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More questions than answers at Kraft Heinz

| August 9, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

After failing to report 1Q19 results, Kraft Heinz released preliminary 1H19 results that included minimal detail, no cash flow statement, and pulled the full year guidance previously provided in the 4Q earnings call. All geographic regions experienced double digit EBITDA declines, and leverage at the company remains elevated after being plagued with earlier accounting issues, write-downs and increased supply chain costs. With no turnaround procedure in place and no guidance with respect to how much lower EBITDA can fall , investors should continue to underweight KHC bonds or do a down in dollar swap.

A long wait for incomplete results

The Kraft Heinz Company (KHC) failed to release 1Q results, leaving the investment community waiting nearly six months for the company to release results. The 1H19 results released on 8/8/19 are “preliminary” and provided minimal detail, leaving investors with more questions than answers. The results showed an organic net sales decline of 1.5% for 1H19, reflecting a 1.3% decline in pricing coupled with a 0.2% decline in volume/mix. Pricing was negatively impacted by promotional activity in North America as well as price reductions to reflect lower commodity costs. Volume/mix was affected by retail destocking in North America and lower shipment internationally. Only Canada and ROW (which includes Latin America and Asia Pacific) posted organic sales growth, up 0.4% and 0.6%, respectively. Adjusted EBITDA fell 19.3% due to higher supply chain costs and increased spending on strategic initiatives. All geographic regions experienced double digit EBITDA declines. While a balance sheet was provided which showed virtually no debt reduction since year-end, KHC neglected to provide a cash flow statement nor was there any guidance provided in the release.

Another day, another write down

KHC recorded a non-cash impairment charge of $1.2 billion in 1H19 which was largely driven by two factors. First, KHC lowered the carrying amount of goodwill for the EMEA East, Brazil, US refrigerated and Latin America exports reporting units reflecting new five-year operating forecasts. Second, the company lowered the carrying amount of certain intangible assets to reflect the sustained decline in the company’s stock price since the start of the year. This write down comes on the heels of the massive $15.4 billion impairment charge taken in February of this year. That charge reflected the goodwill impairment relating to its US refrigerated and Canadian retail units as well as the intangible asset impairments of both the Kraft and Oscar Mayer brands. Management indicated on the call that there remains a continued risk of future impairments given the potential for changes in modeling assumptions going forward.

Guidance pulled…quietly

While the release contained no financial guidance, which is not uncharacteristic of KHC, new management seemed to skirt around the fact that full year guidance had been provided in the fiscal 4Q earnings call. While it was a bit of a departure for previous management to set full year guidance, which they noted on the 4Q call, they did formally state for organic sales growth to be positive and adjusted EBITDA to be in the $6.3 to $6.5 billion range. Management seemed to just relay that they were not providing or updating guidance at this point. That said, only when directly asked in the Q&A did management explicitly state that guidance was being pulled.

Leverage to remain elevated

Despite having closed its merger with Heinz over 4 years ago, leverage at KHC remains elevated after being plagued with earlier accounting issues, write-downs and increased supply chain costs. KHC had initially targeted leverage of 3.5x within 30 months post the Heinz close, however four years post close, KHC’s leverage is hovering around 5.0x. Despite efforts to reduce debt with asset sales, it’s just not enough to offset the drop in EBITDA.  KHC has allocated proceeds from the recent sale of its Canadian cheese unit  of $1.6 billion to debt reduction, which should bring leverage to the 4.7x area.  This would be up from the 4.2x at year end 2018.  With full year EBITDA guidance now pulled, leverage could tick up from the estimated 4.7x if EBITDA continues to decline in the 2H.  On an LTM basis, we estimate that EBITDA was $6.28 billion as of 6/29/19.

Management took the opportunity to reiterate its commitment to IG ratings, but provided no real path or leverage target.  The only information that they were able to provide was that they believed the current business can generate sufficient free cash flow to support de-leveraging organically “over time”.  They also went on to note that free cash flow can support the current dividend payment.

S&P opines?

S&P released a bulletin noting how 1H19 results came in below expectations with adjusted EBITDA missing their estimates by an approximate mid-to-high single digit rate. The agency also noted that they now expect a modestly slower rate for credit metric improvement.  S&P believes that leverage will now not fall to or below 4x for the next 18-24 months. That would mean that leverage will not be at 4x or below for 5.5 to 6 years post Heinz close. No rating or outlook revision was taken.

Relative Value

With no turnaround procedure in place and no guidance with respect to how much lower EBITDA can fall as the company continues to invest in their current brands, investors should continue to underweight KHC bonds. While bonds have widened considerably – roughly +30 bp wider after the results – KHC has yet to test the wides witnessed in late May/early June despite little clarity and the potential for leverage to increase versus decline. For accounts that would like to maintain exposure to the credit given the yield, they can do a down in dollar swap. In particular, accounts can swap out of KHC 5.20% 7/15/45 bonds into KHC 5.0% 6/4/42 for a give of 7 bp while taking out roughly 2 points (even g-spread).

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