Undervalued Dividend Growth Stock of the Week: The Kraft Heinz Co. (KHC)

Brands. 

This world is all about brands.

Just look around you.

You’ll see people wearing branded clothing, eating branded food, and using branded electronics.

Brands matter.

Brands can convey quality, prestige, consistency, values, culture, and even certain benefits to the user.

As such, it’s always important as an investor to look at high-quality companies with excellent brands.

Excellent brands means consumers are willing to repeatedly purchase those products/services, and they’re also willing to pay a premium for the privilege.

That should ensure recurring and growing profit as those consumers get hooked on those branded products/services, paying more money for consumption over time (as prices invariably rise).

More people buying more branded products/services at higher prices equals more profit.

Jason Fieber's Dividend Growth PortfolioAnd that, in turn, tends to lead to growing dividends.

This is a very simple theme that I’ve used to my advantage as I’ve built out my FIRE Fund.

That portfolio is a real-money and real-life dividend growth stock portfolio that generates enough passive dividend income to fund my financial independence and early retirement. 

I was able to become financially independent and retired early at just 33 years old by following the very simple investment strategy of dividend growth investing.

How did that happen? 

Check out my Early Retirement Blueprint for more details.

Dividend growth investing offers a very simple path to wealth: invest in wonderful businesses that have a longstanding track record of raising their dividends to shareholders, which is a behavior that is funded by growing profit.

Brands, growing profit, growing dividends.

Pretty simple stuff here.

As such, it shouldn’t be a surprise that you’ll see many great companies with sought-after brands on the Dividend Champions, Contenders, and Challengers list, which is a document that tracks almost 900 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

However, as great as this strategy is, and as great as profiting from fantastic brands can be, a successful dividend growth investor should aim to buy a high-quality dividend growth stock when it’s undervalued.

Price is what a stock costs, but value is what a stock is worth.

Being able to reasonably separate the two can make a huge difference over the long run.

That’s because buying a dividend growth stock when it’s undervalued can put the long-term investor in a very advantageous position.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk. 

That’s all relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

The higher yield plays out due to the inverse relationship between price and yield; all else equal, a lower price results in a higher yield.

A higher yield goes on to lead to greater long-term total return potential because total return is comprised of two components: investment income (through dividends or distributions) and capital gain. The former is boosted right off the bat by the higher yield.

And capital gain is also given a possible boost via the “upside” that exists between the lower price paid and the higher intrinsic value.

While stocks can be mispriced in the moment, price and value do tend to more closely correlate with one another over the long term.

Striking when there’s a mismatch between price and value can lead to that upside, which is on top of whatever organic capital gain would naturally manifest itself as a company becomes worth more over time.

Of course, this all helps to reduce risk.

It’s obviously less risky to pay less for the same exact asset.

You’re risking less capital (either on the total transaction, or on a per-share basis).

Plus, you introduce a margin of safety that protects your downside in case negative, unforeseen events come to pass.

There’s always risk when investing. That’s the reason for much of the return.

So one should always seek to minimize that risk by paying as low a price as possible, especially in relation to intrinsic value.

Fortunately, these concepts aren’t difficult to understand and use to your advantage.

Fellow contributor Dave Van Knapp has greatly simplified the valuation process for dividend growth investors by way of his valuation guide, which is part of an overarching series of articles (or “lessons”) on the strategy of dividend growth investing.

You can find that valuation guide by reading Lesson 11: Valuation.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

The Kraft Heinz Co. (KHC)

The Kraft Heinz Co. (KHC) is one of the world’s largest consumer packaged food and beverage companies.

I started this article by talking about brands.

Well, let’s talk about brands some more.

Kraft Heinz has over 200 brands sold in nearly 200 countries.

Eight of their brands are billion-dollar brands.

Let’s just rip through a few names for you: Kraft, Heinz, ABC, Capri Sun, Classico, Jell-O, Kool-Aid, Lunchables, Maxwell House, Ore-Ida, Oscar Mayer, Philadelphia, Planters, Plasmon, Quero, Weight Watchers, Smart Ones, and Velveeta.

