Kraft Heinz Cuts Fat

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Since the Kraft-Heinz tie-up was announced in March 2015, much attention has been given to the cost-efficiency target the combined firm seeks to realize, with plans to cut $1.5 billion in costs from its operations over a three-year period. This equates to more than 7% of cost of goods sold and operating expenses excluding depreciation and amortization, compared with the 4%-6% goals of packaged food peers.

We’ve never considered this an unreachable goal. Even before the deal with Heinz, Kraft was going down a similar path, taking steps to realign its U.S. sales organization, consolidate its domestic management centers, and streamline the corporate and business unit organizations. However, after an abrupt change at the top in December 2014, it was clear that the transformation at Kraft was not occurring as expeditiously as the board had envisioned. When the deal with Heinz materialized, we weren’t surprised that 3G Capital would look to fast-track Kraft’s own cost-saving plans, building on the success it had realized at Heinz, where EBITDA margins soared to 26% in fiscal 2014 from 18% predeal in mid-2013. At the combined Kraft Heinz, we expected that a portion of the intended savings would stem from picking the remaining low-hanging fruit, such as reducing unnecessary spending on travel as well as rationalizing IT infrastructure and consolidating vendors. But we thought that the bulk of these savings would ultimately result from corporate workforce reductions, the rationalization of the North American manufacturing network, and enhancements to its supply chain.

While we believe Kraft Heinz will exceed its initial targets by approximately $250 million, we don’t think the well from which the firm will extract cost savings is bottomless. We believe increased investment behind brands as a means by which to withstand intense competitive pressures, the potential for more pronounced commodity cost inflation, and the challenges resulting from its portfolio mix--which includes nearly one third of its total sales from lower-margin packaged cheese and meat offerings--will constrain margins in the longer term.

These factors drive our base-case forecast, which calls for Kraft Heinz’s savings to reach its target of $1.5 billion by fiscal 2017 and expand to $1.7 billion by fiscal 2019. We anticipate that 65% will drop to the bottom line, resulting in 200 basis points of selling, general, and administrative leverage to 3.8% of sales by fiscal 2025. We expect Kraft Heinz will also beef up the spending behind its core brand mix, with the remaining 35% of the savings (about $600 million annually) reinvested in marketing and research and development. We expect gross margins to average 36% -37% over fiscal 2016-20, commensurate with Heinz’s historical margin but about 400 basis points above Kraft’s gross margin on a stand-alone basis. We anticipate that operating margins will expand to around 26%, about 500 basis points above the level generated in fiscal 2015.

To gauge Kraft Heinz’s cost-saving efforts and potential for profit expansion, we examined 3G’s record at the former Burger King (acquired in 2010) and Anheuser-Busch (acquired in 2008) operations. Both acquired firms realized notable improvements in SG&A as a percentage of sales following their deals with 3G Capital, with Burger King posting a reduction of more than 56% three years after the deal and Anheuser-Busch chalking up a 38% decline. After tightening the reins during the first few years after the deals closed, both firms increased spending to maintain their competitive positioning and ultimately reignite sales growth, fortifying their brand intangible assets; we anticipate that 3G Capital will take a similar path at Kraft Heinz. In this context, we expect Kraft Heinz to leverage SG&A expenses from 7.8% of revenue in fiscal 2014 (the year before the deal) to 3.4% in fiscal 2018 (three years after the deal), a decrease of about 56%.

Lower Brand Spending Could Dull Competitive Edge While Kraft Heinz is likely to make significant strides in improving the efficiency of its cost structure, several headwinds could inhibit its trajectory in the longer term. For one, Kraft Heinz's spending behind R&D and marketing pales in comparison with its peers. Management says this reflects its focus on fewer but bigger new product launches as well as advertising that centers on its winning fare. However, we don't think this strategic focus justifies a materially lower level of brand support than peers. We believe Kraft Heinz will ultimately ramp up its brand spending to stave off market share losses, which will constrain its margin gains over time.

Given ever-evolving consumer preferences and trends, we think the onus is on packaged food manufacturers to ensure new products win with consumers at the shelf. But even value-added new products can fail if consumers don’t know about them, so we tend to view marketing spending as essential in touting the value a product provides. In light of the fact that we don’t expect intense competitive pressures will subside, maintaining--or even increasing--brand spending will be crucial in sustaining brand awareness and maintaining a competitive edge.

We expect Kraft Heinz’s marketing to tick up to 4.1% of sales on average over the next 10 years (versus 2.5% in fiscal 2015) and R&D to approximate 1.0% of sales (about $370 million each year, or about 40 basis points above fiscal 2015). But the extent to which this level will offset competitive pressures and ensure Kraft Heinz’s mix stands out from its peers isn’t clear-cut.

