Kraft Heinz Takes Action to Reduce Leverage, Improving Dividend Safety Profile

Kraft Heinz hosted its annual investor day on September 15 and announced several actions that improve the firm's dividend safety outlook.

Therefore, we are upgrading Kraft Heinz's Dividend Safety Score from Unsafe to Borderline Safe.

The packaged food maker previously cut its dividend in February 2019, but its smaller payout continued looking speculative due to the firm's debt-saddled balance sheet and declining sales.

In February 2020, Standard & Poor's even downgraded Kraft Heinz's credit rating to junk (BB+), citing the company's "unwillingness to cut its high payout dividend at a time that leverage is elevated because of underperformance."

However, a lot has changed in the last six months to put Kraft Heinz's payout on somewhat stronger ground.

First, the coronavirus pandemic has boosted the short-term prospects of many packaged food companies as consumers stockpiled groceries.

In each quarter of 2019, Kraft Heinz's organic sales declined at a low single-digit rate. But organic sales increased around 7% through the first half of 2020, with mid-single-digit growth expected to continue in the third quarter.

Increased at-home food consumption is a rising tide that has lifted all boats, though Kraft Heinz's performance still trails the organic growth rates achieved last quarter by peers such as Kellogg (+9%), Campbell Soup (+12%), and General Mills (+16%).

Regardless, this tailwind has increased the amount of cash flow Kraft Heinz retains after paying dividends that can go towards restoring its balance sheet.

Thanks in part to favorable working capital fluctuations and lower capital spending, the company's free cash flow in the first half of the year totaled nearly $2 billion, more than doubling compared to 2019.

Kraft Heinz's dividend cost about $1 billion during that period, resulting in discretionary cash flow of roughly $1 billion.

Management in February expected full-year discretionary cash flow of "at least" $500 million, so Kraft Heinz has performed well ahead of expectations.

In addition to this increased financial flexibility, management announced a $3.2 billion deal to divest some of its lower-margin cheese businesses, which accounted for about 7% of sales and 4% of EBITDA.

Management expects to use the post-tax proceeds from this sale to pay down some of the firm's $28 billion debt load once the transaction closes (expected sometime in the first half of 2021).

Once this occurs, we estimate that Kraft Heinz's net leverage ratio, as measured by the company and ratings agencies, will fall below 4x.

That's an important level since Standard & Poor's had looked for leverage to remain below 4x to keep their BBB- investment-grade rating on the company. This divestiture will likely be viewed as a credit positive event.

Besides pandemic-related cash flow improvement and a divestiture to accelerate its pace of deleveraging, Kraft Heinz plans to take $2 billion of procurement and manufacturing costs out of the business by 2024.

While excessive cost cutting got the company into trouble in the years following the merger of Kraft and Heinz in 2015, the firm's relatively new leadership team promises not to repeat mistakes of the past.

For example, some of these savings will be used to increase marketing and advertising spend by 30%. The rest will mostly help combat inflation rather than attempt to boost margins.

Kraft Heinz has also reorganized its brand portfolio into six platforms compared to its prior structure of more than 55 separate product categories. Management hopes this new structure will improve Kraft Heinz's innovation and ability to take advantage of its scale.

However, it remains to be seen how well the company's results will fare in a post-pandemic world when more consumers return to restaurants and continue increasing engagement with cheaper store brands, as well as healthier and fresher offerings.

Simply put, Kraft Heinz continues facing an uphill battle to breathe new life into some of its aging brands, such as Oscar Mayer and Cool Whip.

Warren Buffett, who helped put together the Kraft-Heinz merger, summarized the challenge well during a February 2019 interview with CNBC. 

He said he "was wrong in a couple of ways about Kraft Heinz" and ultimately overpaid for the business as its pricing power deteriorated unexpectedly: 

In recognition of this new normal, Kraft Heinz on September 15 released a new set of more modest long-term growth targets, including 1-2% organic sales growth and 4-6% EPS growth. 

Shareholders shouldn't expect any dividend increases until the balance sheet and overall business performance have improved, though they can likely continue banking on the payout for now. 

Management continues emphasizing their commitment to sustaining the current dividend, but investors have to decide if they still believe in Kraft Heinz's brands and ability to maintain momentum after at-home food demand normalizes.