Nuevo artículo a propósito de KHC, hablando acerca de cómo se puede evitar entrar en empresas que luego den problemas:
The KHC dividend cut caught a lot of people by surprise.
Did the business take an unpredictable turn for the worse, or could we have seen this coming?
I have never considered Kraft (KHC) as “investable” by my standards, as the Baa3 credit rating falls well short of my nominal minimum. I am not a fan of serial acquisitions, as they make it very difficult to get a handle on the financials, and I like to see a solid ten-year history for a company before investing. But what if I had looked? What would I have seen? What were the shareholders of KHC looking at – and perhaps ignoring – when they looked at the financial statements? Let me pull up Morningstar (through my library’s subscription) and see what it shows…
Income Statement
My assessment of a company’s financial situation typically begins with the Income Statement, as that helps to put the rest into context. Revenue is critical. Is a company growing or shrinking? Have there been any major acquisitions? In the case of KHC, it shows just an eight-year history. The first six of these show essentially flat revenue. That jumps to a new level in 2016, which again continues flat through to the present. It is simple enough to deduce that there must have been a major acquisition closed in 2015 – and in fact that is when the Kraft/Heinz merger closed. (It isn’t clear to me why the reported 2015 numbers appear similar to the 2014 numbers. Perhaps the reporting was not merged until the following year, so 2015 shows only Kraft?)
A quick hop over to the Key Ratios page shows that operating margins jumped with the merger, from a prior level in the teens to the low 20s. I can see why that would be encouraging for investors, though a not-quite-three-year history is a bit short for my tastes. Given the magnitude of the transformation, anything prior to 2016 is likely not relevant to the new business.
Moreover, there is no evidence of top-line growth from 2016 to the TTM. Nor has Operating Income improved over that span, going from $6.1B to $6.8B to $6.0B. Net income was impacted by a tax-reform adjustment of $6.7B in the fourth quarter of 2017, which also gets included in the TTM column, but once you back that out there is no meaningful growth in Net Income either. Nor does EBITDA (which is not impacted by the corporate tax reform) show any improvement, going from $7.5B to $7.8B to $6.7B.
It is hard to reach any kind of sensible conclusion from just a three year history! When looking at a number is it a one-time blip in the trend? Or is a slight dip a harbinger of things to come? You can hash and rehash these same three columns forever and still not be able to forecast the future with any kind of confidence. In its present form, KHC is simply too young to have a proven track record. The lack of top-line growth is mildly concerning, but not unusual in this sector over this period of time.
It is tricky to estimate the payout ratio. Morningstar calculates one, but it appears to be in error (I cannot figure out how they reached the number they did). If I back out the impact on earnings for tax reform, I estimate perhaps $2.75 per share, which suggests a “stretched” payout ratio of over 90%, but not immediately concerning – if the earnings grow from there.
Conclusions from the Income Statement: Limited/no growth, possibly slow revenue declines, and earnings that are barely enough to cover the dividend. I would not see it as an attractive investment based on these qualities, but the numbers do not signal imminent disaster.
Balance Sheet
I prefer to look at the Quarterly Balance Sheet report, and mostly focus on debt trends. Looking at the ten-quarter history, I see that debt declined slightly from $30B in 06-2016 to $28B in 12-2017, but then increased to $31B last quarter. Always concerning to see the debt tick up for a heavily indebted company, but it wasn’t a huge bump or an extended trend. Sometimes liabilities shift from one line to another, and the Total Liabilities line has shown a steady decrease from $64B to $54B over ten quarters.
The debt ratio is potentially an issue. First, the LT debt of $31B is only 2/3 of the total liabilities. There is a huge “deferred taxes liability” as well. But forget that. I’m never sure what to make of deferred taxes anyways. The TTM EBITDA (which is not affected by the tax change) shows as $6.7B, for a debt ratio of just under 4.5x. Anything over 4 is scary-high, and I would need a high degree of confidence in the direction of the company to invest at these levels. It is concerning that the company seems willing to carry debt at this level without paying it down more aggressively.
Conclusions from the Balance Sheet: Heavily leveraged, but that merely confirms and reinforces the BBB- credit rating. It isn’t really anything that I needed to sleuth the financial statements to figure out.
Cash Flow Statement
For many businesses, my look at the cash flow statement is pretty perfunctory. I want to make sure that Operating Cash Flow is sufficient to meet all the basic demands on it – Capital Expenses, Dividends, and Share Buybacks. A single-year shortfall is not a problem, but it is concerning if the OCF regularly falls short.
Morningstar calculates $5.2B of operating cash flow in 2016, $0.5B in 2017, and $1.4B over the TTM. Since the last two overlap, it is also important to look at the quarterly breakdown – however the 4Q17 does not stand out.
It is not at all clear to me how a company that is reporting $6B/year in operating income can somehow show just ~$7B over THREE years in cash from operations. I guess there has been a large build in Accounts Receivable and Inventory, as well as other changes in “working capital”? I might have picked that off the Balance Sheet, if I looked closely, but did not notice it until I looked at the reported cash flow!
