Published March 2nd, 2017 by Nicholas McCullum
Warren Buffett is one of the most famous – and most successful – investors of all time.
As the chairman and Chief Executive Officer of Berkshire Hathaway (BRK.A) (BRK.B), Buffett has an investment track record that is unmatched.
Investors are fortunate that Buffett’s investment portfolio is made available to the public through Berkshire Hathaway’s 13F filings with the Security and Exchange commission, filed quarterly.
Buffett’s single largest holding for Berkshire Hathaway is Kraft Heinz (KHC). 19.5% of Berkshire’s investment portfolio is held in this company. The Oracle of Omaha owns 325,634,818 shares of Kraft Heinz worth approximately $31 billion.
Kraft Heinz is a relatively new holding for Buffett, as Berkshire Hathaway has only owned shares since 3Q2015 (before that, Buffett owned Heinz since February 2013). Buffett did not report any buying of selling of Kraft Heinz stock in the quarter ending December 31, 2016.
This article will analyze the investment prospects of Kraft Heinz in detail.
Kraft Heinz was created on July 2, 2015 when the merger between Kraft Foods Group and H.J. Heinz Holding Corporation was finalized.
The merger brought together an elite group of food brands under one roof. Some of these brands can be seen below.
Source: Kraft Heinz Merger Presentation, slide 3
The transaction gave the pro-forma company a leading position for a number of products and geographies.
The mechanics behind the transaction were quite simple. Kraft (KRFT) shareholders received one share of Kraft Heinz and a $16.50 cash payment for every KRFT share they owned.
Source: Kraft Heinz Merger Presentation, slide 6
Before the merger, Heinz was privately owned by Berkshire Hathaway and 3G Capital. Together, the two holding companies paid a total of $10 billion to Kraft shareholders, and ended up owning 51% of the pro-forma company.
The importance of Berkshire Hathaway’s role in partnering with 3G Capital to finance this merger cannot be understated. The following slide outlines some perceived strong points of each firm that were outlined in the merger announcement presentation.
Source: Kraft Heinz Merger Presentation, slide 10
Buffett in particular seemed excited about the Kraft-Heinz acquisition, writing the following in Berkshire’s 2015 Annual Report:
“The new company has annual sales of $27 billion and can supply you Heinz ketchup or mustard to go with your Oscar Mayer hot dogs that come from the Kraft side. Add a Coke, and you will be enjoying my favorite meal.”
In his typical Buffett-esque way of describing complicated affairs in a very digestible manner, Buffett wrote the following about the benefits of partnering with 3G in this transaction (also from Berkshire’s 2015 Annual Report):
“Their method, at which they have been extraordinarily successful, is to buy companies that offer an opportunity for eliminating many unnecessary costs and then – very promptly – to make the moves that will get the job done. Their actions significantly boost productivity, the all-important factor in America’s economic growth over the past 240 years. Without more output of desired goods and services per working hour – that’s the measure of productivity gains – an economy inevitably stagnates. At much of corporate America, truly major gains in productivity are possible, a fact offering opportunities to Jorge Paulo and his associates.”
Clearly, cost-cutting is looking to be a serious focus in the new Kraft-Heinz entity.
Now that we have a sense of Kraft Heinz’ short corporate history, let’s consider the company’s financial performance since the merger.
On February 15, Kraft Heinz reported earnings for the fourth-quarter and full-year of fiscal 2016. This is the company’s first full fiscal year since the combination.
Their year in review can be seen below.
Source: Kraft Heinz Fourth Quarter Earnings Presentation, slide 2
Kraft Heinz continues to focus on generating cost savings, reducing their balance sheet leverage, and maintaining (and growing) their dividend.
Earnings were also strong for fiscal 2016. The company saw 46.8% growth in adjusted earnings-per-share for the fourth quarter, and an even better 52.1% growth in adjusted earnings-per-share for the full year.
Source: Kraft Heinz Fourth Quarter Earnings Presentation, slide 3
These numbers are obviously very strong, but will almost certainly not be sustained going forward – the company is still executing substantial restructurings and business integrations post-merger. This torrid pace of earnings growth will moderate as the company matures.
Now, let’s consider the company’s growth prospects.
Kraft Heinz operates in the food industry, which is commonly-cited as a slow-growth segment of the stock market.
However, the company has identified key areas of their business that will drive growth for fiscal 2017. These are outlined below.
Source: Kraft Heinz Fourth Quarter Earnings Presentation, slide 10
Looking at the first point, we see that the company is making ‘fewer, bolder bets’. In layman’s terms, it appears that this means that Kraft Heinz has been targeting acquisitions as a means to drive growth.
Recently, this manifested itself in a proposed merger between Unilever (UN) (UR) and Kraft Heinz. While this merger would have been substantial at $143 billion (!), Unilever rejected the offer and said they saw “no merit, either financial or strategic” in a pairing between the companies.
