This article originally appears on The Motley Fool, written by Jeremy Bowman.
The coronavirus pandemic has been a blessing for struggling packaged food companies.
Consumers rushed to supermarkets to stock up on canned goods and comfort foods like Kraft Mac & Cheese and Campbell's Soup to get them through the lockdowns, driving bumper profits at some of these consumer staples companies. However, investors may want to look at the long-term prospects of such companies before investing. One that still comes up short is Kraft Heinz (NASDAQ:KHC).
As you can see from the chart below, Kraft Heinz stock is roughly flat for the year, with returns similar to the S&P 500. But the chart is deceiving when it comes to Kraft Heinz's pandemic-era performance.
Kraft Heinz shares had already fallen significantly in February before the pandemic hit, as shares tumbled after a fourth-quarter report showed revenue and profits declining. The company took a $666 million writedown on its Maxwell House brand, which followed a $15.4 billion writedown on the Kraft and Oscar Mayer brands the year before.
Looking at Kraft Heinz's performance since Feb. 21, the day before the market started to crash on pandemic fears, you can see that it has outperformed the S&P 500 by a wide margin.
You might expect a consumer staples company like the ketchup-maker to outperform during a crisis since such stocks are generally recession-proof. But Kraft Heinz has beaten the broad market even during the recovery. Results have been solid as organic sales, which strip out the impact of acquisitions, divestitures, and foreign currency, jumped 6.2% in the first quarter, driven by consumers' stocking-up. The company was targeting a low- to mid-single-digit organic sales increase in the second quarter.
While the recent tailwinds might make the stock appealing, there are a number of reasons Kraft Heinz is best avoided.
The pandemic was a black swan event. It was impossible to see it coming in 2019, and it has upended the world in a way that few could have imagined. The rush to stock up on non-perishables was a boon to Kraft Heinz, but consumers are likely to tire of eating Mac & Cheese and other such foods or just home cooking in general. Restaurant takeout and delivery from places like Domino's (NYSE: DPZ) soared in April and May, as consumers tired of cooking and worked through their stockpile. In other words, the boon in the first half of the year was a one-time thing.
Over the longer term, Kraft Heinz is fighting against broader food trends. These include a shift toward organic foods and away from processed foods, private label brands taking market share, and more wallet share going to restaurants rather than stores. The company's premium brands could also suffer during the recession as consumers look to cut back on spending.
Unlike many of its peers, Kraft Heinz has been focused on cost-cutting rather than acquiring growth brands, following the 2015 merger of Kraft and Heinz. Other packaged food companies have recognized the headwinds against legacy brands and are diversifying to younger brands in order to continue growing. Cheerios maker General Mills has bought organic foods brand Annie's and pet food brand Blue Buffalo. Coca-Cola made a deal with cafe chain Costa Coffee and Pepsico acquired SodaStream. Kellogg acquired RXBar, and Campbell's bought organic soup brand Pacific Foods. The list goes on.
Despite being one of the largest packaged food companies in the world, Kraft Heinz has made no such significant moves. Instead, it's been forced to take impairments on billions of dollars of brand value, and has struggled to sell smaller brands to free up capital to potentially buy brands like the ones above.
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In a deal-focused industry like packaged foods, it helps to have a strong balance sheet to allow for opportunistic acquisitions and steady cash returns, even when times get tough. Kraft Heinz's balance sheet has been anything but. The food company was forced to slash its dividend by 36% last year as profits narrowed and it couldn't support the quarterly payout. At the end of the first quarter this year, the company had $32.8 billion in debt and $5.4 billion in cash equivalents after tapping a $4 billion credit facility. Last year, the company paid $1.4 billion in interest, equal to about half of its free cash flow, meaning interest expense is already putting a significant dent in profits.
The asset side of Kraft Heinz's balance sheet isn't too impressive either. Underpinning that debt is mostly intangible assets like goodwill and brand names, which recent history has shown aren't as valuable as the company may believe. Of the $104.1 billion in assets it had at the end of the quarter, $83.3 billion was in intangible assets. The company took another $226 million goodwill impairment in the first quarter.
With a large debt burden and more potential impairments coming up, both Kraft Heinz's financial results and its ability to make acquisitions and investments in key areas like marketing and innovation will be negatively impacted.
Value investors may argue that Kraft Heinz is worth buying, but at a P/E of 13 based on this year's expected earnings, the stock doesn't look cheap enough for its prospects, even if its 5% dividend yield might lure some income-seekers.
2021's results will almost surely be worse than this year's, as the company will no longer have the tailwind from the pandemic. And a vaccine or other clear end to the crisis is sure to unleash a wave of pent-up demand for restaurant food, likely taking sales away from Kraft Heinz.
Meanwhile, the company's portfolio of brands like Jell-O and Cool Whip seems vulnerable to more writedowns, and its debt could pose a serious problem down the road if the company can't grow sustainably.
Given all these question marks, I'm still taking a hard pass on Kraft Heinz. You should too.
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MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above Read our full disclosure policy here.
Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool recommends Domino's Pizza. The Motley Fool has a disclosure policy.
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