options but the company has been criticised for not innovating fast enough to embrace the trends. The onslaught of private label in the US presents another challenge, while the company is, again like many of its food industry counterparts, saddled with legacy brands that either need revitalising through investment or ditching altogether.

John Baumgartner, a US-based senior analyst at Wells Fargo, writes in a research note to clients: "Only 40 days into his CEO role, Patricio didn't provide much detail other than a new long-term strategy in early 2020. Still, we sense that emphasis will be on spending smarter (not necessarily harder) with inefficient investments reallocated, a modified approach to new product development, and further refinement of net revenue management and consumer insights." 

Patricio didn't mince words to describe the disappointing performance, which came on the back of a $12bn fourth-quarter loss and a subpoena by the US Securities and Exchange Commission in relation to procurement and accounting practices.

He says: "The level of decline we experienced in the first half of this year is nothing we should find acceptable moving forward. We have significant work ahead of us to set our strategic priorities and change the trajectory of our business." 

Shares underperform peers

In the six months to 29 June, Nasdaq-listed Kraft Heinz posted a 51% drop in operating income to $854m, and a 19% decline in adjusted EBITDA to $3.03bn based on reported net sales of $12.4bn (down 1.5% in organic terms). Adjusted earnings per share fell 24% to $1.44.

The stock is underperforming other US food heavyweights with similar turnovers. Kraft Heinz shares have slumped 40% this year, while General Mills, with annual sales of $17bn, is up by the equivalent magnitude. Mondelez International ($26bn) has climbed 37%, while Kellogg ($14bn) has advanced 9%.

Daniel Martins, a US-based analyst at DM Martins Research and a former employee at B. Riley FBR, Bridgewater Associates and Nielsen, says: "Kraft Heinz (KHC) is about as cheap a packaged food name as one can buy in the market today. But rather than a compelling value play, I believe the depressed valuations simply reflect the substantially higher risk profile of the company and its stock. 

"Not only have the company's financial results been unimpressive lately and the efficacy of its internal controls been questionable, KHC severely lacks any market momentum to justify a 'buy-the-dip' move at current levels." 

New strategic approach

The CEO tells analysts Kraft Heinz's board has "mandated a new approach", one focused on the consumer and food industry trends, and Patricio suggests its presence in China also has room for expansion.

"This strategy has to be based on understanding the future, understanding the consumer," Patricio says. "The ones that are going to take this opportunity are the ones that will understand the future better than the others."

There are signs Kraft Heinz's growth in emerging markets is slowing. In terms of penetration in China, Patricio points out how Kraft Heinz is the leading supplier in just two provinces - Guangdong and Fujian. And he also says the company is under-represented in terms of ethnicity in the US, where the Hispanic community accounts for 20% of the population and 40% of population growth: "We don't have absolutely anything in our portfolio today to attend this population."

The CEO emphasises how critical it is for Kraft Heinz to innovate faster and embrace consumer eating habits whereby it becomes a pioneer and not just a company chasing existing trends.

"Big transformation represents a big opportunity and we as an organisation need to be at the forefront of this change," so that Kraft Heinz "can be faster and more consumer-centric with our new products".

And he says greater weight needs to be put behind core product lines, while revitalising others rather than coming out with too many new brand offerings.

Patricio adds: "I think that we have an amazing portfolio of brands, some are shiny, some are not. But I think the heritage that we have in the brands, the household proliferation that we have, the awareness that we have, makes me feel very positive about the possibility of turning around some of the trends that we have in the brands that are not doing as well." 

He says Kraft Heinz expects to accelerate investment in innovation in the back half of the year, and going forward needs to find a better balance between spending and marketing.

Wells Fargo's Baumgartner adds: "Trading at 11 times our estimated 2020 EBITDA (15% discount versus US food peers), we see limited incremental downside risks absent another EBITDA re-basing, dividend cut, or dilutive asset sales. At this point, we see a low risk of all of the above and while KHC's 5.7% dividend yield is tempting, lingering fundamental weakness and lack of 10-Q filings maintains reduced visibility." 