Yeah. Brands.

Kraft Heinz holds the #1 or #2 market position in 17 different categories, which speaks to everything I noted at the outset of today’s piece.

What’s really great about this business, though, is how simple and timeless it is.

We’re talking basic food and beverage products.

Unless people were to suddenly stop eating and drinking, Kraft Heinz should have a floor under the business.

This company has a complicated corporate history, with its current iteration being formed after a number of spin-offs and mergers.

They’ve now arrived into a position of dominance, albeit at the cost of growth.

And due to that complicated corporate history (which included the spin-off of Mondelez International Inc. (MDLZ) in 2012), Kraft Heinz is now looking at most of its sales occurring in a strong but mature US market.

That said, dividend growth investors should like quite a few aspects about the dividend here.

First, let’s talk the juicy yield.

The stock is yielding a very appealing 4.49% right now.

That’s awfully attractive in this environment, considering it’s more than twice what the broader market is yielding.

However, the company’s dividend growth track record is thus far quite short, mostly due to that aforementioned corporate history.

The company has increased its dividend for five consecutive years, which isn’t terribly noteworthy.

However, the numerous legacy businesses that make up the current iteration of Kraft Heinz all had their own prestigious reputations regarding dividends. I think that adds a certain intangible nature to the dividend and the growth of it moving forward.

In addition, the five-year dividend growth rate, at 16.1%, is stout.

So there’s that.

On the other hand, the payout ratio for the business is sitting at 80.6% (using TTM EPS that factors out one-time gains for Q4 2017).

That’s high, even for a mature, stable company such as this.

As such, there might be a tiny crack showing in the dividend, as the company elected to keep the dividend unchanged with their most recent announcement (Q2). They were scheduled for a dividend increase, which means this is the fifth quarter in a row in which the dividend is the same.

Still, I think this stock offers a lot to like from the standpoint of current income, along with some modest income growth expectations.

Of course, in order to build out those future dividend growth expectations, we need to build out the future business growth expectations. The dividend should more or less track bottom-line growth from here (or perhaps even trail it slightly), due to the high payout ratio.

I usually like to start building out these forward-looking assumptions by looking at what a company has done over the long haul (using the last decade as a proxy).

But that’s not possible here because of the way this company has been formed.

With 3G capital and Berkshire Hathaway Inc. (BRK.B) at the helm, a merger was completed between Kraft Foods Group and H.J. Heinz Company in 2015.

3G Capital and Berkshire Hathaway (especially Berkshire Hathaway) both have a reputation for making great investments. 3G is, in my view, bringing its shrewd eye toward synergies and cost savings, while Berkshire brought to the table its immense capital and reputation.

So when you buy stock in what’s now Kraft Heinz, you have two of the biggest hitters out there going to bat for you.. That’s something to think about.

Indeed, Berkshire Hathaway (read: Warren Buffett) owns over 325 million shares of Kraft Heinz, worth over $18 billion. That’s about 25% of the company.

It’s rarely a bad idea to invest alongside Buffett, especially when he goes heavy into something.

As aforementioned, though, all of this makes it difficult to accurately analyze the fundamentals here because this newly-formed company has only had a few years to work. It’s still finding its legs.

I’m going to rely on just two fiscal years’ worth of top-line and bottom-line data, which means this analysis will more heavily rely on a future forecast.

Kraft Heinz generated $26.487 billion of revenue in FY 2016, which moved to $26.232 billion in FY 2017. Basically flat.

Earnings per share came in at $2.81 for FY 2016. That number jumped to $8.95 in FY 2017 due to one-time gains mostly related to US tax reform. The adjusted number for FY 2017 was $3.55. This isn’t a total apples-to-apples comparison, but that is 26% YOY growth.

If we take the adjusted EPS for both fiscal years, we go from $3.33 to $3.55. That’s 6.6%, which is more than respectable.

