Saturday, December 22, 2012

Heinz Not Looking That Impressive

H.J.Heinz (NYSE: HNZ) delivered a pretty solid quarter, but I have my doubts. In the short term, its relatively high and stable dividend yield seems to be the main attraction of the stock. The longer term underlying story with Heinz is how emerging market growth and favorable movements in tax revenues are generating the income to enable it to invest in growth elsewhere.

If I’m right in my argument then Heinz’s shareholders must consist of some unusual bedfellows. There are the usual yield chasers looking for the stability of the food sector, and then there are those who believe in the long term story. Considering that investors can get that yield elsewhere, it is more interesting to focus on the growth numbers in the report and how they came about.

Heinz’s Recent Results

The results reflect the good work that its management has been doing in a difficult environment. Strategically, it is not at all dissimilar to what its rival Campbell Soup (NYSE: CPB) is trying to do. Campbell is trying to keep a ‘holding pattern’ in the US while aiming for emerging market growth and trying to squeeze anything it can out of positive growth categories like snacks.

Turning back to Heinz, most analysts liked the results, but I think the results are not good as they may initially seem.

Overall organic growth was a respectable 3.3%, while emerging markets delivered 13.2% organic growth. As ever, the movement in income by segment reveals a lot.

Overall segmental operating income was down $1.5 million, however the reported operating income was up $35.5 million. The difference was largely made up of a $37.3 million charge taken for a productivity initiative last year. In fact, the only positive comparisons came from Asia/Pacific and the US Foodservice segments.

North American Consumer Products income took a hit despite revenues being essentially flat, thanks to marketing expenses being up double digits. There was some positive commentary over marketing investment in the likes of ketchup, snacks and Hispanic advertising, but the results speak for themselves. The strategy seems to be to chase volume growth at the expense of margins. This is fine if the economy improves, and Heinz is able to take pricing in the future on that retained volume; but it's not so good if consumers continue their tendency to want to trade down.

In addition, Heinz faces difficulties because of the type of shopping that consumers are doing these days. While the recent results from discounters like Dollar Tree have indicated a slowing of same store sales growth, I think this is largely a consequence of the amount of competition among discounters (they have all expanded store numbers aggressively) and the traditional retailers reacting to encroachment on their market share. My point is that Heinz is still going to be challenged, because consumers continue to migrate away from its traditional sales channels and/or seek out private label alternatives.

The US Foodservice segment did well and it appears that the productivity initiatives were well spent in getting this segment back on track. In fact, its increase in operating income of $9.3 million wasn’t far away from Asia/Pacific’s $9.7 million (the only two in positive territory). Nevertheless, it is not a large part of profits, and comparisons will get harder going forward.

As for Asia/Pacific, growth looks strong and management seems to be focusing attention on this region, but I have some concerns here too. Much of Heinz’s growth in emerging markets was believed to have come from infant/nutrition, and when a company like Mead Johnson (NYSE: MJN) warns of increasing competition amidst heavy promotions in the Far East and Heinz reports a 5.4% drop in revenues, it’s hard not to conclude things will get tougher.  Indeed, Johnson & Johnson (NYSE: JNJ) reported lackluster results in the US and is subject to increasing competition there too. This is somewhat worrying for Heinz because it implies that Danone and others will chase growth in China very aggressively, and we can expect Mead Johnson to fight back too.

Europe’s consumer difficulties are well known, but fortunately Heinz is relatively insulated thanks to its remarkable popularity in the UK. All of which is fine, but I think the European mass market is a tough place to be in right now. US investors need to understand that it was Germany that led the ‘movement’ towards shopping in discount stores. In other words, don’t expect any respite from the trend towards increasing value awareness.

Where Next for Heinz?

As discussed above, if you add back the $37.3 million charge last year then operating income actually fell by $3.75 million. Moreover, a lower tax charge of $31 million vs. $53 million last year helped attributable net income rise by 22%. Heinz’s management has done very well to get the tax charge lower, and it affirmed that it was confident over the issue for the next six quarters; but frankly, many of these things are decided by political considerations, so it’s hard to rely on this low level in say, a discounted cash flow analysis.

My point is that a few moving parts have created a very positive optic in these results. Some unfavorable tax movements in the future, plus more competition (likely) in infant/nutrition and a continuation of the ongoing ‘mass consumer’ spending malaise, and Heinz could very easily report negative numbers.  In addition, analysts are only forecasting single digit growth for the next couple of years, but the market is asking you to pay 19.4x earnings and an EV/EBITDA multiple of 11+.

On a more positive note, the management is doing a great job in difficult conditions. The turnaround in foodservice is evident, and emerging market growth prospects look good with the lower tax rate giving them time to continue investing in higher growth areas.

I think the rating is too rich, but the market wants yield right now, so don’t be surprised if it goes higher. However, for a GARP based investor like me this stock has few attractions.

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