The Long and Short
Kraft Heinz performance and lower leverage could spur upgrade
Meredith Contente | October 28, 2022
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.
The Kraft Heinz Company’s third quarter results came in ahead of consensus, as management’s turnaround strategy to focus on “GROW” brands in North America helped fuel strong organic net sales growth. And while KHC had long held a stated net leverage target below 4.0x, management recently revised its target to 3.0x. The new leverage target bodes well for a potential upgrade by S&P, given the positive outlook, which could fuel further spread tightening.
KHC has been aggressive on pricing, but it saw less volume deterioration on pricing actions in the third quarter than some peers, leading to increased US retail consumption and improved market share (Exhibit 1). Pricing actions and further operational improvements are expected to generate sequential margin improvement in the fourth quarter.
Exhibit 1. North America Packaged Food Organic Net Sales Comparison
Strongest 3Q Growth in GROW Platforms – Improved Consumption Levels
KHC’s turnaround strategy appears to have legs as third quarter results produced double digit consolidated organic net sales growth of 11.6%, ahead of consensus estimates of 9% growth. While pricing was the largest factor behind the sales outperformance, KHC’s focus and investment in GROW platforms (brands), which account for 64% of the company’s North America brand portfolio, witnessed 12% growth year-over-year. This compares favorably to the 11% and 2% growth rates witnessed in the STABILIZE and ENERGIZE platforms, respectively (Exhibit 2). Additionally, KHC noted that the compounded average growth rate of sales since the third quarter of 2019 was 8% in the GROW platform, more than double the rate of its other platforms.
Exhibit 2. KHC North America 3Q Organic Net Sales
KHC has witnessed increasing retail consumption in the US relative to 2021. For the quarter, consumption increased 9.2% year-over-year, and KHC has seen a sequential quarterly increase in consumption every quarter year-to-date. While supply chain issues continue to challenge capacity, a revived focus on innovation has led to very strong consumption growth across key brands. Lunchables witnessed a 23% increase in consumption year-over-year, while Kraft Mac & Cheese delivered 18% consumption growth.
The high double-digit consumption growth translated to increased market share versus the year ago-period. KHC noted that they have less private label competition relative to peers, which bodes well for continued growth in this highly inflationary environment. In fact, only 11% of KHC’s brands are subject to private label competition, versus 20% for the North American packaged food and beverage space.
Margins Set to Improve
While KHC witnessed some margin deterioration in the quarter, EBITDA is expected to improve in the fourth quarter as pricing actions taken during the third quarter provide a tailwind for the quarter. KHC estimates that 57% of adjusted EBITDA in the second half of this year will be generated in the fourth quarter. Additionally, management revised the low end of its EBITDA guidance range and now expects full year adjusted EBITDA to be in the $5.9 billion to $6.0 billion range, up from a range of $5.8 billion to $6.0 billion. Given the updated EBITDA guidance, KHC is estimated to generate roughly $1.64 billion to $1.74 billion of adjusted EBITDA in the fourth quarter. This translates to an adjusted EBITDA margin of at least 23.1% in the last quarter of the year, roughly 160 bp better than the 21.5% posted in the third quarter.
New Leverage Target Could Prompt an Upgrade
Earlier this year, both S&P and Fitch raised KHC’s ratings to IG given the improved operational performance coupled with the lower overall debt levels. KHC reduced net debt by roughly $8.5 billion since 2019, using both non-core asset sale proceeds and excess free cash flow. The debt reduction reduced leverage from 4.9x in 2019 to 3.3x currently. Additionally, management revised its net leverage target from below 4.0x to roughly 3.0x. With EBITDA margins expected to improve next quarter, net leverage could decline further, on no additional debt reduction. Furthermore, KHC is expected to generate higher levels of free cash flow than it witnessed pre-pandemic, which should more than cover the annual dividend as well as opportunistic share repurchases.
S&P’s positive outlook reflects the potential for a higher rating over the next 18 months should management continue to effectively manage inflation while growing the top-line organically. Additionally, the agency would like to see KHC sustain adjusted net leverage below 3.0x. Given management’s new net leverage target of 3.0x, we think KHC increased its chances of an additional upgrade by the agency. The new leverage target demonstrates a commitment to more prudent financial policies moving forward. KHC management has also explicitly stated its commitment to maintaining IG ratings and noted that maintaining a strong balance sheet provides the company with sufficient flexibility to navigate economic cycles.
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