Lessons On Investing: Kraft-Heinz


Last time I wrote one of these “Lessons On Investing” posts, the chosen stock was a HUGE success.  It was one of those successes that everyone dreams about investing in.  The kind that make you rich.  I still criticize myself for not investing in the company 20 years ago.  That company was Apple, Inc.

Investing successes are great of course, but we can also learn from investing failures.  Some people even say you learn more from failures than you do from successes.

I do know this for certain — Investments that fail to produce an adequate monetary return can still have significant value if you learn from your mistakes.  Failing to learn and then apply those learnings is the most expensive outcome possible… because you’re bound to repeat the same mistake again.

Learning from other’s mistakes is a better way to go — So this time around we’re going to look at a recent stock disaster someone else made (and it’s a doozy).  Even though I researched it last year, I personally chose NOT to invest in this stock.

The company is Kraft Heinz (Stock symbol: KHC).

 

The Kraft Heinz Disaster

Even though I chose not to invest in Kraft-Heinz a year ago, some of the world’s greatest investors did.  Warren Buffet owns about 26.7% of the shares outstanding, and 3G Capital owns about 23.9%.  (If you’re not familiar with 3G Capital, there’s a great book written about them).

These two super-investors effectively control Kraft-Heinz by owning slightly more than 50% of voting shares outstanding.

The control of Kraft happened through a merger of Heinz (which Buffet and 3G Capital 100% owned) and Kraft Food Group.  All this happened back in 2015.  Kraft shareholders got 1 share in the merged company for every share of Kraft Foods they owned AND a $16.50/share special dividend.  Buffet and 3G got control of the merged company.

Fast forward four years later, and it’s been a disaster — Last week KHC reported a loss of $10.34 per share (mostly because of a $15.4B goodwill write-down), and slashed its dividend by 36%.  They also announced a SEC investigation into their accounting.

khc stock price
It’s been a bad couple of years for Kraft Heinz investors.

One week later and shares have fallen 32%.   Since KHC shares first started trading back in 2015, the stock has fallen 63%.

Ouch!  What the heck happened?

 

Lesson 1: Brands Under Attack

To begin, let’s rewind things a few decades — people used to pay a premium for Kraft cheese, and Heinz ketchup.  They were the food brands people grew up with and trusted.  A big brand like Heinz meant good quality and good flavor.

Investors used to do pretty well investing in these kinds of packaged food companies too — profit margins were healthy enough to fuel global growth, share buybacks, and large dividends.

These days, the big packaged food brands don’t hold nearly the brand power they used to.  Today, many private-label brands like Costsco’s Kirkland brand, or Kroger’s Private Selection, have supplanted those trusted brands.  Customers know those private label store brands are just as good and cheaper.  You really can’t tell the difference in flavor.

Opening up my own refrigerator I can see just how true this is — Only one Kraft Heinz product, but about half a dozen generic brand packaged goods that taste just as good as the more expensive Kraft versions.

Today, people expect quality and good flavor from a store brand (and aren’t willing pay a premium for it).  Organic products, non-gmo products, paleo, no sugar, fair trade, gluten-free, vegan, and other “unique value propositions” are what people are willing to pay a premium for these days.

If you don’t care about those “unique value propositions”, then you probably just buy cheaper store-brands.

Just take a look at KHC’s stable of brands:

kraft heinz brands

I wouldn’t willingly feed most of that “food” to my kids.  I think this says something really important about Kraft-Heinz’s competitive position today.

Kraft-Heinz brands are no longer products people are willing pay a premium for.  Those brands represent the outdated chemical laden products of our parents (or grandparents) — NOT the healthy foodstuffs we can trust to feed our family with.

All this competition has been eating into Kraft-Heinz’s margins for years — even before Buffett and 3G got involved.  Buffett probably knew all of this when he invested in Kraft… but he did it anyway.

My guess is, 3G Capital had a reputation for cutting costs and maintaining the strength of tired brands.  Buffett probably trusted his partner.  When I looked at KHC last year, I pointed out that I thought the company was “still broken”.  3G hadn’t turned it around yet.

That still seems to be the case today.  3G may have cut costs, but overall profitability of the company has declined due to a loss in overall pricing power.

