A few weeks ago I wrote an article as a direct refutation of an argument made by Warren Buffett. He essentially denied the idea that Kraft Heinz (KHC) is a wonderful business. Towards the end of the article, I gave the company a fair value estimate of $ 54.6 billion, even from what I believe is a very optimistic view of future business development. As I reflected on this price target, I realized that I had oversimplified the differences between debt and equity, and I would like to dive deeper into the company's capital structure and further refine my fair value estimate.
Debt Is Cheap But Risky By the end of 201
8, Kraft Heinz contributed $ 31 billion in long-term debt, an increase of $ 2.5 billion over the previous year, and paid about $ 1 billion , $ 3 billion in interest from 4%. At the time of writing, the company has a market capitalization of about $ 40 billion, which means debt is now almost as big as equity. In my article explaining my valuation method, I need a minimum return of 10% on every equity I'm interested in, which makes the purchase of debt 4% much cheaper. However, this also means that debt repayment is a costly affair, as the money spent in this way only achieves a return of 4%. Unlike reinvested earnings, which are reinvested at 71% in core business, or even unlike shareholder returns with a return on income of 8.6%, debt repatriation offers poor returns.
Even if the debt is currently very high Since it is cheap and therefore offers poor returns, the aspect of the risk must be taken into account. Shareholders' income of 8.6% will not do the shareholder good if the company goes bankrupt or the income deteriorates otherwise, so that 8.6% shrink over time before the company has paid enough to make a worthwhile investment to have made. Interest rates are a big chunk with $ 1.3 billion in interest against $ 6 billion in operating income. Of course, 42% of the capital structure is indebted, consuming only 22% of the pie, which is a profit. The risk, however, is that a small decline in operating income due to shareholder interest expense has a greater impact on earnings.
|Operating Result||$ 6,000 million||$ 5,400 million||$ 4,800 million||$ 4,200 million||$ 3,600 million|
|0%  -10%||-20%||-30%||-30%||-40% interest expense||$ 1,300 million||$ 1,300 million||1,300 Millions of dollars||$ 1,300 million||$ 1,300 million||22%||24%||24%||%||31%||36%|
|US $ 4,700 million||US $ 4,100 million||US $ 3,500 million||US $ 2,900 million||USDUS000000000000000000000000000000000000000000000000000000000000000||0%||-13%||-26%||-38%||-51%|
Source: Author Only.
As this example shows, should operating income be achieved to continue to decline, interest expense will make up a larger portion of the whole. On the other hand, if the operating income reverses the recent trend and moves up, the leverage will, of course, benefit shareholders as interest rates make up a smaller part of the total and earnings before tax will rise faster than operating income.
The premise is pretty simple: when profits rise, debts, even growing debts, are not a problem and can be used for the benefit of shareholders. However, with declining earnings, debt can very quickly lead to a downward spiral, as discounting low-interest-bearing debt contributes little to the bottom line. In a perfect world, companies would have the opportunity to repay their debt over time and continue to offer their shareholders compelling returns. Then, even in bad times, "bad" becomes a relative term and meaningful recovery would be possible. In fact, companies tend to overestimate themselves and risk a spiral of death to reassure shareholders by at least appearing to provide compelling returns to their shareholders in the short term.
The Dividend Cut – What does it mean? [19659045ImletztenQuartalsenkteKraftHeinzdiejährlicheDividendevon250USDauf160USDjeAktieumdieVerpflichtungenzurTilgungvonSchuldenzureduzierenDiesbedeutetzweiDinge-dieAnteilseignererhaltenwenigerunddieSchuldnermehrImLaufederZeitwirddiesdasRisikoverringernaberauchdieAktionäreindiesemProzessschmerzen
With 1.22 billion shares outstanding this change by 0.90 USD per share result in an annual $ 1.1 billion to be opened to cover the debt. At a 4% interest rate, this increases the pre-tax annual profit by approximately $ 44 million, which represents a gain of nearly 1%. This growth can be attributed in any manner most appropriate to the management. Later, I will summarize it below and credit the dividend growth rate directly, but it will also have a small impact on the rate of coverage of the term coverage, although it is too small to be very meaningful.
However, if the same dividends of $ 0.90 were included in the dividend, at a current market price, this would yield around 7.6% or 2.7% above the current price. While the company's total revenue can be increased by 1% per annum, if this additional $ 1.1 billion is used to pay off debt, a single shareholder would have a share of other stable revenues at 2.7% higher Rate increased if he had received this cash himself and at the current rate reinvested in the stock. In fact, a dividend yield of 2.7% was traded for a dividend growth rate of 1%. With reinvestment of the dividends this means an annual impairment of the total return of shareholders of 1.7%.
