On February 22, Kraft Heinz (NASDAQ: KHC) shocked investors with a trifle of bad news in the income statement: operating profit, disclosure of accounting irregularities and a massive weakening of goodwill, and followed up by cutting dividends per share almost 40%. Investors in the company reacted by selling their shares, which led to the share price falling over 25% overnight. While Kraft is neither the first, nor will it be the last company, to have a bad quarter, they are worthy of a simple reason. Substantial parts of the stock were held by Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) (26.7%) and 3G Capital (29%), a Brazil-based private equity group. Berkshire Hathaway's leading oracle is Warren Buffett, honored by someone who traces their all expressions, and tries to imitate their actions. 3G Capital may not have Buffett's name recognition, but its leading players are seen as ruthlessly effective executives, capable of delivering huge cost savings. In fact, their first joint venture to bring together Heinz and Kraft became two of the biggest names in the food industry, seen as a masterpiece and given the tribe to the two investors, guaranteed to succeed. As the promised benefits have not met, the investors who followed them in the agreement seem to see their failure as a betrayal.
The Back Story
You don't have to like ketchup or processed cheese to know that Kraft and Heinz are part of American culinary history. Heinz, the older of the two companies, traces his story back to 1869, when Henry Heinz began packing and selling horseradish, and after a brief bout of bankruptcy, he turned out to make 57 varieties of ketchup. After a century of growth and profitability, the company hit a tough patch in the 1990s and was targeted by activist investor Nelson Peltz in 2013. Soon after, Heinz was acquired by Berkshire Hathaway and 3G Capital for $ 23 billion, becoming a private company. Kraft started life as a cheese company in 1903, and during the next century it first expanded to other dairy products, and then expanded the repertoire to include other processed foods. In 1981, it merged with Dart Industries, manufacturer of Duracell batteries and Tupperware (NYSE: TUP), before being acquired by Philip Morris in 1988. After a series of seizures, parts of which were sold and rested with Nabisco, Kraft was spun by Philip Morris (renamed Altria (NYSE: MO)) and targeted by Nelson Peltz (yes, same gentleman) in 2008. Through all mergers, sales and spin-offs, leaders made promises of synergy and new beginnings, dealmakers made money But little of the substance actually changed in the products.
In 2015, the two companies were assembled, with Berkshire Hathaway and 3G playing both matchmakers and contractual finance, such as Kraft Heinz, and the merger was completed in July 2015. At the time of the agreement, investors and market observers were extremely enthusiastic, and part of the undoubted acceptance that the new company would become a strength in the global business activity was the pedigree of the largest investors. In the years following the merger, however, the company has had problems delivering expectations of income growth and cost savings:
The bottom line is that while much was promised in terms of revenue growth, from expanding its global footprint and increasing margins, from cost-saving, to The time of the agreement, the figures tell a different story. In fact, if investors were surprised by the low growth and falling margins in the latest earnings report, they should not actually have been, since this has been a long, slow bleeding.
Earnings report that triggered the share price breakdown, for Kraft Heinz, was released on February 22, and it contained bad news on many fronts:
- Flatlining Operations: Revenue for 2018 remained unchanged from revenues in 2017, but operating revenues doubled (before write-downs) from $ 6.2 billion in 2017 to $ 5.8 billion in 2018; The operating margin decreased from 23.5% in 2017 to 22% in 2018.
- Accounting irregularities: In a surprise, the company also announced that it was under SEK survey for accounting irregularities in its procurement area and took an amount of $ 25 million for to reflect anticipated cost adjustments.
- Impairment of Goodwill: The company took an amount of $ 15.4 billion for the amortization of goodwill, mainly on their US buying and Canadian segments, an admission that they paid too much for acquisitions in previous years.
- Dividend savings: The company, a large-scale dividend payer, cut dividends per share from $ 2.50 to $ 1.60 to prepare for what it would be a difficult 2019.
While investors were shocked, the crumpled driver was up to this report contained important clues. Revenues had already leveled out in 2017, compared to 2016, and the decline in margins reflected difficulties that 3G faced in trying to cut costs, after the agreement was made. The only ones who care about write-downs, a meaningless and delayed payment of overpayment on acquisitions, are those who use the book value of equity as a proxy for total value. The yield reductions were perhaps a surprise, but more in what they say about how panic management must be about future operations, since a dividend-related company cuts them only as a last resort.
The Value Effects
With bad news in the performance report still fresh, let us consider the implications for the history and value of Kraft Heinz. The flat income and the decreasing margins, as I see them, are part of a long-term trend that will be difficult, if not impossible, to reverse. While Kraft Heinz can have a quarter or two with positive blips, I see more of the same going forward. In my valuation, I have orecast a revenue growth of 1% per year less than the inflation rate, reflecting the headwinds company is facing. The downbeat growth in revenue growth will be accompanied by a matching "bad news" story of the operating margins, where the company will face price pressure in its product markets, leading to a murder (but small and gradual) in operating margins over time, from 22 % in 2018 (already down from 2017) to 20% over the next five years . The company's cost of capital is currently 6%, reflecting the nature of its products and the use of debt, but over time, the benefits of the latter will be thin, and since it is close to the industry average (US food industry companies have an average cost of capital of 6.12 %), I will leave it unchanged. Finally, the mistakes of recent years will leave at least one positive remnant in the form of restructuring costs, which I suppose will give partial relief from taxes, at least over the next two years.
The good news is that, even with a stilted story, Kraft Heinz has a value ($ 34.88) that is close to the stock price ($ 34.23). The bad news is that potential upside looks limited, as you can see in the results of a simulation I did, so that expected revenue growth, operating margin, and cost of capital can be deducted from deployments, rather than using point estimates.  Simulation Results
The discovery falls within a tight range, with the first decile of around $ 26 and the ninth of nearly $ 47 should not surprise you, as the ranges on the inputs are also not wide. As an investor, it is those actions that follow this valuation.