The big lesson here for investors is that being a well-known brand is no longer the durable competitive advantage that it used to be.  Companies like Costco or Kroger can quickly create their own private brand and develop consumer trust in a relatively small amount of time.

The internet has also made it a lot easier for smaller brands to enter into people’s homes.  I can quickly search Amazon for “ketchup” and find dozens of little-known brands that aren’t carried at my local stores.

The dominance of the big consumer brands is definitely under attack, and the competition won’t be going away anytime soon.

 

Lesson 2:  Overpaying For Quality

In a recent interview on CNBC, Buffett admitted he’d overpaid for Kraft.  Historically speaking, Kraft-Heinz used to be able to generate about 6 billion in pre-tax operating profit.  Those days appear to be long behind it.

Back when Buffett and 3G invested in 2015, Kraft-Heinz had an enterprise value of about 104 billion and it generated around $6 billion in pretax operating profit.  I call this an “optimistic” price to pay for a company with little-to-no growth.

To put this in-terms of a PE ratio, that’s like paying a PE of 30 for Kraft (EPS in 2016 was 2.81 and share price was around 88)  That’s pretty expensive by most standards.

To be fair, Buffett has long extolled the virtues of paying-up for quality companies.  This strategy of paying-up for quality has mostly worked-out well for Buffett — Buying quality companies (like See’s Candies) really paid-off for him, generating billions over the years.

In general, it works because higher quality companies earn better returns on capital.  (This concept is well covered in Joel Greenblatt’s book)  Kraft use to score pretty well on that front too.

Kraft looked like a decent company if you go back pre-2015.  It earned decent returns on invested capital, but 3G probably though they could improve upon this by cutting corporate waste.

khc roic
Returns on invested capital have been poor in recent years.  Note: The sharp spike at the end of 2017 was a tax benefit, not a true improvement.

Today, the enterprise value of KHC sits a lot closer to $70 billion and the company is likely to make somewhere around $5 billion in pre-tax operating profit.  Returns on invested capital appear to be in the single digits.

If we back-out all the non-cash goodwill write-downs from Q4 2018,  Kraft earned EPS of 0.84/share.  At today’s price of $32.40/share I still feel that’s a premium to pay for a set of brands under attack.  It’s NOT the kind of company I’d want to pay a premium for.  The margin of safety just isn’t there.

The big lesson for investors here is NOT to overpay for quality.  You could very well be miss-assessing the quality of that investment.

In the past, I’ve written how every investor should invest considering multiple potential outcomes.  This rings very true in the Kraft-Heinz case.

Buffett and 3G might have fallen in love with the ‘bull’ case, but the ‘bear’ case is what actually manifested into reality.

 

Additional Thoughts

Investing is never a sure thing… even for the world’s greatest investors.  Some investors like to follow big investors into stock investments like this… and occasionally it even works out.

In this case, you could have followed Buffett into Kraft-Heinz and done terrible.  Despite their incredible record, the future is anything but certain.

Kraft-Heinz was also a large dividend payer — Being a high return on capital business, KHC needed very little in additional funds to maintain the business.  It paid out much of that cash to shareholders.  At it’s height, KHC paid out $2.52/share annually.  Yet those dividends did very little to compensate investors last week after all the bad news was announced.  It’ll take more than a decade of dividends to make up for last week’s fall.

Dividends and high returns on capital are not a cure-all if the business itself is ‘sick’.

This is why I frequently repeat the mantra “don’t chase high-dividend yields”.  Yield is not an indicator of quality or longevity.  Even long-time dividend aristocrats can run into trouble when the world changes.

Investors who bought into Kraft-Heinz should learn theses lesson well.  The rest of us should pay attention too.  Even with the combined might of Warren Buffet and 3G Capital, Kraft Heinz took quite a beating when the world changed.

Big brands selling packaged food no longer have the same mojo that they once did.

Indeed, it was Buffett himself that once said, “The single most important decision in evaluating a business is pricing power.  If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.  And, if you have to hold a prayer session before raising prices by 10%, then you’ve got a terrible business.”

It’s a pity he didn’t follow his own advice.

