Costs Keep The Squeeze On Heinz

By Stephen D. Simpson, CFA | February 22, 2012 AAA

There are good companies and good stocks and they don't always (or even necessarily often) go together. While the pressures affecting HJ Heinz (NYSE:HNZ) today do not diminish it as a quality food company over the long-term, they do create near-term issues of value and momentum. Unless and until Heinz can prove that it can better surmount cost inflation, these shares remain a stretch on valuation.
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Third Quarter Results Not as Good as They Seem
Although Heinz beat on the top and bottom lines, the quality of the latter was not very good. Revenue rose more than 7% this quarter and organic growth (volume + price) of more than 4% was legitimately good in the present environment. The top brands did even better (up 6% organically), while emerging markets continue to be a major growth driver.

Unfortunately, margins are a problem. Management revealed on the call that pricing and productivity actions recaptured only about half of the cost inflation it experienced for the quarter. Gross margin fell 140 basis points and missed most analysts' expectations. Likewise, operating income growth of just 4% was disappointing and the company's earnings beat was driven by a lower tax rate. (To know more about income statements, read Understanding The Income Statement.)

The Peak Margin Problem
For a couple of years now, bearish commentators have argued that American companies were enjoying peak margins and that profitability had to decline - compressing earnings growth with it. I don't believe that margins are ever static, but I do see the point that higher margins are getting harder and harder to attain.

In the case of Heinz, the company is seeing higher agricultural input prices (tomatoes, dairy, meats, etc.), higher packaging prices and so on. While it is true that Wal-Mart (NYSE:WMT) is a relatively smaller part of Heinz's sales than most retailers, the fact is that there's only so far a company can push on price before they go to competitors like ConAgra (NYSE:CAG), Nestle (OTCBB:NSRGY) or private label.

Similarly, productivity improvements can only go so far. Heinz has a geographically diverse manufacturing base and that puts certain limits on cost-cutting and consolidiation.

A Good Mix of Brand and Geography
That said, Heinz is a great company in many respects. Many of its products (ketchup, Worcestershire sauce, Ore-Ida, etc.) are leading brands and enjoy strong pricing. The company also benefits from licensing agreements with TGI Friday's and Weight Watchers (NYSE:WTW) that essentially give it free advertising.

Heinz is also more geographically diverse than most investors realize. Fully 20% of the company's sales come from emerging markets like China and Indonesia, and only Kraft (NYSE:KFT) exceeds Heinz's reach among American companies. With recent acquisitions like Quero in Brazil and Foodstar in China, these markets are even bigger growth drivers.

Heinz also has an infant nutrition business that is often forgotten or overlooked. Rumors are circulating that the company may bid for Pfizer's (NYSE:PFE) nutrition business (widely known to be for sale for around $9 billion to $10 billion). Although Heinz would have to take on quite a bit of debt to do this deal, it's a rare asset that Heinz may feel it cannot afford to let go to Danone (OTCBB:DANOY) or Nestle.

The Bottom Line
Heinz's margin issues lead to me assume a slightly lower free cash flow conversion rate, as I see no pressing reason to believe that food and packaging costs are going to abate anytime soon. As a result, I see Heinz producing low single-digit growth in free cash flow over the next decade. Fair value, then, seems to be somewhere in the low $50's - a little lower than today's price.

Although I would be in no great hurry to sell Heinz and pay capital gains tax, I likewise wouldn't rush to buy shares today. Heinz is, and almost certainly will remain, a very good company but the stock is not so compelling today. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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