Via SeekingAlpha.com

The Kraft Heinz Company (KHC) is one of the world’s largest food and beverage companies with net sales reaching nearly $25 Billion in 2019. Shares of the company have struggled in recent years, however the company managed to outperform the market in the last three months due to higher consumer demand for its products. In fact, sales during the first quarter of 2020 came above market’s expectations recording a first sales growth of 3.2% after four consecutive quarters of year-over-year declining sales.

Source: TIKR graph by author

For the second quarter, Kraft Heinz’s management expects a low to mid-single digit y-o-y organic net sales growth. We will value the company based on the Free Cash Flow model by making some conservative assumptions. Our model puts the company on the buy list with a price target of $37.98. This investment is suitable for investors seeking reasonable capital gain while maintaining a steady cash income amid a dividend suspension environment.

Strong product mix

Kraft Heinz manufactures and markets food and beverage products spread across different segments and considered essential for consumers. In fact, the recent emergence of the COVID-19 pandemic proved that Kraft’s products cannot be eliminated from the consumers’ carts. This pandemic has had a positive impact on the company’s operations and gave it an opportunity to regain some lost market share. The challenge for Kraft’s management lies in taking appropriate measures to move forward and reestablish the upward growth trend. As per their latest earnings call, Kraft Heinz’s CEO Miguel Patricio seems confident in managing the current crisis.

The next several months will be critical in understanding the path forward and potential for our industry… Overall, our business is strong. We are operating to peak capacity, performing at world-class levels and leveraging our industry-leading safety, quality and hygiene practices.

Source: kraft heinz 10k graph by author

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Risk factors to be considered

Various risks might impact the business model of Kraft Heinz leading to a substantial hit on the company’s bottom line.

  • Competition: The company operates in a highly competitive marketplace with a high degree of concentration. Moreover, improving market share and introducing new products requires increased advertising expenditures.
  • Brand risk: Having various iconic brands with global recognition increases the company’s brand risk which should be managed and extended to new platforms in order to maintain sustainable satisfaction.
  • Currency fluctuations: Global presence with a strengthening U.S. Dollar exposes the company to unfavorable currency movements.

In addition to the above major risk factors, high indebtedness levels of the company raises a red flag for investors. Long-term debt of the company stands at $32,773 million, and as shown in the below chart, total debt/EBITDA increased to 6.24x while EBIT/Interest and EBITDA/Interest recorded 3.45x and 4.24x respectively. Those figures assess the company’s ability to meet its future debt obligations by relying on its current operating income. The below ratios should be monitored during future periods.

Source: TIKR graph by author

Model Assumptions

Despite the positive outlook stated by management and the increased demand on Kraft Heinz’s products during the COVID-19 pandemic, we assumed a negative growth of -5% during FY2020, then a 0.5% growth per year to reach a terminal growth of 2% in FY2024 and beyond. We applied a gross profit margin of 35.4% (the average of the previous four years), and we projected the gross profit over the coming five years.

In addition, we will assume the below over the next five years:

  • On average, SG&A constituted 9.8% of the company’s revenues over the previous four years, thus we will assume it will remain at this rate;
  • Research and Development growth of 5% yearly;
  • Tax rate of 21%;
  • Capital expenditures and Depreciation growing at 5% yearly;
  • Yearly change in non cash working capital at -6.8% of revenues (its historical four year average).
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After incorporating those assumptions into our model, we reached below projected after-tax operating income.

Based on the company’s most recent quarterly filings, long-term debt with its current portion totaled $32,773 Million. The market cap of the company is estimated at $ 38,923 Million by using 1,224 million diluted shares outstanding at the current market price of $31.8.

We estimated the required return on equity at 6.41% by applying the capital asset pricing model as per below:

  • Risk free rate = 0.64%
  • Beta of Kraft Heinz= 1.03
  • Market Return = 6.24%

We assumed a cost of debt of 4.30% by calculating the previous four years interest expense/long-term debt. And, in order to account for additional risks we will adjust cost of equity and cost of debt by adding a 1.5% risk adjustment spread. Accordingly, the weighted average cost of capital is estimated at 6.39% which will be used as a discount rate in our valuation model.

If we assume a perpetual growth rate of 2.00% beyond FY 2024, the terminal Free Cash Flow of Kraft Heinz is estimated at $81,727 Million. By discounting all the projected Free Cash Flows we reach an operating value of $74,123 Million.

The company recorded a cash position of $5,403 Million, long-term debt outstanding of $32,773 Million and a minority interest of $115 Million. Since P/B of the food processing industry is trading at 2.36, we will assume that the market value of minority interest is estimated at $271 Million.

As such, we can reach a fair value for Kraft Heinz of $37.87 per share.

As per below chart, by varying cost of capital we can conclude that Kraft Heinz stock price is expected to rebound with a cost of capital below 7.00%.

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Source: created by author

Conclusion

Success of Kraft Heinz highly depends on the management’s ability to correctly interpret changes in consumer preferences and demand while offering new products satisfying their needs.

The company benefited from recent market turbulence and regained positive growth in revenues during the first quarter of 2020. However, adverse impacts from rising costs and currency rate fluctuations along with its high level of indebtedness are the main threats of its future outlook.

The stock is a good investment with a target price of $37.98, implying a 19% capital gain. The stock can be added as a long-term holding in case the company managed to strengthen its balance sheet and monitor its debt levels in the coming period.

Source: kraftheinzcompany.com

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in KHC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.