The reasons for the dividend cut have been made quite clear – debt is considered a problem. In the recent past, the company's free cash flow has been adversely affected, and debt has risen simply through the payment of dividends, a clearly unsustainable target. However, as I assumed in my previous optimistic opinion that working capital is back in balance and earnings are recovering, the company would generate about $ 3.6 billion in free cash flow each year. Even in this optimistic scenario, only $ 550 million per year would be left to repay the debt. For debts of $ 31 billion, this would take most of life to eliminate it completely. So if debt is considered a problem, it makes sense to attack it more aggressively. The fact that this is a problem, however, suggests that the optimistic case is most likely.
An Alternative – If Things Do not Look That Bad
If the debt is paid at a rate of $ 550 million a year was considered too slow, but the debt itself was not considered a serious problem. The write-down of trademarks was unavoidable and would likely have materially affected the stock. If the stock had fallen to around $ 36 without the dividend cut, the stock would have gone down 7%. This is well below the 4% that the company pays on interest. If management believed that profits would grow or even remain stable, this discrepancy would have given them a chance.
With a difference of 3% between the dividend yield and the interest rate paid on the debt, this would give management the opportunity to reduce its overall obligations by issuing debt to repurchase shares. If the repayment rate of $ 550 million a year is considered too slow, an additional $ 20 billion spent on repurchasing shares could reduce total commitments by $ 600 million per annum and 1,150 Millions of dollars a year are available for repayment of debt. This would actually result in a reduced (but still very long) term against the new $ 51 billion, while the payout ratio drops. Shareholders could continue to either borrow $ 2.50 per share or reinvest at a yield of 7% (should the market price not change), and the dividend could grow into the future through savings from debt settlement and profit growth.
Considering Kraft's concern today, it would probably not be in the best interests of the company to pay debts. This is perhaps the biggest indication that an investment in Heinz today is a bad decision. If management relied not only on stable earnings but on earnings growth, another $ 20 billion in debt would be manageable, though that would be questionable in the short term. The company has stable returns. If management believes that the future looks like my optimistic case, it would be a legitimate way to maintain long-term shareholder returns, ultimately accelerating the repayment of debt and lowering the dividend payout ratio. 19659053] Valuation
With the reduction in the dividend and the signs that more cash is being put into debt than in the past, my equity only valuation method is incomplete, as not all free cash flows go to shareholders. It's worth tracking where the money goes exactly. In my optimistic scenario, with $ 3.6 billion in free cash flow, $ 1.95 billion is currently being distributed to shareholders through dividends, with the remainder being used to pay down debt. With organic profit growth of 4% per annum and nearly 2% per annum earnings growth through interest rate cuts, a dividend yield of at least 4% would be required to meet my 10% minimum target return. In fact, this has an optimistic fair value for the stock, with an uptrend of $ 40 per share, with a somewhat broader rise in the long run, as more cash is converted from debt into shareholder returns or even higher interest rates are invested in core business can
However, it is important to understand how optimistic this case is. Because the management had the potential instrument of issuing debt to buy back the shares and reduce the total obligations, if the income as at least considered stable, but rather chose the less risky act of lowering the dividend, I would hypothesize that management is concerned that the business will continue to deteriorate in the long term and profit will continue to decline. Given the stabilization of earnings around the average post merger level and the (still optimistic, if the cash flow statement can not be adjusted) interest rates of $ 1.6 billion a year, I think this is more likely, and possibly even Still too optimistic scenario to believe in 2% long-term earnings growth that could be transformed into a dividend growth rate. To reach a total return of 10% in this scenario, the stock would have to trade at a dividend yield of 8% at $ 20.
In this article I have examined in more detail the capital structure of Kraft Heinz. In doing so, I refined and significantly improved my optimistic fair value estimate from $ 20 to $ 40. On the other hand, I also found a clear reason to believe that $ 20 is still not cheap enough. I think it is justified to say at this stage that if you really believe in the company, it will provide reasonable but not exceptional results. Without unbelievable confidence in the management and the business that is reasserting itself, KHC is not worth a second look, unless it drops below $ 20.
Disclosure: I / we have no positions in the named shares. and no plans to initiate positions within the next 72 hours. I wrote this article myself, and it expresses my own opinion. I can not get any compensation for it (except from Seeking Alpha). I have no business relationship with a company whose warehouse is mentioned in this article.