Capital Expenditures are the first demand on the cash flow. They can be managed by the company, to a degree, but declining investment can be a bad sign (unless there is a very good reason why a company requires less investment than in previous years). CapEx from 2016 onward has been trending lower, from $1.2B in 2016-2017 to $855M over the TTM. It is concerning that despite this decrease, CapEx over the last seven quarters has exceeded OCF, $1.8B to $1.4B. That would not seem to leave ANY cash for other purposes.
The Cash Flow Statement also shows the dividend payments, a current run rate of $762M/quarter or $3.0B/year. While the free cash flow in 2015 was barely sufficient to cover the 2015 dividend, the negative cash flow since was clearly inadequate to the need.
Conclusions from the Cash Flow Statement: There is something badly wrong with the business, as it has struggled for seven quarters to generate consistent cash flow. Cash generation is barely sufficient to cover capital expenditures. It is not clear that the business is generating enough cash at this time to support any dividend at all.
Conclusions
It is hard to formulate an investment thesis for a business with a track record (in its present form) that is just three years old. I like to see stability and consistency, as that gives me confidence in future earnings. The Income Statement from KHC is too volatile and too brief to support that degree of confidence. The quarterly results might offer a little greater insight, but the decline in Operating Income from ~$1.6B/quarter in 2016 to $1.3B in 2Q18 and $1.1B in 3Q18 should give pause – if anybody took a careful look at the quarterly trend.
The leveraged balance sheet is more obvious. In fact you could guess at that simply by looking at the credit rating. It is always debatable how much debt a business can support, but LT Debt/EBITDA over 4.0 is considered dangerous, and a business that skates along at that level is risky. That is what the BBB or Baa3 credit ratings tell us. I might be willing to invest in a business with a low credit rating, but I would need a very high degree of confidence in its outlook.
But it is the Cash Flow statement that raises the most red flags. I’m not enough of an accountant to reconcile the respectable reported Operating Income with the weak/non-existent cash flows. But recognizing that I lack this expertise, I want to see BOTH the Income Statement AND the Cash Flow Statement supporting my confidence in the business. In this case the cash flow is clearly insufficient.
Now yes, this is hindsight in that I’m looking at past numbers and pretending that I didn’t have an inkling of what was to come. I previously never took more than a superficial look at the credit rating (unacceptably low) and Debt/EBITDA (unacceptably high). It is not a business I already owned, and given the obvious weakness it was not one that I cared to research in any detail. I prefer to spend my time researching quality companies that I might want to own!
But when a company with zero top-line growth has fallen well short of being able to cover the dividend out of OCF (let alone FCF) over the past two years, and only barely covered it the year prior, then it is hardly a surprise when the dividend is cut! I would presume that shareholders periodically review the financials of the companies that they own? I admittedly don’t look carefully at all of my holdings every quarter, but I take a close look at any that are showing marginal credit or deteriorating earnings quality. I do not believe that KHC should have passed such an inspection.
Looking Ahead
For those considering holding on to KHC, or considering a speculative buy to take advantage of a rebound, I would raise three concerns.
First, the dividend was cut by 36%. If I take the former $3.0B annual dividend obligation and reduce it by 36%, I get a $1.9B dividend obligation. While the cash flow statement for the latest quarter has not yet been released, as far as I know, the average FCF over the last three years has been $1.28B. Unless they find a way to dramatically increase the FCF, I don’t think they can afford the current dividend rate either. Thus a second dividend cut (likely eliminating it entirely) could be in the cards. And that could be the best thing for the business.
Second, while the Intangibles/Goodwill writedown did not affect the actual operations of the company, it does weaken the asset book. S&P has already indicated that it will consider downgrading KHC from its current BBB rating. KHC cannot afford downgrades, and thus would be well advised to take steps to repair the credit rating. That can include elimination of the dividend (freeing up cash to work off the debt more quickly) or an equity raise (diluting current shareholders and likely also resulting in a dividend cut).
Third, the weakness in cash flow is shocking. Before investing in the company, I would need to understand why their reported cash flow over the last seven quarters is so much weaker than the reported income.
The immediate default for an investor should be “do nothing”. Under most circumstances, you are better off allowing a situation to develop before acting. You are less likely to miss a great opportunity than you are to miss making a bad mistake. But competing with this is the “show me” principle. If you cannot confidently project stable and growing revenues, earnings, and cash flow, then it is very hard to justify investing in a company. A retreat in a recession is expected. A collapse during a period of economic expansion is a surprise.
I will refrain from making specific recommendations, but would encourage any KHC shareholder or anybody considering an investment in KHC to find their own answers to the three questions raised. It is entirely possible that you will find solid answers that my limited research has not turned up. Read the transcript of the conference call (or better yet, listen to the recording). Review the SEC filings whenever they are released. Consider the direction that management lays out. Is that sufficient to answer these concerns?
Still, I expect we will be fine. I actually lean optimistic in this kind of stuff.
Enjoy!"