Looking out over the next three years, CFRA is predicting that Kraft Heinz will compound its EPS at an annual rate of 9%.

That would be very impressive for an enterprise such as this.

CFRA is citing US tax reform (which should disproportionately benefit Kraft Heinz because of their US-centric business model) and margin expansion (vis-à-vis 3G’s expertise).

Now, I don’t believe Kraft Heinz has to compound at a 9% annual rate in order to be a satisfactory investment moving forward. Something closer to that 6%-7% mark they achieved in YOY adjusted EPS growth would be more than enough to drive solid (say, 5% or so) dividend growth while still allowing for some debt reduction and payout ratio compression.

But if they are able to come in closer to that 9% mark, this could be something closer to an excellent investment.

Moving over to the balance sheet, this is an area of weakness.

The long-term debt/equity ratio is sitting at 0.43, while the interest coverage ratio is right at 5.

In my view, the latter tells the true story. The former number doesn’t look bad, but I think that’s mostly due to the fact that common equity is quite high. The company is carrying over $28 billion in debt, which is fairly substantial in both absolute and relative terms.

Profitability is next to impossible to gauge right now. The short combined corporate history doesn’t give us much to go on.

But I’m giving the company the benefit of the doubt due to the backing of 3G Capital, which is known to be fairly ruthless when it comes to squeezing out a margin.

This is simultaneously a boring and interesting investment, both of which are for good reasons.

I say boring because we’re talking a food company that was founded almost 100 years ago.

This is meat, cheese, ketchup. American staples.

On the other hand, I say exciting because the massive shakeup perpetrated by 3G and Berkshire Hathaway injects fresh blood, experience, and capital into the business.

Jorge Paulo Lemann and Warren Buffett are both very intelligent. They’re not going to put their capital and reputations behind this business if they thought it wasn’t going to work out pretty well.

Of course, this is a very competitive space. And it’s a mature business operating in a mature market.

But if you’re a dividend growth investor who wants to invest in a pretty stable business model that offers plenty of yield and modest growth, backed by legendary investors, Kraft Heinz looks like an opportunity.

That opportunity looks especially compelling now that the stock has dropped from the low $80s earlier this year to the high $50s now…

The stock is trading hands for a P/E ratio of 18.02 (using adjusted TTM EPS), which is obviously well below the broader market.

One could argue this stock deserves the inferior valuation, but there’s nothing inferior about that three-year growth forecast.

Meanwhile, the yield is more than twice the broader market, and this is a business that, I believe, would move the planet to keep that dividend intact.

With a 25% drop YTD, the stock does look appealing on the valuation front. But how appealing might it be? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 6%.

That DGR is definitely on the lower end of what I allow for, but I think the mature business model, high payout ratio, and recent dividend activity warrants the cautious outlook here.

However, the CFRA forecast for EPS growth could offer some upside here. And 3G Capital is really just getting started.

The DDM analysis gives me a fair value of $66.25.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

Even with my fairly conservative look at future growth, the stock looks well undervalued.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at, which adds balance, depth, and perspective to our conclusion and final valuation.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates KHC as a 3-star stock, with a fair value estimate of $62.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates KHC as a 3-star “HOLD”, with a 12-month target price of $63.00.

We have a rough consensus here. Averaging the three numbers out gives us a final valuation of $63.75, which I believe is a pretty accurate look at intrinsic value. That would imply the stock is potentially 14% undervalued right now.

Bottom line: The Kraft Heinz Co. (KHC) is a company that owns over 200 brands across essential food and beverage products that people all over the world love and consume. Eight of those brands are billion-dollar brands. With the backing of legendary investors, a perfect position for margin expansion, a forecast for growth acceleration, a ~4.4% yield, and the possibility that shares are 14% undervalued, dividend growth investors should take a good look at this stock.

-Jason Fieber

Note from DTA: How safe is KHC’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 47. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, KHC’s dividend appears borderline safe with a low risk of being cut. Learn more about Dividend Safety Scores here.

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