A few weeks ago, I wrote an article as a direct rebuttal to an argument Warren Buffett made, essentially contesting the idea that Kraft Heinz (KHC) is a wonderful business. Towards the end of the article, I issued a fair value estimate for the enterprise of $54.6 billion, even under what I considered to be a very optimistic assessment of future business performance. When reflecting on this price target, I realized that I had over-simplified the differences between debt and equity, and I would like take a deeper dive into the capital structure of the company, and refine my fair value estimate further.
Debt Is Cheap, But Risky
As of the end of 2018, Kraft Heinz carried almost $31 billion in long term debt, an increase of $2.5 billion from the prior year, and paid about $1.3 billion in interest on it, a rate of about 4%. As of writing, the company has a market cap of about $40 billion, meaning debt is now making up almost as large a piece of the pie as equity. In my article explaining my valuation methodology, I require a minimum return of 10% on any equity I’m interested in purchasing, which makes debt at 4% quite a lot cheaper. However, this also means that repaying the debt is an expensive affair, as any cash spent in this way carries only a 4% return on investment. In contrast with retained earnings being reinvested into the core business at 71%, or even in contrast with shareholder returns, at an earnings yield of 8.6%, paying down debt offers poor returns.
Of course, even though debt is currently very cheap, and thus offers poor returns, there’s the aspect of risk that must be considered. Shareholder returns at 8.6% won’t do the shareholder a dime of good if the business goes bankrupt, or earnings otherwise degrade, such that that 8.6% shrivels up over time, before the business has paid out enough to have made a worthwhile investment. With $1.3 billion in interest against about $6 billion in operating income, interest is eating a big chunk of the pie. Of course, 42% of the capital structure is tied up in debt, and it only consumes 22% of the pie, which is a win. The risk, however, is that a small decline in operating income will have a larger impact on shareholders’ bottom line, due to the fixed interest expense.
|Interest As %||22%||24%||27%||31%||36%|
|Change in Pretax||0%||-13%||-26%||-38%||-51%|
Source: Author – example only.
As this example shows, should operating income continue to dwindle, interest expenses will make up a larger portion of the whole. Of course, on the flip side, should operating income reverse the recent trend, and move upwards, the leverage will be to shareholders’ benefit, as interest will make up a smaller portion of the whole, and pretax income will rise more quickly than operating income.
The premise is pretty simple: If earnings are rising, debt, even growing debt, isn’t a problem, and can be used to the benefit of shareholders. However, if earnings are falling, debt can very quickly lead to a downward spiral, as paying off low-interest debt adds very little to the bottom line. In a perfect world, companies would have the ability to both pay down debt over time while continuing to offer their shareholders compelling returns. Then, in even the bad times, “bad” becomes a relative term, and an expedient recovery would be possible. In reality, companies tend to overestimate themselves, and put themselves into risk of a death spiral, in order to appease shareholders by at least appearing to offer compelling shareholder returns in the short term.
The Dividend Cut – What It Means
In the most recent quarter, Kraft Heinz cut the annual dividend from $2.50 to $1.60 per share, in an attempt to reduce commitments for the purpose of paying down debt. This boils down to meaning two things – equity holders will receive less, and debt holders will receive more. Over time, this will reduce risk, but also cause some pain to shareholders in the process.
With 1.22 billion shares outstanding, this $0.90 per share change will result in opening up $1.1 billion per year for debt coverage. At a 4% interest rate, this will add about $44 million to the pretax income on an annual basis, adding almost 1% growth to the bottom line. This growth can be allocated in whatever manner seems best to management. Later, I’ll be tallying it up into the bottom line, and directly crediting it to the dividend growth rate, but there will also be a small impact on the rate of forward debt coverage, though too small to be very meaningful.
However, if this same $0.90 had been kept in the dividend, it would be carrying a yield of about 7.6%, or 2.7% higher than currently, at current market price. While the whole company’s earnings can be grown at 1% per year by using this extra $1.1 billion to pay down debt, an individual shareholder could have grown their own portion of otherwise-stable earnings at a rate 2.7% higher, if they had received this cash themselves, and reinvested into the stock at current price. Effectively, a 2.7% dividend yield was traded for a 1% dividend growth rate. With dividends reinvested, this is a 1.7% annual impairment to shareholders’ total returns.