 

[Image Credit: Flickr]

21 thoughts on “Lessons On Investing: Kraft-Heinz

  • March 2, 2019 at 7:47 AM
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    I bought shortly after the decline. The bond market still thinks KHC is a solid investment. I’m going to see if I can catch a bounce!

    Reply
    • March 3, 2019 at 11:49 AM
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      I think the bonds will be fine, but there could be more equity writedowns coming. Like I mentioned in the post, I just don’t see a margin of safety.

      That said, it could go either way.

      Reply
  • March 2, 2019 at 8:02 AM
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    Heinz ketchup is the best, there is no contest. 🙂
    I still buy the cheaper ketchup, though. It’s not worth the premium unless it’s on sale.
    That’s the problem with dividend investing. You have to be up to date on consumer trends. If you don’t pay attention, your stock might will drop like KHC. I’d rather buy and forget. I guess I should find a good dividend fund and go with that. I’m horrible with trends.
    Oh, I had Kraft at some point. I think it splits into Kraft and Mondalez. I still have Mondalez, but sold Kraft years ago. Mondalez is still doing very well. They focus mainly on selling snacks (junk food) in South America, I believe. I guess junk food is still selling well in developing countries. I probably should sell MDLZ sooner rather than later. What do you think?

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    • March 2, 2019 at 9:52 AM
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      I find that we eat ketchup so infrequently at home (unless we’re hosting a party) that it takes ages to go through a bottle. We don’t even get it at Costco because it can take us years to use up one massive bottle, let alone the two pack.

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    • March 3, 2019 at 11:50 AM
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      MDLZ? Yeah, I didn’t spend a huge amount of time researching it, but it looks like revenues aren’t keeping up with inflation. That’s a bad sign especially in the regions where they operate.

      I’d probably look to get out of that one.

      Reply
  • March 2, 2019 at 9:13 AM
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    Those brands represent the outdated chemical laden products of our parents (or grandparents) — NOT the healthy foodstuffs we can trust to feed our family with.

    I think that’s the main reason. Enough people have caught on that’s it’s hurt them. Sure, obesity in America is at an all time high but most research lately pins a good deal of that on added sugar. I have friends who are overweight and borderline obese and they steer clear of the chemical-foods these days. But hey still struggle with plain ‘ole sugar though.

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    • March 3, 2019 at 11:53 AM
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      Indeed, there doesn’t need to be sugar in everything! I think it’s crazy how much sugar and salt they put in everything.

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  • March 2, 2019 at 9:02 PM
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    I live in Canada and Heinz shuttered factories here and that turned people here off to their products.

    French’s is the go to ketchup here.

    If cut costs without regards to people it usually catches up with you. History is full of companies that fall on their own petards.

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  • March 3, 2019 at 1:33 AM
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    This is a good post and worth reflecting over. I’m one of the people who bought a smallish to medium position in KHC a few months ago. I guess I thought that the volume drop would be more controlled and stable than recent news would suggest.

    I agree with the lessons learned you posted but must point out that nobody has a crystal ball to determine how future events will unfold.

    For example I bought a large position in MCD back in 2014 that I still hold through today. At the time the company was facing a slight volume drop in YOY same store sales and the narrative was the new players like Shake Shack and Five Brothers were going to kill them. I ran some models of valuation and thought I was buying in at a reasonable price (like with KHC).

    Once Steve Easterbrook became CEO of MCD he was successful in reviving campaigns for breakfast and sales started growing again. I’ve more than doubled what I put into that investment and am a happy long term shareholder.

    As an aside I do note that even when companies offer healthy options consumers still gravitate to the Junk and comfort food, so maybe it’s a case of perception versus reality on this when examining on how people vote with their wallet. So don’t write off KHC just yet. But there needs to be more execution to improve the financials and the brand strength for sure. At this point I’m not selling nor buying more. If I need to tax loss harvest later this year for some reason I will then sell off some KHC.

