One Of Buffett's Favorite Stocks Is A 'Buy'

Nick Lanyi's picture

Tuesday, June 7, 2016 - 12:30pm

by Nick Lanyi

When people around the world want something to eat, there's a good chance they reach for a 
product made by Kraft Heinz.

And for investors looking for a combination of value and quality, Kraft Heinz (Nasdaq: KHC) should be on your menu right now.

Formed by the mega-merger of Kraft Foods Group and H.J. Heinz in July 2015, Kraft Heinz is the third largest food and beverage company in North America, and the fifth largest in the world. The company boasts more than 200 brands, including Kraft, Heinz, Oscar Mayer, Jell-O, Kool-Aid, and Lunchables. Eight of the company's brands each generate $1 billion a year in sales, and the combined company's overall revenue was $27.4 billion in 2015.

Kraft Heinz sells products in dozens of countries around the world, but the United States accounts for just over 70% of earnings, with the rest focused in Canada, Europe and Latin America. That's a big plus, because it implies that the company has room to grow by increasing market share overseas. (Some of this expansion may take a few years, because of noncompete agreements made with former Kraft sibling Mondelez when the companies split.)

Strong brands don't guarantee a string of rising sales and earnings from here to infinity -- just ask McDonald's -- but in the global packaged-food market, a mega-brand that is #1 or #2 in its category enables a company to secure coveted shelf space at top retailers, more quickly secure and build on market share in new areas and introduce brand expansion products to boost revenue. Kraft Heinz has 17 of these types of brands in staple categories -- mac & cheese, coffee, ketchup, mustard, nuts, French fries, fruit drinks -- and the financial might to take advantage of them.

The company is currently revamping its Kraft mac & cheese products to generate higher sales and profit margins, and in April it launched an expansion of Heinz products with a line of five new barbecue sauces (entering a market in which Kraft already plays).

As big as Kraft Heinz already is, it has room to expand further into the restaurant and food-service industries -- where Heinz, Grey Poupon, Maxwell House and Philadelphia already have major presences. 

Another selling point for Kraft Heinz: the merger was supported by two of the savviest investors on the planet. Warren Buffett, whose love for Heinz's steady cash flows long predated the deal, and Brazil-based investment firm 3G Capital, which took Heinz private with Buffett in 2013 and then worked with him on the Kraft merger. 3G and Berkshire Hathaway (NYSE: BRK-B), Buffett's holding company, own a controlling stake in Kraft Heinz and Buffett sits on the board of directors.

Buffett's investment philosophy values cash flow above all, and 3G's specialty is taking over food and beverage companies and increasing cash flows by cutting costs. This team is experienced at cutting overhead after a merger and finding ways to use economies of scale to save money (for example, through negotiating better deals from suppliers). At Kraft Heinz, the goal is $1.5 billion in cost savings by 2017. Considering that Kraft Heinz already produced more than $2 a share in free cash flow in 2015, we envision a scenario of modestly rising revenue but faster gains in profit margins and free cash flow in the years to come -- which could lead to an increase in the dividend payout, share buybacks and smart acquisitions of other companies.
 
Less than a year after the merger, the cost-savings efforts already seem to be paying off. The company reported $225 million in cost savings in the first quarter of 2016 alone. Analysts hailed the first quarter earnings announcement, which indicated that the company has moved quickly to find synergies from the merger. Operating income grew 21% year over year on a pro forma basis, an impressive result.

Kraft Heinz also is working hard to deleverage after the merger, paying down debt and funding pension liabilities. Lower debt will allow the company to keep more of its cash flows for capital investments and rewarding shareholders.

At recent prices, Kraft Heinz trades at about 27 times analysts' consensus estimate for 2016 earnings per share. But analysts also expect earnings to grow in the 16% to 20% annualized rate in the coming years, making this a high-quality stock that still trades at a reasonable valuation. Look for the stock to hit $100 in the next 12 months.

Risks To Consider: As a producer of consumer staples, Kraft Heinz should perform fine even if the economy slows, but because analysts' expectations for sales and earnings growth have risen, the stock is vulnerable to earnings disappointments.
    
Action To Take: Buy Kraft Heinz below $89.

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Nick Lanyi does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.