Monday, October 15, 2012

Heinz Equity Research and Analysis

Usually when companies give results and the stock price gains a few percentage points there is a good reason. However, I’m struggling to see what was so exciting about H.J. Heinz $HNZ last earnings. In summary, outside of emerging markets the growth numbers were pretty anemic. Heinz operates in some difficult markets and on closer inspection there are some surprising things in this report which need to be considered before investing in this yield play.

Headline EPS Good but Why?

The headline EPS growth number of 10% is superficially impressive but it is made up of some beneficial movements in taxes and a $40m productivity charge taken last year made the comparable easier. In reality, gross profits only rose 1.9%. Headline sales growth decreased by 1.5% but organic sales growth was up 4.8%. Of course, the reason for the discrepancy is down to currency effects and specifically the fact that emerging markets growth grew 19.3% on an organic basis and now represents 26% of company sales.

On a brighter note, gross margins increased with productivity improvements and pricing increases overcoming commodity inflation. Management talked about margins building significantly throughout the year. Whilst I can buy this argument with the regards the softening of certain soft commodities, I am not so sure about consumers taking pricing. US shoppers in particular are becoming very price conscious and companies have found it very difficult to make prices stick.

Moreover, the US and Europe (another region becoming increasingly price conscious) only make up 55% of sales but crucially they contribute 78% of operating income.

So let’s not get too excited about the idea of relying on emerging market growth.

North American Challenges

Putting aside emerging markets for a moment, let’s consider what is going on in the US food industry. It seems to be a kind of revolving door game with mass market consumer products. A company increases pricing, it then loses market share but gains a bit on margins. Then it decides to spend some of that margin gain on promotions and discounts, it gains market share back but then loses margins. And back we go to square one. Frankly, I don’t think Heinz is immune from this cycle and I note the ramp in marketing spend due in Q2.

Furthermore, the commentary from rivals has not been particularly positive. I have a more detailed information on Campbell Soup $CPB in an article linked here. Not only is top line growth hard to come by but its earnings growth is challenged too. Much of this is to do with soup being a weak category right now and I note that Treehouse Foods $THS reported weak numbers and is closing some soup operations.

Soup may be out of fashion but all these companies have to deal with another damaging trend. US consumers are increasingly doing more of their grocery shopping in discount and ‘dollar stores’ and this marginal shift is hurting food companies with traditional strength in the conventional groceries.  Even Treehouse –traditionally seen as a ‘trading down’ play due to its private label focus- is suffering as it has to shift to alternate retail channels. Moreover, customers are being more frugal and want smaller size portions.

Readers will be as surprised to see that North American Consumer Product organic growth of .9% was less than the 2% organic growth recorded in austerity laden Europe! These numbers might be skewed with the inclusion of a BRIC (Russia) in the European numbers and the ongoing and genetic obsessive compulsive disorder that the British have with Heinz baked beans, but it still tells you a lot about how difficult conditions are in the US consumer food sector.

Again, I think a certain amount of skepticism need be applied to the plan to increase US pricing.

Pockets of Growth

Heinz’s management drew attention to its ‘trio of growth engines’ namely global ketchup, the top 15 brands and emerging markets. I think this emphasis says a lot about the direction of the company.

Ketchup and Sauces now make up 47.3% of total revenues and with divestitures elsewhere (frozen desserts) plus slowing sales growth in other categories, the management is focusing on growing this powerful brand. This is a good as in slow economic times you probably want your companies to focus on their core products rather than chase category expansion.

While conditions are tough in Europe and the US, emerging market growth looks assured. It strikes me that the emerging middle classes in the BRICS are going to seek out aspirational everyday brands like Heinz in a similar way to how they are willing to Yum! Brands $YUM) has been able to aggressively grow sales in China. Traffic and same store sales growth are both doing well in China. Speaking of YUM, it was able to buy the extremely popular Little Sheep Group. I had some dealings with investors in this company and I can affirm that it is phenomenally popular in China. In the same way, Heinz bought Chinese company Foodstar (Soy Sauce) in 2010 and investors might expect more acquisitions as Heinz needs to chase growth.

The food sector could be one of the best ways to play emerging markets going forward as the slowdown appears to be focused on the industrial side. Worker’s wages continue to rise and so does the expansion of the middle class. That said McDonald’s Corp $MCD recently reported weak sales trends in China. While reasons for this are difficult to discern, other fast food companies are reporting good growth. Nevertheless, potential investors in Heinz should watch McDonald’s commentary very closely, particularly with regards emerging markets.

So, Where Next For Heinz?

In conclusion, Heinz is a well-run company with good prospects in the BRICs but near to mid-term challenges in developed markets. Going forward the company is forecasting 4% organic sales growth, EPS growth of 5-8% in constant currency and operating cash flow of $1bn for 2013.

 Frankly, it’s hard to put these numbers together and reconcile that Heinz is cheap. The yield of 3.6% is certainly attractive but, when was paying nearly 20x current earnings for single digit earnings growth an example of a cheap company? Moreover, forward FCF/EV is around 4.6% and I don’t think that is cheap for a low growth food company, especially as I am a bit skeptical about any company looking to take pricing to the US consumer right now.

That said yield chasers will like the stock and the relative stability of its earnings and this type of stock is in fashion. The stock does deserve a premium due to its excellent management and it wouldn’t surprise me to see it go higher but as a GARP based investor, I am going to take a pass