    -Mike

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    • March 3, 2019 at 2:51 PM
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      The dividend cut would be big red flag for me. I have had a few of those in the past and out of those 75% of them have continued their downward trajectory. I too bought MCD in 2014 and have been happily rewarded. It is hard being an investor and watching how people making unhealthy decisions that you profit from as an owner. I also own a fair amount of GIS and am not excited about how much they paid for Blue Buffalo, but they have a long history of working through these type of issues. Your absolutely right Mike about how you never really know how things are going to turn out, a large percentage of the possible future success is really out of your control.

      Reply
    • March 4, 2019 at 12:41 AM
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      You’re definitely more optimistic than I am Mike! I hope that optimism is well founded! Good luck to you! 😉

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      • March 4, 2019 at 9:51 AM
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        Thanks. Obviously I’m disappointed with the turn of events. The value of KHZ that I’m now is barely above 1% of my current after tax portfolio so even if there is another cut coming it won’t be a mortal wound.

        A Lesson learned indeed!

        -Mike

        Reply
  • March 3, 2019 at 7:22 AM
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    This was a great read. I’m like FV who commented earlier, I actually bought shares after the tumble.

    I think this is ultimately a bet on management. With near 50% control by Warren and pals, I think they’ll get management corrected and steer the company. 10x earnings is easier to stomach and most of the private labels are contracting with someone to make their product.

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    • March 4, 2019 at 12:45 AM
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      I don’t disagree — there’s a lot of life left in the business. But as a stock? Hmm… I’m not sure about that.

      Most of the value of a stock resides in it’s future prospects (aka future cash flows). In my estimation, I see those future cash flows slowly sinking as the trends I identified continue to eat away at the KHC business.

      Reply
  • March 4, 2019 at 6:45 PM
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    Excellent analysis. I’m one of those people you described… that would pay a premium for organic and for a lack of ingredients I can’t pronounce. Other than that, if the store brand is cheaper, I’ll go with the store brand.

    A bit off topic, but I hope that next generation looks back at the junk we eat and wonders “what were they thinking?”, the way we look back at the generations where 70% of the population smoked.

    Reply
  • March 5, 2019 at 10:00 AM
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    Interesting to see your take; I had looked into KHC a couple years ago and concluded that they weren’t as profitable as they should be and passed.

    But I do disagree that the “big brands” aren’t better than the generics. I have a rather unusual shopping situation, in that because of where I live there are large numbers of “grocery outlet” stores where the prices are the same (very low) regardless of whether it is a big brand or a generic. So I have had the opportunity to do side by side taste tests for pennies on the dollar for many packaged foods like ketchup, pasta sauce, etc. For foods that are in-date (out-of-date has some additional considerations), the big brands taste better 85-90% of the time than the store generics with a few exceptions (Kirkland is one; Trader Joes is another). So my experience is that if you remove price from the equation, big brands are mostly better.

    But, would I pay a lot more? No, I probably wouldn’t buy a lot of this stuff at all if it weren’t so inexpensive. My mother makes better ketchup than Heinz; I presumably could too, but the convenience of cheap store-bought ketchup is sometimes worth it. As a side note, I have had people, at barbecues where we had the good stuff (homemade) and Heinz available, prefer the Heinz by a large margin. People are mostly unwilling to try new things, so it’s probably due to familiarity. But that is another situation where price has also been removed from consideration. Ketchup from our tomatoes is cheaper for us, but for our guests the costs is the same. I think the long term outlook for many of these companies may depend more on their profitability when making the generics. Many of the generics are made on the same lines, but to different specs. But grocery margins are slim at best, and there’s not a lot of room generally for large gains, so that has an impact as well.

    Reply
  • March 5, 2019 at 7:48 PM
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    Hi – what price do you think it would start to look cheap?

    I believe in an interview Warren Buffet said he will hold onto the stock given his company has such a large position. Do you think that it is positive news that Buffet plans to be in this stock with a longish term horizon or is it bad news that the 2 major shareholders will not likely change (hence the board might in essence be controlled by the same folks)?

    Reply
    • March 5, 2019 at 10:35 PM
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      In my estimation, anything under $20 has significant margin of safety.

      In general, I think having those two in control will be good for shareholders. But they’ll definitely manage the company in a way that’s good for them. Not necessarily what’s best for employees and suppliers (like the tomato farmers mentioned by another poster).

      Reply

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