Long-term investors should hold off on this narrow-moat name for now.
By Erin Lash, CFA | 11-04-16 | 08:00 AM | Email Article

While  Kraft Heinz  again reported stellar profitability (with adjusted operating margins expanding 660 basis points to 26.9%), the firm’s top line remains muted, as organic sales slipped 1% in the quarter (reflecting 0.7% lower prices and a 0.3% negative hit from volume declines and unfavorable mix). We haven’t wavered from our stance that Kraft Heinz will propel margin gains in the longer term through workforce reductions, the rationalization of its North American manufacturing network, and enhancements to its supply chain. Our forecast calls for the firm to modestly exceed its initial $1.5 billion target by around $250 million by fiscal 2018.

Erin Lash, CFA, is a director of consumer sector equity research for Morningstar.

However, given lagging sales momentum, we maintain that further reinvestment behind its brands will be necessary to reignite its positive sales trajectory. In that vein, our forecast calls for marketing to tick up to 4.1% of sales on average over the next 10 years (versus 2.5% in fiscal 2015) and R&D to approximate 1.0% of sales (about $370 million each year, or about 40 basis points above fiscal 2015). Management’s rhetoric seems to support our stance on the importance of brand investments, as the firm alluded to the need to step up brand spend to offset intense competitive pressures (which in the quarter were concentrated in packaged meats, roast and ground coffee, and nuts).

These factors drive our expectations for 3% annual sales growth and mid-20s operating margins over our 10-year forecast--about 500 basis points above the 21.5% generated in fiscal 2015 and in excess of the mid- to high teens peers boast, but more muted than the market's 30% consensus estimate. We intend to review our near-term assumptions, but we don't anticipate a material change to our $69 fair value estimate outside of the time value of money. Trading at nearly a 25% premium to our valuation, we view shares as inflated at 24 times fiscal 2017 earnings, and we suggest long-term investors refrain from building a position in this narrow-moat name.

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Erin Lash, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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