- If you owned Kraft Heinz before the income report (and I fortunately did not), the sale will now reach little. The damage has already been done, and the shares that are priced now are a real value investment. I know 3G sold nearly a quarter of its holdings in September 2018, good timing given the revenue report, but some attempts to sell now will not get them anything. (I made a mistake in a previous version of the post, and I thank those of you who pointed it out.)
- If you do not own Kraft Heinz, the valuation suggests that the stock is fairly valued at today's price, but at a lower price , it would be a good investment. I have a share buy-in at a price of $ 30 (close 25 th percent of the distribution), and if it hits that price, I will be a Kraft Heinz shareholder, regardless of the fact that I believe the future does not promise. If it does not fall so low, there is another fish to catch and I will continue.
There are two concerns, but the investors who look at this stock must consider. The first is that when companies claim that they have discovered accounting irregularities, but they have cleared up their actions, they are often confusing and there are more shocks coming. With Kraft Heinz, the size of the irregularity is small, and since they have no history of playing accounting games, I am willing to give them the benefits of doubt. The other is that the company carries $ 32 billion in debt, and while that debt has no toxic side effects today, it is because the company is perceived as having stable and positive cash flows. If the margin price that I expect becomes a marginal route, the debt will expose the company to a clear and current hazard. Simply put, it will make the bad case scenarios embedded in the simulation worse, and perhaps threaten the company's existence.
There are lessons in the Kraft Heinz Inflatation, but I will be careful, since I run the risk of offending someone, with talk that you can see as not just wrong but sakrilegious:
- It is human to Failure: With the risk of saying the obvious, Warren Buffett and 3G's key operators are human and tend to not only make mistakes, like the rest of us, but also to have blind spots in investing that hurt them. In fact, Buffett has been open about their mistakes and how much they have cost him and Berkshire Hathaway shareholders. He has also been honest about his blind spots, which include an unwillingness to invest in businesses he doesn't understand, a sphere that only grows as he gets older and the economy changes, and an excessive confidence in the leaders of the companies he invests in. While mostly an excellent judge of character, his investment in Wells Fargo (NYSE: WFC), Coca-Cola (NYSE: KO) and Kraft Heinz shows that he is not perfect. The error, in my opinion, is not with Buffett, but with legions of investors, analysts, and journalists who treat him as an investment goddess, his words cite as gospel and caring and springs to anyone who dares to ask them.
- Shares are not bonds: In my data records, I looked at how companies in the US have moved from dividends to buybacks, as a way to return money. However, this trend has not been universally welcomed by investors, and there is still a significant amount of investors, with strategies built around buying large dividend stocks. One reason why shares like Kraft Heinz become attractive to investors with conservative values is because they offer high dividends, often much higher than what you can earn from investing in treasury or even safe corporate bonds. In fact, the reasons the investors use are that by buying these shares, they actually get a bond loan (with dividend coupons), with price increases. From Dowens dogs to screening based on dividends, the underlying premise is that investors can count more on dividends than on buybacks. While it is true that dividends are sticky than buybacks, with many companies maintaining or increasing dividends over time, these dividend-based strategies become confusing as they treat dividends as mandatory payments rather than anticipated. After all, since companies do not like to cut dividends, they are not contractually obliged to pay dividends. In fact, when a stock gives a dividend yield that looks too good to be true, it is usually almost unsustainable dividend, and it's just a matter of time before dividends are cut (or even stopped) or the company runs into a financial ditch.
- Brand name lasts a long time, but nothing lasts forever: A large lodge with conventional value investment is that while technology, cost-effectiveness and new products are all competitive advantages that can generate value, it is the brand name that is the moat that has the most power. Again, this sentence reflects a truth, which is that brand names last long, often extending over decades, but even brand names fade as customers change and companies seek to become global. The problems of Kraft Heinz are part of a much larger story, where some of the most reputable and valuable brands of the twentieth century, from Coca-Cola to McDonalds (NYSE: MCD) find their magic fading. Using life cycle terminology, these companies are aging and no economic engineering or strategic repositioning is going to make them young again.
- Cost cuts can take you far, but no longer: In the last few decades, we have cut a lot of slack for those who use cost savings as their way of creating value, with many leveraged buyouts and restructurings built almost entirely on their promise. Don't get me wrong! In companies with significant cost inefficiency and bloating, cost savings can yield significant gains in profits, but even with these companies, these gains will be time-limited, as there is only so much fat to cut. Worse, companies are in trouble for a myriad of reasons that have little to do with cost-effectiveness and cutting costs that these firms are a recipe for disaster. It is true that 3G did a masterful job, cut costs and increasing margins in Mexico's Grupo Modelo, the Mexican brewer they bought through Inbev, but that was because Modelo's problems were a cost-effective solution. It may even have worked at Kraft Heinz in the first place, but at this time, the company's problems can have little to do with cost requests, and much to do with a stable product that is less appealing to customers than it used to be, and costs – Cutting is the wrong medicine for anything.
I hope you don't read this as a hit on Warren Buffett and / or 3G. I admire Buffet's adherence to a core philosophy and his willingness to be open about his mistakes, but I think he is poorly served by some of his devotees who insist on putting him on a pedestal and refusing to accept the reality that his philosophy has its boundaries, and as in the rest of us, he has an ego and makes mistakes. If you have confidence in value creation, you should be willing to have the faith tested by the mistakes you and the people you admire do in their persecution. If your investment views are dogmas, and you think the road is just right for success, I want you the best, but your justice and stiffness will only set you up for more disappointments like Kraft Heinz.
] Editor's Note: The abstract schools for this article were selected by Seeking Alpha editors.