Home / Business / A mountain of debt difficulties Kraft Heinz – This is the damage – Kraft Heinz Company (NASDAQ: KHC)

A mountain of debt difficulties Kraft Heinz – This is the damage – Kraft Heinz Company (NASDAQ: KHC)



A few weeks ago, I wrote an article as a direct contradiction to an argument made by Warren Buffett, essentially disputing the idea that Kraft Heinz (KHC) is a wonderful affair. Towards the end of the article, I issued a true valuation estimate for the company of $ 54.6 billion, even under what I considered a highly optimistic assessment of future business results. When I reflected on this course goal I realized that I had overcompensated the differences between debt and equity and I would like to have a deeper dive in the company's capital structure and further deepen my valuation tax.

Debt Is Cheap But Risky

By the end of 2018, Kraft Heinz had nearly $ 31 billion in long-term debt, an increase of $ 2.5 billion from the previous year and paid about $ 1.3 billion in interest on it , 4%. As a writer, the company has a market cap of about $ 40 billion, which means that debt now accounts for almost as much of the circle as equity. In my article explaining my valuation method, I require a minimum return of 10% on equity that I am interested in buying, making debt at 4% pretty much cheaper. But it also means that repayment of the debt is an expensive affair, since all the money spent in this way only yields a 4% return on the investment. In contrast to the retained earnings being reinvested in the core business of 71%, or even in contrast to the shareholders' returns, with a return of 8.6%, repaying the debt pays poor returns.

Of course, even if the debt is currently very cheap and thus offers poor returns, the risk aspect must be taken into account. Shareholders' return of 8.6% will not make the shareholder a good sum if the business goes bankrupt or that the result increases otherwise, so that the 8.6 percent rise over time before the business has paid enough to have done a valuable investment. With $ 1.3 billion in interest rates at about $ 6 billion in operating profit, the interest rate is a big piece of the circle. Of course, 42% of the capital structure is bound in debt, and it consumes only 22% of the circle, which is a profit. The risk is, however, that a small decline in operating profit will have a greater impact on the shareholder's bottom line due to the interest cost.

Movement Income $ 6000M $ 5.400M $ 4,800M [19659006] $ 4,200 [19659006] $ 3,600M [19659011] Change

[19659006] 0% [19659006] -10% [19659006] ] -20% [19659006] -30% [19659006] -40% [19659011] Interest expense

$ 1.300M $ 1.300M $ 1.300M $ 1.300M $ 1,300M
Interest as% 22% 24% 27% 31% 36%

Pretax Revenue

$ 4,700M ] $ 4,100M $ 3,500M $ 2,900M $ 2,300M
Change in Pretax 0% -13% -26% -38 % -51%

Source: Author – only examples.

As this example shows, operating profit should continue to decrease, interest expense will be a larger part of the whole. Of course, if we were to do so, the operating profit would reverse the latest trend and move upwards is the leverage effect for the shareholders, as the interest rate will constitute a smaller part of the whole and the premium income will increase faster than operating revenues.

The pricing is quite simple: if the revenue increases, the debt, even growing debt, is not a problem and can be used for the benefits of the shareholders. However, if revenues fall, the debt can very quickly lead to a downward spiral, as payment of low interest rates puts very little on the bottom. In a perfect world, companies would have the opportunity to both pay the debt over time and continue to offer their shareholders compulsory returns. Then, in the bad times, "bad" becomes a relative term, and an appropriate recovery would be possible. In reality, companies tend to overestimate themselves and risk a death spiral in order to pamper the shareholders by at least appearing to offer compelling shareholder interest rates in the short term.

Dividend clip – what it means [19659045] Kraft Heinz has during the last quarter lowered the annual dividend from $ 2.50 to $ 1.60 per share in an attempt to reduce commitments in order to pay off the debt. This points to two things – shareholders will receive less, and debt holders will get more. Over time, this will reduce the risk, but also cause some pain to the shareholders.

With 1.22 billion shares outstanding, this $ 0.90 per share change will result in $ 1.1 billion in debt coverage. With a 4% interest rate, this will add about $ 44 million to annual premiums, giving nearly 1% growth to the bottom. This growth can be distributed in any way that seems best for management. Later I will list it at the bottom and directly credit it to the dividend growth, but it will also have a small impact on how much the debt covers, even though it is too small to be very meaningful. [19659047] However, if the same $ 0.90 had been held in the dividend, it would have a return of about 7.6%, or 2.7% higher than at present, at current market prices. While the entire company's revenue can be grown to 1% per year by using this extra $ 1.1 billion to repay the debt, an individual shareholder could have increased his own share of otherwise stable earnings to a rate of 2.7% higher if they had made this pay themselves and reinvested in the share at the current price. Effectively, a 2.7% dividend exchange was traded for a 1% payout ratio. With reinvestment of dividends, this is an annual write-down of 1.7% of the shareholders' total return.