Kraft Heinz presently allocates more toward cost of goods sold as a percentage of sales than others in the industry (at 67% in fiscal 2015 versus 62% on average for its competitors, which could reflect the composition of its product mix, and as a result, its commodity cost basket). Despite its cost-efficiency efforts, we expect that its costs of goods sold will still average around 64% of sales over the next 10 years, 300-400 basis points above its industry group. Kraft Heinz’s SG&A expense, at just 6% of sales, was already muted relative to its peer set, and we forecast this will fall to less than 4% of sales on average over our 10-year explicit outlook as the firm seeks to extract excess, putting this expense allocation materially below the 10% of sales we anticipate peers to spend. This suggests that Kraft Heinz won’t maintain much ability to strip out excess fat beyond the current restructuring plans. We expect Kraft Heinz will bolster its brand reinvestments from the measly 2.5% and 0.6% of sales it spent on marketing and R&D, respectively, in fiscal 2015, but at just 4.1% and 1.0%, it will still lag its peer group, which spends closer to 8% of sales in total on marketing and R&D. Because of this lower level of brand spending, we forecast that Kraft Heinz’s operating margins will average nearly 26% over the next 10 years versus just north of 18% for its competitive set.

If Kraft Heinz opts for lower levels of brand spending in the longer term, as a means by which to bolster profitability, this could ultimately impede its competitive position. Effective spending behind R&D and marketing stands to enhance the stickiness of Kraft Heinz’s retailer relationships and subsequently strengthen an aspect of its intangible asset moat source. Manufacturers like Kraft Heinz that compete in categories throughout the grocery store have amassed high switching costs in the eyes of retailers, which are reluctant to risk costly out-of-stocks with unproven suppliers. All else equal, we suspect retailers would rather do business with an established vendor with whom they have a long-term relationship. But we think these relationships could be jeopardized if Kraft Heinz were to instead opt to inflate its profit levels.

Commodity Cost Inflation Likely to Eat Into Margin Gains Lower commodity costs have recently boosted gross margins, but this is unlikely to persist in the longer term, in our view. Commodity prices across a number of categories have been on a downward trajectory, despite more elevated levels of inflation in the recent past. Kraft Heinz's most significant exposure to raw materials includes dairy, coffee, meat, wheat, soybeans, nuts, and sugar, the prices of which are likely to ebb and flow based on supply and demand in the longer term. In that light, we don't expect deflationary trends will persist.

Rather, we believe that stints of unfavorable weather and increased global demand for commodities will lead to a mid-single-digit rate of inflation on average annually over our 10-year explicit forecast horizon, which is generally in line with the long-run historical average, hampering profitability for players throughout the space, including Kraft Heinz. Futures prices for grains such as wheat, corn, and soybeans as cited by the Chicago Mercantile Exchange suggest a generally higher trend line over the next year, in line with our thinking. However, some of the commodities to which Kraft Heinz maintains an exposure (such as dairy and proteins) aren’t actively traded.

We don’t think Kraft Heinz will just be able to raise prices in order to offset these higher expenses. Consumers could balk at increased prices, which would ultimately constrain volume, a situation that is even more likely when macroeconomic challenges are pronounced. Brands can prove advantageous for consumer product firms, but in our view, branded manufacturers should be able to garner value from their portfolio mix and pass through inflationary pressure to customers. Kraft Heinz priced a touch above inflation, with price/mix, adjusted for inflation (as measured by the consumer price index), at 0.1% in fiscal 2015. However, this only reflects one year’s results, given the timing of the deal, and we doubt this will prove sustainable over a longer time horizon. In its two years as an independent organization, Kraft failed to price in excess of inflation to the tune of a more than 1% shortfall on average each year.

Exposure to Packaged Meat and Cheese Could Hurt Kraft Heinz's business mix may also impede profit progression in the longer term. The company garners nearly one third of its consolidated sales from the lower-margin packaged cheese and meat categories, far exceeding its packaged food peers, which maintain minimal (if any) exposure to similar commodified aisles in the grocery store. We estimate that the operating margins generated by these segments range from the high single to low double digits, significantly below the mid- to high teens of peers and the mid-20s we forecast for Kraft Heinz's consolidated operations. In our view, the biggest challenge to these categories is price elasticity; consumers tend to consider price before brand when making purchase decisions. And because input costs, rather than an enduring competitive edge, determine pricing, we don't foresee this margin differential narrowing over time.

Despite our belief that Kraft Heinz will continue to scrutinize its business mix, we doubt its meat or cheese operations will get the ax, given their legacy and the significance they maintain as two of the largest product segments in which the firm competes. We expect little shift in Kraft Heinz’s portfolio mix, with packaged meat and cheese accounting for more than 30% of total sales in fiscal 2025 versus about 32% in fiscal 2015, suggesting that these lower-margin segments could continue to hamper profits in the longer term.

It’s this inclusion of less profitable fare that has constrained Kraft Heinz’s ability to derive an outsize cost edge relative to its peers, in our opinion. We’ve stripped out customer acquisition costs (R&D, advertising expenses, and some other discretionary costs) to compare the go-to-market cost structures of companies across the consumer staples industry. On that basis, it is evident that despite Kraft Heinz’s scale, particularly in North America, which accounts for around 80% of its consolidated sale base, the firm still resides in the bottom half of its peer group in its ability to leverage its fixed costs. When adjusted for expenses not directly linked to the production and distribution process, its profitability and costs per employee lag those of other global packaged food operators.