The reasons for the dividend cut have been made fairly clear – the debt is seen to be an issue. In recent history, the company’s free cash flow has been impaired, and so the debt has been growing simply through paying dividends, a clearly-unsustainable pursuit. However, as I assumed in my optimistic view in my prior article, with working capital returning to balance, and earnings recovering, the company would to generate about $3.6 billion per year in free cash flow. Even in this optimistic scenario, it would have left only $550 million per year to pay down debt. For $31 billion in debt, this would take the better part of a lifetime to erase entirely. So, if the debt is considered to be a problem, it makes sense to attack it more aggressively. However, the fact that it’s seen as a problem at all betrays the idea that the optimistic case is the most likely.
An Alternative – If Things Didn’t Look So Bad
If paying down debt at a rate of $550 million per year was considered too slow, but the debt itself was not considered a major issue, I believe there would have been a better way of handling it. The write-down of brands was inevitable, and likely would have impaired the stock pretty significantly. Had the stock traded lower, to about $36, without the dividend cut, the stock would have still yielded 7%. This is markedly lower than the 4% the company pays on interest. If management believed earnings were to grow, or in fact, even to remain stable, this discrepancy would have offered them an opportunity.
With a 3% difference between the dividend yield, and the interest rate paid on debt, it would offer management an opportunity to reduce their total commitments by issuing debt to buy back stock. If $550 million per year was deemed too slow a rate of debt repayment, an additional $20 billion in debt used to buy back stock could reduce total commitments by $600 million per year, reaching $1,150 million available for debt repayment per year. Against the new total of $51 billion, this would actually lead to a reduced (but still very long) repayment duration, while reducing the dividend payout ratio. Shareholders would be able to continue either collecting $2.50 per share, or reinvesting at a 7% yield (should market price not change), and the dividend could be grown into the future with the savings from both debt repayment and earnings growth.
As distressed at Kraft Heinz appears to be today, it would probably not be in the company’s best interests to be issuing debt. This is perhaps the biggest tell we have that an investment in Kraft Heinz today is a poor decision. If management was confident in not only stable earnings, but earnings growth, moving forward, an additional $20 billion in debt would be a manageable thing to pull off, even if quite questionable in the short term. The business has inherently stable earnings, so if management believed that the future looked like my optimistic case, it would offer a legitimate method to sustain long-term returns for shareholders, as well as ultimately accelerating debt repayment and reducing the dividend payout ratio.
With the dividend cut, and the indications of putting more cash towards debt than in the past, my equity-only valuation method is imperfect, because not all free cash flow goes to shareholders. In this, it pays to follow where exactly the money goes. Assuming my optimistic case scenario, with $3.6 billion in free cash flow, about $1.95 billion is currently being allocated to shareholders through dividends, and the rest can be used to pay down debt. With 4% organic earnings growth per year moving forward, and almost 2% earnings growth per year through interest rate reductions, it would require at least a 4% dividend yield to reach my minimum 10% target returns. This actually has an optimistic fair value for the stock with some upside at $40 per share, with a little further upside in the extreme long term as more cash can be reallocated from debt coverage towards shareholder returns or even reinvested into the core business at higher rates.
However, it’s important to understand how optimistic this case is. Because management had the potential tool, if they considered earnings to be at least stable, of issuing debt in order to buy back stock and reduce total commitments, but rather chose the less-risky act of cutting the dividend, I would hypothesize that management is concerned about a further long-term decline in the business, and for earnings to decay even further. With earnings stabilizing around average post-merger levels, and with the (still-optimistic, if the cash flow statement can’t be cleaned up) $1.6 billion in interest repayments per year, I think it’s a more-likely, and potentially even still too-optimistic, scenario to believe in 2% long-term earnings growth, which could be put into a dividend growth rate. For this scenario to reach a 10% total return, the stock would need to trade with a dividend yield of 8%, at $20.
In this article, I’ve more closely examined the capital structure of Kraft Heinz. In doing so, I refined and significantly upgraded my optimistic fair value estimate to $40 from $20. On the other hand, I’ve also identified a clear reason to believe that $20 still may not be cheap enough. I think that it’s fair to say, at this point, that if you are a really big believer in the company, it offers reasonable, but not exceptional, returns moving forward. However, without any incredible faith in management and the business returning to strength, KHC isn’t worth a second look until and unless it drops below $20.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.