Shares of the narrow-moat firm look rich today, and we suggest investors wait before building a position.
By Erin Lash, CFA | 08-04-17 | 08:00 AM | Email Article

Since the  Kraft Heinz  merger two years ago, investors' focus has centered on the significant potential for operating margin expansion, which by all accounts has been impressive (up 50 basis points in the second quarter to 29.4%, a level that towers above the mid- to high teens generated by its packaged-food peers). However, we’ve long thought this stringent eye on cost management was only half of the equation, and progress generating even modest top-line gains has continued to prove elusive; organic sales slipped 0.9% in the quarter (on top of a weak year-ago quarter, during which sales ticked down 0.5%), reflecting 0.4% lower prices and a 0.5% negative hit from decreased volumes and unfavorable mix.

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

As such, we haven’t wavered from our stance that amid an intensely competitive landscape, and with the need to invest behind its brands to bolster top-line performance, the firm’s margin trajectory could be constrained in the longer term. Further, we surmise commodity cost inflation headwinds (which management called out as pronounced within cheese and coffee to the tune of $80 million in the quarter) are also poised to eat into profits. While Kraft Heinz has paid lip service on the need to up investments behind its brands, we have yet to see evidence that it is willing to sacrifice margin improvement to do so. Beyond potentially aiding its top-line prospects, we also believe effective spending behind research and development, or R&D, and marketing could enhance the stickiness of Kraft Heinz's retailer relationships, and subsequently strengthen an aspect of the intangible asset source behind its narrow moat.

With the firm’s first-half results generally aligning with our full-year expectations (for 0.5% reported sales growth and high-20s operating margins), we see little impetus for change to our $70 fair value estimate, but with shares trading at nearly a 25% premium to our valuation, we’d suggest investors refrain from building a position at such lofty levels.

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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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