Investor Disgust May Have Created an Opportunity in The Kraft Heinz Company

On Thursday Kraft Heinz Co. KHC blind-sided investors with a carton of rotten eggs when it closed its books for 2018.

The company faced a bad earnings report (expected by many as the company had been struggling with lack of growth for some time), a Securities and Exchange Commission investigation into its accounting practices that resulted in a $25 million charge and a monster write-down of intangible goodwill that resulted in a $15.4 billion charge. Its book value per share was slashed from $54.70 in 2017 to $42.45, and it cut its dividend by 36% from $2.50 a share to $1.60. The new dividend yield as of Friday is 4.6%.

The stock, which hit a high of $90 two years ago, plunged 27% Friday, the day of the report, closing at $34.95. This plunge has been a humiliating comedown for the great Berkshire Hathaway and 3G Capital, who midwifed the merger between Kraft and Heinz to create Kraft Heinz, which was supposed to consolidate the food industry. In fact, only a year ago, Kraft Heinz tried but failed to acquire Unilever (UL) towards that goal. Berkshire owns about 26% of the common shares and 3G owns about 22%. 3G’s modus operandi is ruthless cost cutting using a management tool called zero-based budgeting.

The media narrative is that too much value was extracted from the Kraft Heinz brands through cost cutting, which impacted growth and innovation while at the same time consumer tastes were shifting against conventional packaged foods towards more healthy choices. While I do not know the internal machinations that drove the rather sudden recognition of the goodwill impairment, my guess is that this may have been through the intervention of the external auditor, PricewaterhouseCoopers. In any event this appears to be kitchen-sink quarter, with management taking its lumps all together and putting a brave face forward.

The reaction among shell-shocked investors, financial media and the blogosphere has been savage. Many small investors who followed Warren Buffett (Trades, Portfolio) into Kraft-Heinz vented frustration and bitterness on the internet forums and blogs. They lost their trust in management and fear that more cockroaches are coming.

But lost in the clouds of crying, lamentations and angry finger pointing are two silver lines. First, the company has reported a modest increase in net sales from $26.259 billion to $26.085 billion – a minuscule move in the right direction.

Second, the company's operating cash flow (ignoring non-cash impairments and non-cash tax adjustments from last year) is still $3.86 per share (see note below) compared to around $5.37 to last year. The non-cash impairment, while unfortunate, is driven by accounting assumptions of growth and discount rates and is largely an adjustment of already sunk cost. It’s at best a belated recognition that the company paid too much to buy the said asset originally, and the market conditions do not warrant that valuation.

Goodwill for brands is such a fuzzy and intangible concept that I do not find it meaningful for valuation purposes. Operating cash is much more real for valuation, and right now and Kraft Heinz sells for around nine times each dollar of operating cash flow. Nestle, for example, sells for around 18 times operating cash flow, Unilever is at 18, General Mills at 10 and Campbell Soup at 7. Hopefully, Kraft Heinz will improve its numbers from their current depressed state. The 4.6% dividend is all not too shabby.

Figure 1-From Kraft-Heinz fourth-quarter 2018 investor presentation

My adjustments to get to 2018 operating cash flow estimate:

Disclosure: I am long Kraft Heinz and am currently underwater.