Kraft Heinz Has the Right Recipe for Growth

10/2/17

Large-cap food stocks are not known for their growth, but the top line performance for some of the biggest food companies has been disappointing. Consumers increasingly demand natural foods, and retailers are cutting prices to remain competitive, which in turn puts pressure on food brands to reduce their prices to accommodate the biggest grocers like Wal-Mart.

The Kraft Heinz Company (NASDAQ:KHC) has been no exception. In the second quarter, Kraft Heinz continued its struggle to grow revenue with sales declining 1.7%. Excluding the negative impact of currency fluctuation, sales still declined 0.9%. On the bright side, that decline narrowed from the first quarter to the second, from both a better sales mix and the benefits of recent holidays that boosted in-store activity.

Kraft Heinz corporate logo with Kraft written in blue and Heinz in red.

IMAGE SOURCE: KRAFT HEINZ.

Sales growth: weak but expected to improve

Despite the weak showing, Kraft is seeing consumption gains in important categories. Frozen-food, which makes up less than 10% of total net sales, saw strong growth after years of decline, driven by the launch of Devour and SmartMade brands. Other products like frozen snacks, Kraft Singles American cheese, Philadelphia Cream Cheese, and Oscar Mayer bacon are performing well, too.

Given the strength of some of these larger brands, management expects to see growth pick up as we move into the second half of the year. Behind the scenes, initiatives are underway to make this happen, including international expansion. At the time of the merger with Heinz, Kraft had 98% penetration in North American households, which means much of its future growth would be overseas. Currently, management is focused on increasing investment in its distribution capabilities in order to expand in Mexico and South America.

Strong growth on the bottom line

While stronger sales have been tough to come by, earnings performance has come much easier for Kraft Heinz since the 2015 merger. Investment firm 3G Capital -- which owns about a quarterof the company -- has followed its typical playbook of cutting costs. That boosted earnings per share 52% in 2016 (excluding costs associated with the merger). Through the first six months of 2017, adjusted earnings grew another 15% year over year.

Investors should continue to expect strong earnings growth. Management has cut $1.45 billion of costs since the 2015 merger, with plans to cut an additional $250 million by the end of 2017. For perspective, adjusted net income for 2016 was $4 billion, which means the company would be only about half as profitable without the cuts.

However, weak performance on the top line continues to weigh on the stock. Cost cutting will only get you so far, and at some point, a company has to show sustainable sales growth to drive long-term stock price gains for shareholders.

Long-term growth strategy

The second quarter actually served as a microcosm of Kraft Heinz's big picture growth strategy. Management is relying heavily on innovation and marketing, but given the industry slump from promotional activity and changing consumer tastes, investors will have to follow management's lead and be patient for the time being.

In the meantime, the company is using the extra profit from cost savings to reinvest in the company's growth objectives, especially international expansion. Kraft Heinz also paid off $2 billion of debt during the quarter and announced a 4.2% increase in the quarterly dividend.

For the third and fourth quarter, management expects better in-store execution, quality marketing, and price increases to drive stronger sales growth. That's also a preview of the company's long-term growth strategy in a nutshell.

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