Looking ahead, some investors are speculating that Kraft Heinz may be targeting Mondelez International (MDLZ) as their next acquisition target. Mondelez is another Buffett holding. The two companies have a convoluted history, as Mondelez was spunoff from Kraft Foods in 2012.
Investors have also speculated that Campbell Soup (CPB) could be another acquisition target. Kraft Heinz seems open to all opportunities when it comes to acquisitions – in fact, Buffett has said that Berkshire and 3G will consider all options when asked about this on CNBC.
Acquisitions aside, the rest of Kraft Heinz’ foreseeable growth will come from the continued integration of the two previously separate businesses. This is the area of expertise for 3G, and with Warren Buffett’s close eye on the process, I am confident in their ability to continue to generate cost synergies and grow earnings-per-share.
Competitive Advantage & Recession Performance
As a large diversified food company, Kraft-Heinz’ competitive advantage comes from its strong portfolio of popular brands. The company has #1 or #2 positions in at least 17 core categories across 50+ countries.
Some of Kraft Heinz’ more iconic brands can be seen below.
Source: Kraft Heinz Merger Presentation, slide 2
Because of their strong product portfolio, one would expect Kraft-Heinz to perform well during recessions. After all, consumers need to eat regardless of what the overall economy is doing, and Kraft Heinz’ products are a natural choice for many consumers.
However, investors don’t really have any historical recession performance data to validate these expectations. Kraft-Heinz was only formed in 2015, and the economy has been relatively strong during that time.
The closest we can come is by looking at the earnings-per-share performance of the predecessor Kraft during the global financial crisis:
- 2007: $1.62*
- 2008: $1.92 (18.5% increase)
- 2009: $2.03 (5.7% increase)
- 2010: $2.39 (17.7% increase)
- 2011: $1.99 (16.7% decrease)
- 2012: Data not applicable as Mondelez spinoff was completed October 1, 2012
Kraft, the publicly-traded predecessor of Kraft Heinz, managed to raise earnings each year during the global financial crisis only to see a dropoff in earnings during 2011. While I cannot be certain because of the Mondelez spinoff, I expect that Kraft would have returned to positive earnings growth in fiscal 2012.
Based on this, I would expect Kraft Heinz to perform similar well during future economic downturns.
*For investors looking for historical performance of Kraft Foods, please note that the earnings-per-share information listed above is actually filed under Mondelez International, which fell under the Kraft umbrella until 2012. SEC filings under ‘Kraft Foods’ only includes 10-Ks post-2012 (the year of the spinoff).
Valuation & Expected Returns
Future total returns for Kraft Heinz shareholders will be composed of dividend yield, earnings-per-share growth, and valuation expansion/contraction.
Kraft Heinz currently pays a $0.60 quarterly dividend, which equates to annual dividends of $2.40 per share. Based on March 1’s closing stock price of $91.43, Kraft Heinz has a dividend yield of 2.6%.
Moreover, Kraft Heinz reported adjusted earnings-per-share of $3.33 when they reported fiscal 2016 earnings. This corresponds to a dividend payout ratio of 72%. While this is high, I expect it to decrease over time as the company grows per-share earnings more quickly than their dividend.
It is unclear exactly how quickly Kraft Heinz is expecting to grow their earnings-per-share. In addition, the company is so new that they don’t have an established track record.
However, based on the previous performance of their predecessor Kraft (who compounded their diluted earnings-per-share at a 18.6% CAGR between 2006 and the Mondelez spinoff) and 3G Capital’s expertise in driving operational efficiencies, I think it’s reasonable to conservatively estimate 8%-10% bottom line growth for this company. In reality, results might be even better.
Turning to Kraft Heinz’ valuation, we note that that the company’s $91.43 stock price and their $3.33 of 2016 adjusted earnings-per-share corresponds to a price-to-earnings ratio of 27.4. This is a very high earnings multiple, but the company will likely ‘grow into’ the high valuation via strong earnings growth.
That being said, I would still expect that valuation contractions will likely detract from Kraft Heinz’ total returns over the long run.
This means that total expected shareholder returns will be composed of:
- 2.6% dividend yield
- 8%-10% earnings growth
For total returns of 10.6%-12.6% before the effects of valuation change.
Warren Buffett holds nearly 27% of the pro-forma Kraft Heinz. While it is not wise to blindly follow high-profile investors into the purchase of companies, it does speak to the high quality of Kraft-Heinz’ business model.
The company is still realizing cost synergies after the merger between Kraft and Heinz. This results in many uncertainties, and a lot of the company’s future success lies on management’s ability to successfully execute the merger.
An investment in Kraft Heinz is not without risk.
However, the company benefits from a global presence, popular products, and financial strength from the backing of 3G Capital and Berkshire Hathaway. I expect Kraft Heinz to continue their rapid growth for the foreseeable future.