The reasons for the dividend decision have been made quite clearly – the debt is seen as an issue. In the recent history, the company's free cash flow has deteriorated and the debt has therefore become increasingly more by paying dividends, a clearly unsustainable endeavor. But, as I assumed in my optimistic view in my previous article, with working capital falling back to balance and profit margin, the company would generate about $ 3.6 billion a year in free cash flow. Even in this optimistic scenario, it would have left only $ 550 million a year to repay the debt. For $ 31 billion in debt, this would take the better part of life to erase completely. So if the debt is considered a problem, it makes sense to attack it more aggressively. But the fact that it is perceived as a problem at all makes the idea that the optimistic case is most probable.

An alternative – if things are not so bad

If you pay down the debt at a rate of $ 550 million per year was considered too slow, but the debt itself was not considered an important issue, I think it would have been a better way to manage it. The write-down of brands was unavoidable and would probably have weakened the share quite significantly. Had the stock market traded lower, to about $ 36, without dividend savings, the stock would still have had 7%. This is significantly lower than 4% that the company pays on interest. If management believed that revenue would grow or actually even remain stable, this difference would have offered them an opportunity.

With a difference of 3% between the dividend yield and the interest rate paid on the debt, it would allow management to reduce their total commitments by issuing debt to buy back shares. About $ 550 million a year was considered too slow a repayment rate, another $ 20 billion in debt repurchase debt would reduce total commitment by $ 600 million annually and amount to $ 1,150 million for debt repayment per year. In fact, against the new total of $ 51 billion, it would lead to a reduced (but still very long) repayment period, while reducing the dividend payout. Shareholders could continue to either raise $ 2.50 per share or reinvest with a 7% return (if the market price does not change) and the dividend can grow in the future with the savings from both debt repayment and profit growth.

As disturbed at Kraft Heinz seems to be today, it would probably not be in the company's best interests to issue debt. This is perhaps the biggest story we have that an investment in Kraft Heinz today is a bad decision. If the management were convinced not only of stable performance, but profit growth, ahead, another $ 20 billion in debt would be a manageable thing to deduct, although it is quite dubious in the short term. The business itself has stable earnings, so if management believed that the future looked like my optimistic case, it would offer a legitimate method of maintaining long-term returns for shareholders, and ultimately accelerate debt repayment and reduce dividend payout. 19659053] Valuation

With the dividend reduction and the indications of placing more money against debt than before, my valuation method for equity was incomplete, because not all free cash flow goes to the shareholders. In this, it resolves to follow where exactly the money goes. If I assume my optimistic case scenario, with $ 3.6 billion in free cash flow, about $ 1.95 billion is now being distributed to shareholders through dividends and the rest can be used to pay off the debt. With 4% annual organic earnings growth and almost 2% annual earnings growth through interest rate cuts, it would require at least 4% return on dividends to reach my minimum return of at least 10%. This actually has an optimistic fair value for the stock with some upwards of $ 40 per share, with a little further up in the extreme long term, as more money can be redistributed from debt coverage to shareholder returns or even reinvested into core business at higher interest rates.

However, it is important to understand how optimistic this is. Since the management had the potential tool, if they considered the result to be at least at least stable, to issue debt to buy back shares and reduce total commitments, but rather the less risky act chose to reduce the dividend, I would suggest that management is concerned about a continued long-term downturn in the business and that the result disappears even further. With a result that stabilizes around average levels after the merger and with those (still optimistic, if the cash flow analysis cannot be cleared up) $ 1.6 billion in interest payments per year, I believe that it is a more likely and possibly even overly optimistic scenario to believe in 2% long-term profit growth, which could be put into a dividend growth. For this scenario to reach a total return of 10%, the stock would have to trade with a dividend yield of 8%, to $ 20.

In this article, I have examined Kraft Heinz's capital structure in more detail. Thus, I refined and upgraded my optimistic real value estimate to $ 40 from $ 20. On the other hand, I have also identified a clear reason to believe that $ 20 is still not cheap enough. I think it's fair to say that at this time, if you are a really big believer in the company, it offers reasonable but not exceptional returns. But without any incredible belief in the management and the business that returns to strength, KHC is not worth a second look until and if it does not fall below $ 20.

Disclosures: I / We have no positions in any specified inventory, and no plans to launch any positions within the next 72 hours. I wrote this article myself and express my own views. I do not get compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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