While no-moat Kraft Heinz (KHC) boasted its second-consecutive period of more than 2% organic sales growth (an about-face for a firm that has struggled to string together much in the way of top-line gains since the businesses merged four years ago) in the last quarter of 2018, this was overshadowed by a rash of unfavorable headlines surrounding profit contraction, an SEC investigation into its procurement accounting, and a reduction in its quarterly dividend to $0.40 per share from $0.625. The combination of this news sent shares tumbling at a high-teens clip in after-hours trading.
In the quarter, adjusted operating margins contracted 440 basis points to 21.1%, partly due to a 260-basis-point erosion in gross margins to 32.4% as manufacturing and transportation cost inflation remained elevated (and failed to be offset by cost saves). Although this pressure is likely to persist, we view the firm’s emphasis on ratcheting up spend behind its brands (both in terms of marketing and product innovation) and capabilities (including category management and e-commerce) favorably. More specifically, research, development, and marketing spending at Kraft Heinz has hovered in the low-single digits of sales the past few years--lagging the mid- to high single digits peers expend--but we expect investments will expand to a mid-single-digit range annually over our 10-year forecast.
In light of profit headwinds, we intend to edge down our $60 fair value estimate by a mid-single-digit rate, but still view shares as undervalued given the pronounced pullback the last few months. From our vantage point, Kraft Heinz’s concern on delivering outsize margins (in the mid-20s versus the mid to high-teens peers chalk up) has been to the detriment of its competitive position, impairing not only its top-line trajectory (as sales amounted to $26.3 billion in 2018, which is down from $27.4 billion the year the tie-up was inked) but also its retailer relationships.
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Erin Lash does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.