I began looking at Kraft Heinz in the past week or so when I noticed that the price had dropped below $60 per share. Kraft Heinz Co. (KHC) is one of the “Big Food” companies. They are a consumer staples company and produce a diverse array of food products. Their most well-known brands are Kraft, Heinz, and Planters. You have probably heard of at least one of these three core brands.
Kraft Heinz Origin Story – Born of a Merger
Kraft Heinz was formed as a merger of Kraft and Heinz back in 2015. I was aware of this merger at the time but chose not to invest due to the high stock price. The merger was led by Heinz which was owned by Warren Buffett’s Berkshire Hathway and 3G Capital. These two stakeholders together continue to hold majority ownership of the combined Kraft Heinz company.
Why is this important?
Warren Buffett has stated that he intends to hold onto his shares of Kraft Heinz forever. This means that you have a long-term oriented majority shareholder. If you buy into this company, you are buying into a controlled corporation. Therefore, your votes basically don’t matter in the election of corporate directors.
This is a good thing. Warren Buffett is notorious for his long time horizon. A long time horizon allows the management of Kraft Heinz to ignore quarterly earnings fluctuations. Instead, they can instead focus on continuing to grow and expand their moat.
3G Capital’s contribution to Kraft Heinz
3G Capital is a Brazilian investment company. They specialize in acquiring large companies and cutting costs to improve margins. They like to focus on companies which have stagnated for some time and could use outside experience on running a lean operation.
In the past two years since acquiring Kraft Heinz, 3G’s management of the company has done a fantastic job in increasing the profitability of the underlying business.
An ideal investment candidate for a long-term hold
3G Capital’s specialty of cutting costs complements Berkshire Hathaway’s style well. 3G is able to drastically improve profitability in a short period of time. Meanwhile, Berkshire Hathaway gives companies the long leash needed to achieve long-term success as well.
Investors considering Kraft Heinz shouldn’t be worried about the fact that they are minority shareholders in a controlled company. On the contrary, this is great news. The best management you could want in an investment is one whose interests are aligned with shareholders and has a long-term focus. 3G and Berkshire Hathaway provide that.
Kraft Heinz stock might soon provide an attractive entry point for new investors
Kraft Heinz stock has fallen approximately 40% from its 52-week high of $93.88. Shares are currently priced at approximately $57. With an annual dividend of $2.50 per share, this represents a dividend yield of 4.4%. Their earnings are a bit more difficult to state.
There are a few complications to determining a normalized earnings rate for Kraft Heinz. First and foremost, they have a very large positive adjustment from the 2017 passage of the Tax Cuts and Jobs Act. This earnings distortion has made Kraft Heinz’s 2017 reported GAAP earnings to be completely detached from a normalized reality. A simple P/E ratio analysis would show a trailing twelve month P/E of somewhere in the six to seven range. That number isn’t real. The true P/E is definitely over 10.
A second complication is that Kraft Heinz has only been operating for about three years as a combined entity. This isn’t enough time to properly determine normalized earnings. In addition, past earnings are difficult to analyze because there are numerous one-time charges associated with the merger and restructuring of the business. It is certainly possible to determine normalized earnings. However, that process is simply difficult.
The Kraft Heinz dividend can provide a conservative proxy for normalized owners earnings
There are three critical drivers that allow us to make some simplifying assumptions.
First, Berkshire Hathaway is a controlling shareholder which allows us to assume that the dividend will never be cut under standard business conditions. Warren Buffett wants to allocate the capital from those dividends himself. He intends to hold the company shares forever, so we can use very long time horizons for this assumption.
Second, Warren Buffett encourages sustainable dividend policies. This means that dividends are likely to be below normalized owners earnings. It’s difficult to know exactly how much the dividends are below owner’s earnings. However, that’s not necessary for our analysis.
Third, Kraft Heinz is a branded consumer staple company. The fact that Kraft Heinz provides a staple good such as food, allows us to assume that they will grow earnings at a rate that matches inflation. This is a conservative assumption because the company intends to grow overseas, and there is potential for future acquisitions. However, we’re just seeking a conservative baseline.
Kraft Heinz’s dividend yield is a real after-inflation yield
The end result of our simplifying assumptions is that we can assume that the dividend yield is a real yield. With the current dividend yield of 4.4%, we can assume that at a minimum, Kraft Heinz should return 4.4% after inflation and before taxes. This is critically important.
Historically, the stock market has returned 10% per year accordingly to Jeremy Siegel’s Stocks for the Long Run.* 6% of that return was real return, and 4% of that return was due to inflation. The historical returns of the stock market are a reasonable basis to set our opportunity cost. Therefore, I target at least a 10% rate of return on my investments.
What I really am targeting though, is a 6% real rate of return. This means that I have an embedded assumption of a 4% future inflation rate matching the historical average.
A conservative appraisal of Kraft Heinz
We know that the Kraft Heinz dividend is definitely LESS than normalized owners earnings. As a branded consumer staples company, we also know that Kraft Heinz should reasonably be able to grow at the same rate of inflation. Based on these assumptions, I can definitely achieve my target 6% real rate of return by buying Kraft Heinz stock at a 6% dividend yield.
With the current dividend of $2.50 per share, this means that Kraft Heinz is definitely an attractive buy at $41.66 or less.
Kraft Heinz shouldn’t trade at less than $41.66.
That isn’t to say that Kraft Heinz is worth only $41.66 per share. On the contrary, I believe it’s an attractive buy at that price. Therefore, I believe the true valuation is likely much higher. The stock price of $41.66 would embed a solid margin of safety for an investor interested in buying stock in one of the world’s most profitable food companies.
My Initial Interest Level = 90%
I give it a 90% chance that I’ll come back to look at Kraft Heinz again in the near or medium-term future. The business is definitely high quality. Yet, the market is starting to allow the company’s stock price to free fall. Kraft Heinz might reasonably be called fair valued even at current prices, but that will require further research on my part.
How much do you believe Kraft Heinz is worth?
Please share your appraisal in the comments below. I would be glad to know how you think about this business and look forward to discussing it with you.
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