Other profitability constraints could be at play down the road. Kraft Heinz has generally shied away from expanding in the natural and organics space; however, given the more attractive mid- to high-single-digit growth prospects we expect the category to enjoy, the company could look to build a more notable presence in the aisle. Introducing Capri Sun Organics and removing artificial colors and flavors from its macaroni and cheese lineup are two examples of Kraft Heinz’s efforts to bring on-trend products to market.

However, the faster growth this category affords doesn’t necessarily lead to an enhanced competitive positioning or improved margins (operating margins for natural and organics are about half the level of Kraft Heinz’s consolidated business). While in general the price premium amassed by organic products seems to support a brand intangible asset, we don’t view this as a sustainable source of competitive advantage. Rather, we believe organics’ pricing power may wither if supply catches up with demand or if consumers lose confidence in the quality of organic products.

Kraft Heinz Has Yet to Drive Accelerating Sales Kraft Heinz has been plagued by sluggish sales performance, reflecting efforts to forgo sales of unprofitable offerings (which we view as prudent) and unfavorable foreign currency movements. Fiscal 2015 pro forma reported sales tumbled nearly 6%, although underlying sales slipped just more than 1%, after accounting for more than a 5% hit from unfavorable foreign currency movements. However, we think revenue synergies may ultimately prove attainable, as Kraft has historically derived the bulk of its sales from North America but now has access to Heinz's vast global distribution platform, which before the tie-up garnered 60% of sales outside North America, including 25% in emerging and developing markets. We think this stands to bolster the firm's sales growth potential in the longer term.

We forecast around 3% consolidated sales growth over the next 10 years, with slightly more than half of the increase resulting from higher volume and favorable mix and the remainder from increased prices. We expect foreign currencies to hinder sales growth in fiscal 2016, but given that the firm derives more than 70% of its sales from the United States, our forecast calls for the negative impact from exchange rates to approximate just a low-single-digit rate. We don’t incorporate changes in foreign currency rates beyond our current-year outlook.

We forecast top-line growth in the firm’s developed-market regions (U.S., Canada, and Europe) to range between 2% and 3% annually over the course of our explicit forecast. This aligns with our outlook for the industry and incorporates our view that intense competitive pressures and muted category trends will temper the growth prospects for the firm’s center-of-the-store product mix. Despite the slowing growth of late, we still expect the pace of emerging-market growth to exceed more-developed markets in the longer term, given favorable demographic and disposable income trends. As such, we forecast the firm to chalk up about 5% annual sales growth on average in its emerging-market regions, nearly double the low-single-digit average annual growth we forecast for North America and Europe.

Kraft Heinz's Shares Look Rich Our $69 fair value estimate incorporates low-single-digit annual sales growth, 400 basis points of gross margin improvement to nearly 37%, and around 500 basis points of consolidated operating margin expansion to nearly 27% by fiscal 2025.

The market doesn’t seem to appreciate the challenges that stand to counteract some of the benefits of Kraft Heinz’s cost-efficiency efforts. Extracting costs from one business (as was the case following the Heinz buyout three years ago) is probably less painstaking than navigating the pitfalls of integrating two disparate businesses while also driving material efficiency gains (as is the situation this time around). Moreover, we maintain that Kraft Heinz’s valuation fails to account for the need to reinvest a portion of these savings behind its brands as a means to drive growth and ensure its entrenched position with retailers remains intact.

Kraft Heinz trades at a price/earnings ratio far in excess of its packaged food peers’. This valuation is even more pronounced in the context of the slower long-term earnings per share growth we forecast. We expect narrow-moat Kraft Heinz to chalk up less than 6% annual EPS growth in the longer term, compared with the peer average of nearly 7% and the 8%-9% growth we foresee for wide-moat operators Hershey HSY and Mondelez MDLZ, both of which trade at a discount to Kraft Heinz.

We suspect that a portion of Kraft Heinz’s premium valuation could result from the interest held by 3G Capital. 3G has instilled a stringent cost-management culture in its acquisitions in the past, but we don’t believe this justifies a 20% valuation premium relative to the peer set, particularly given the more tepid growth prospects for several of the center-of-the-store categories in which Kraft Heinz competes.

The premium valuation could also reflect the potential for the combined firm to seek out acquisitions. However, we don’t believe management’s penchant for deals justifies a higher valuation. Melding distinct corporate cultures stands to add a further challenge to any integration and could ultimately inhibit Kraft Heinz’s ability to extract the degree of costs it is aiming for. Further, assuming that valuations in the space continue to trend higher, Kraft Heinz could pay an excessive premium for its next tie-up, which would add to the challenge of deriving synergies. Finally, management aims to reduce the debt balance, as total debt/adjusted EBITDA stood at 3.6 at the end of fiscal 2015, above the 2-3 times of peers. As a result, we don’t think the firm presently has an appetite for additional leverage.