Kraft Heinz: Possible Dividend Cut May Overshadow Solid Earnings by Ian Bezek

Summary

Kraft Heinz reported significantly better than expected earnings Thursday.
The stock bounced in a major way and is now well off its August lows.
Don't expect a straight path higher from here, however.
The company signaled Thursday that it may cut the dividend in 2020 to shore up the balance sheet.
This idea was discussed in more depth with members of my private investing community, Ian's Insider Corner. Get started today »

Kraft Heinz (KHC) surprised a lot of folks on Thursday. The company announced quarterly earnings that - while far from spectacular - significantly topped expectations. Not surprisingly, KHC stock exploded higher, enjoying its best trading day of the year:

Source: Finviz

In fact, shares have gotten back nearly all their post-February losses and are up a quick 30% off the August lows.

Unfortunately, I got to the Kraft Heinz story way too early. I started buying in the $50s, thinking that was a fine discount to the prices that original 3G/Buffett followers had paid. Don't forget that KHC stock traded as high as $90 at the height of optimism around 3G building a packaged foods M&A platform. It's been a long tumble for this former blue chip company. Regardless, with more purchases subsequent to the February collapse, I lowered my overall cost basis to $43. All that to say, I'm certainly not taking a victory lap with Kraft's recovery Thursday.

In fact, I write this to offer a note of caution. While I'm still bullish on the stock, it won't be a painless recovery, and the earnings report gives us at least one big reason to be cautious going forward.

Over the long-haul, I expect Kraft Heinz stock to trade higher, at least back to $40. If you compare it to other mediocre packaged foods companies, it still looks cheap; Kraft Heinz went from being overly-loved with its Buffett/3G backing to being overly shunned following the dividend cut, write-offs, management changes, and so on. Take all the drama away and imagine Kraft Heinz was a generic food company selling so-so products at high profit margins and generating a lot of cash. The $25 share price this August made no sense given that the company can still do nearly $3/share in annual EPS (8x earnings at that price). But don't mistake Thursday's price action for everything being fixed in a day.

These Were Hardly Amazing Quarterly Results

If you read Kraft Heinz's quarterly earnings in a vacuum, with no knowledge of the drama around the stock, you'd probably be shocked to see that folks bid the stock up 13% Thursday on these results. Overall, the company's organic revenues dropped 1.1%. The headline number was even weaker still, though that was driven by brand divestitures and currency translation.

The organic sales figure should raise concern though. A company with a clean balance sheet can survive a lot of boneheaded management decisions and other hardships. A levered-up company needs most things to break correctly, by contrast. Kraft Heinz has a huge debtload, and has already optimized its business as far as overhead costs and profit margins go. You can fault 3G all you want for a lack of skill in R&D and marketing, but they keep a lid on costs. Thus, Kraft Heinz really needs to figure out the top line to turn things around. There's simply not much left to cut on the cost side of the equation, other than the dividend (more on that in a second).

Kraft Heinz did manage to push through price increases this quarter, which is a good sign. Packaged foods companies have had to deal with flat pricing or even decreases as they face stiffer store brand and online competition. So, it's nice to see Kraft Heinz be able to show some pricing power. Unfortunately, it came at the expense of volumes - organic sales volumes dropped 2.1% on the quarter. I just want to reiterate that a shrinking business is a particularly dangerous place to be when your balance sheet is weak; you can't shrink your way to prosperity when your debtload remains the same size.

Did Management Just Signal A Dividend Cut Next Year?

Here's the facts as far as the Kraft Heinz dividend goes. The company is currently paying $1.60/share per year in dividends. Across 1.22 billion shares of KHC stock, this results in the company sending roughly $1.95 billion annually to shareholders.

As the company noted in its most recent conference call, between the merger and the end of the 2018, the company paid down just $2.4 billion of gross debt. For a company with about $30 billion in total debt, that's not a particularly satisfying rate of debt retirement. Sending nearly $2 billion out the door in dividends annually when it is struggling to repay debt - even with asset sales - doesn't necessarily make a lot of sense.

Take this just announced quarter. As management noted, in Q3 they generated $860 million of free cash flow and used just shy of $500 million of that on the dividend. If your top priority is the debt, you might not want to maintain a dividend policy of paying out roughly 60% of your cash flow.

...Originally Posted On Seeking Alpha

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