"Navigate" the present

"Inefficiencies" at Kraft Heinz are an area Patricio plans to hone in on and a factor that needs to be dealt with before considering new investments. 

And while the new CEO takes stock, he has reportedly put a number of divestments on the back burner, namely the disposal of the Breakstone's dairy business and baby-food unit Plasmon, although he's committed to selling the Maxwell House coffee brand.

Patricio says: "I don't want to talk about divestitures or non-divestitures until we make our strategic decisions. We need to navigate through the present but we need to build a strategy for the future. We need to find where this business is going to grow, where food is going to grow and be ahead of everybody else." 

Even though Kraft Heinz marketing spend has increased over the past couple of years, investment in media has been lacking, he says, and despite gains made in e-commerce a "longer-term outlook of the channel growth" should be developed.

Supply-chain losses also need to be addressed, which have been rising double-digits in the last few years, "maybe because of all the complexity that we put in the system", Patricio concedes. Those losses must be reduced to free-up cash for investment.

Instead of allocating more funds to media promotions, Kraft Heinz has paid too much attention to agency fees, production, research and product development, he says. 

Potentially more impairment charges

The new round of write-downs suggests Kraft Heinz made poor investment decisions in the past for which it is now paying the price.

But while they may be seen as short-term pains for longer-term gains, they don't help allay any uncertainty of what might be yet to come, although one assumes the impairment charges will go some way toward setting a fairer value.

Of the write-downs, Kraft Heinz said $744m arose from non-cash impairment charges to lower the carrying amount of goodwill in its reporting units EMEA East, Brazil, United States Refrigerated, and Latin America Exports "primarily based on new five-year operating forecasts for several international businesses that establish revised expectations and priorities for the coming years in response to current market factors". 

Another $474m was related to non-cash impairment charges "primarily driven by the application of a higher discount rate to reflect the markets' perceived risk in the company's valuation". 

Meanwhile, CFO Knopf provided an update on the accounting irregularities in February which resulted in restated earnings. The cumulative impact from 2015 to 2018 was less than 1% of net income.

Knopf also sought to explain the decline in organic sales (1.5%): unfavourable promotional timing in the US and Canada, an "exceptionally strong" performance last year in UK soups, lower inventory levels at North American retailers and lost sales in parts of "Continental Europe" as a result of price negotiations. 

But he warned of further potential impairment charges.

"You should keep in mind that we did start the year at nearly $60bn of goodwill and indefinite-lived intangibles with less than 20% attrition relative to carrying value," Knopf tells analysts. "So what that means is there's going to be risk of future impairments, given any change in forecasts or modelling assumptions can particularly trigger that." 

Baumgartner adds: "Recent Nielsen data gave us more optimism that trends were poised to inflect but inventory adjustments pressure US shipments and surprisingly softer international revenue reinforces [the] sense of weakness in [the] model. [The] $1.2bn write-down to goodwill and intangibles [is] hopefully the last shoe to drop on valuation true-up."

Either way, investors will eagerly be anticipating new guidance, which Patricio hopes to reveal early next year once he has completed his review.

"I've asked David [Knopf] that we not provide or update specific point estimate financial guidance," the CEO explains. "Setting short-term targets publicly won't be productive as we set and work to deliver against our strategic directions and priorities." 

And until Kraft Heinz can detail specifically how it expects the business to perform and what outcomes may arise from Patricio's review the share price is likely to remain under pressure.

But what seems apparent is Patricio still has some tough decisions to make before Kraft Heinz is back on course to sustainable growth. 

Sanford Bernstein is avoiding the stock until it receives more clarity on a number of fronts.

Senior analyst Alexia Howard writes: "Investors may have been hoping for something solid to grab onto, like updated guidance or specific building blocks to build up a forecast. Instead, management made clear that with only 40 days under his belt, it is simply too early for Mr. Patricio to provide such concrete guidance. As such, the outlook remains highly uncertain, with multiple moving pieces. 

"With little visibility into the company's fundamental outlook or future portfolio or financial strategy, we remain on the sidelines for now."