Why you shouldn’t buy KHC’s 36.2% discount

Over the last week or so, I’ve written about a few companies in the Food Products industry that I think offer some interesting possibilities under current market conditions – something that is even more true if the market sees an increase in short-term volatility. Investors are putting a lot of focus on geopolitics right now, so every new move the President makes is being scrutinized pretty closely. While trade talks with China seem to be progressing well, and even Trump’s top economic advisor this morning predicted a positive resolution on CNBC, don’t be surprised if the markets keep showing some uncertainty. That means that defensive-oriented companies like the Food stocks I’ve been writing about can be a good place to put your money to work for you right now.

You still have to be careful, though; it’s pretty easy to gravitate to well-known, established names like GIS, CPB, and KR, to name just a few, but just because a company has a great name and brand, it doesn’t mean the stock is a good opportunity right now. It is still important to pay attention to a company’s underlying business – in fact, I would argue that it may be more important than ever, because so many stocks still remain significantly below the highs they’ve found over the last year. That fact can lead to the mistaken notion that it is a bargain; but sometimes, a stock drops off of those historical highs because the market is trying to tell you something.

Kraft-Heinz Co. (KHC) is an example of what I mean. Look in your pantry or fridge, and you’ll probably find a lot of their products on your shelves. In terms of recognizability, there aren’t too many food brands that can claim the brand recognition this company has. Heinz condiments including ketchup, mustard, mayonnaise have been a mainstay of my fridge for years, and Kraft brands like Oscar Meyer are regulars, too. That should mean the company has a stable, strong business, right? Not so fast. One of the big struggles a lot of traditional names in the Food Products business have been fighting has been the trend away from pre-packaged products and into healthier, organic options. While some, like CPB and GIS, seem to finding ways to stay relevant, KHC really appears to be struggling. A week ago, the company reported a massive earnings loss of more than $8 per share that reflected a multi-billion-dollar “impairment charge” of more than $15 billion. That sent the stock into freefall, from about $45 per share to its current level below $35, overnight.

The valuation numbers for KHC right now, compared to their historical averages, point to an outsized bargain opportunity; but this is really a classic example of a value trap. The fundamentals in this case are very, very poor – enough so that it’s hard to say the stock has any reason to drive to any of the levels its seen over the past couple of years, when it hit a high in February 2017 just a little below $100 per share. The market’s reaction to the last annual report pushed the stock out of what looked like a nice consolidation and stabilization pattern, and it has yet to establish a new one. That implies the stock could still drop much, much lower – that things could still get much worse before they get better.

Fundamental and Value Profile

The Kraft Heinz Company is a food and beverage company. The Company is engaged in the manufacturing and marketing of food and beverage products, including condiments and sauces, cheese and dairy, meals, meats, refreshment beverages, coffee and other grocery products. The Company’s segments include the United States, Canada and Europe. The Company’s remaining businesses are combined as Rest of World. The Rest of World consists of Latin America and Asia, Middle East and Africa (AMEA). The Company provides products for various occasions whether at home, in restaurants or on the go. The Company’s brands include Heinz, Kraft, Oscar Mayer, Philadelphia, Planters, Velveeta, Lunchables, Maxwell House, Capri Sun, and Ore-Ida. The Company’s products are sold through its own sales organizations and through independent brokers, agents and distributors to chain, wholesale, cooperative and independent grocery accounts, convenience stores, drug stores, value stores, bakeries and pharmacies. KHC’s market cap is about $40.7 billion.

Earnings and Sales Growth: Over the last twelve months, earnings decreased almost -7%, while sales were flat, but positive at .2%. In the last quarter, both earnings and revenues were positive, at a little more than 7.5.% and 8%, respectively. Despite that improvement, the company margin profile turned sharply negative for both the trailing twelve months and the last quarter. Over the year, the number is -39%, and widened even more sharply to -183% in the last quarter.

Free Cash Flow: KHC’s free cash flow was about $560 million over the past twelve months and translates to an unremarkable Free Cash Flow Yield of just 1.37%.

Dividend Yield: KHC’s dividend is $1.60 per share, and translate to an attractive yield of 4.8% at its current price; however it should be noted that in their last report, the company announced they would be decreasing their dividend from its previous level of $2.52 per share. Given the current state of their balance sheet, it’s debatable whether the dividend is sustainable at all.

Debt to Equity: KHC has a debt/equity ratio of .47. This is a very low number that I think is misleading, because the fact is that the company has an outsized level of debt, with poor and rapidly deteriorating liquidity. Their balance sheet shows $1.1 billion in cash and liquid assets against more than $30.8 billion in long-term debt. Even more telling is that in the last year, cash dropped more than $500 million.

Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for KHC is $5377 per share. That translates to a Price/Book ratio of .62. The stock’s historical Price/Book ratio is 1.42, which puts a long-term target price at nearly $77 per share. That sounds attractive, but when you consider it against the larger backdrop of the company’s fundamental profile, it really should make think more about the fact that sometimes, a cheap stock is just a cheap stock.

Technical Profile

Here’s a look at the stock’s latest technical chart.

Current Price Action/Trends and Pivots: This chart traces the stock’s movement over the last year. The diagonal red line traces the stock’s downward trend; it also acts as the baseline for the Fibonacci retracement lines shown on the right side of the chart. The stock’s freefall to its current levels in the last week is apparent, and the Fibonacci lines are useful to act as a reference for how far the stock will have to move to provide any kind of realistic probability for a new upward trend. The current negative state of market sentiment and momentum against this stock makes any kind of push near to the $45 level indicated by the 38.2% retracement line unlikely; it also makes identifying any kind of realistic support level for the stock difficult, if not impossible, since the stock is currently plumbing new all-time lows.

Near-term Keys: A bullish trade on KHC right now is nothing but sheer speculation. Some very aggressive traders may point to the more than $10 overnight gap that pushed the stock to its current levels a week ago, with the halfway point at around $40 as a short-term price target if the stock can pivot off of its current lows and rally in the next few days; but I just don’t think there is much basis for that kind of trade right now. What about shorting the stock? You’ll be joining a pretty big crowd if you do, but given how far the stock dropped on an overnight basis, it also isn’t a given the stock will keep pushing to new all-time lows. More likely is that the stock sees some stabilization as bears who got in before the drop start covering their short trades by buying the stock. At what point could the stock offer a real, legitimate value? It is really going to have to reverse its pattern of declining revenues and negative Net Income first; until that happens, I just don’t believe there is going to a solid basis to build any kind of useful, value-oriented case for the company.


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