Heinz's Growth Doesn't Seem To Merit This Kind Of Premium

By Stephen D. Simpson, CFA | May 24, 2012 AAA

There's quite a lot to like about Heinz (NYSE:HNZ). No other company really comes close to matching their U.S. share in condiments like ketchup or Worcestershire sauce, and the company has enviable exposure to faster-growing emerging markets. That said, the company's North American growth really isn't that much better than its peer group and earnings are going to be pressured by increased spending to grow the emerging market businesses. With that in mind, paying a premium for Heinz's stock today seems like a bad move.

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Q4 Comes Up Short
Heinz closed the year on something of a downer. While the company did see organic sales growth of more than 4% (including 1.5% volume growth), this result was still a little shy of estimates. The North American consumer business was soft (with volume down nearly 2%), and that appeared to drive most of the miss. More encouragingly, emerging market organic revenue growth was a strong 17%.

Cost inflation continues to be a problem for the company. As is the case for other food companies like General Mills (NYSE:GIS) and Kraft (NYSE:KFT), there's only so far the company can go on price before the fall off in volume makes it not worthwhile.

Adjusted gross margin fell about 150bp, and largely drove the company's operating income miss vis-a-vis sell-side estimates. Adjusted operating income rose just 4% this quarter, though management did a respectable job of controlling SG&A.

SEE: Understanding The Income Statement

Frozen Foods Needs Fixing
Heinz has been having some meaningful issues in its frozen food business, and some of it can be tied to company execution. To be fair, though, many companies are having challenges in this broad category. According to Nielsen data, ConAgra (NYSE:CAG) and Nestle (OTCBB:NSRGY.PK) have both been seeing meaningful declines in volume (tied, it seems, to hefty pricing actions).

Heinz announced a few months ago that it would be discontinuing the TGI Friday's line of entrees and refocusing that brand around snacks. Now it looks as though the frozen potatoes (Ore-Ida) business needs some TLC as well.

Infant Nutrition - In or Out?
It was not a major surprise that Heinz failed to win the bidding for Pfizer's (NYSE:PFE) infant nutrition business; Nestle was pretty clearly willing to pay whatever it took, and Heinz was not going to compete with that. It does raise the question, though, of whether this is a business that Heinz should build or sell.

Heinz's infant nutrition business is solid in China (an area where Nestle's weakness likely prompted the high bid for Pfizer's division), but the company has had challenges growing the business in other markets and the margins seem to be below peer levels. Now, I still happen to think that there is above-average growth and margin potential in this business, and particularly so in the emerging markets. Nevertheless, it seems fair to at least ask the question if the company would be better served selling this business to Danone or Mead Johnson (NYSE:MJN) and reinvesting the proceeds in its overall emerging market expansion strategy.

SEE: Earning Forecasts: A Primer

The Bottom Line
It was disappointing to see management reduce its long-term growth estimate, though the Street seemed relatively more comfortable with the idea of spending a little more in the short term (and reducing earnings) to invest more in the emerging markets businesses and boost their long-term potential.

I don't see why Heinz should enjoy a premium valuation today. The company has solid historical returns on capital, but not spectacular returns. Likewise, while I do like the company's non-U.S. exposure and growth potential, I don't think that potential is so large that these shares deserve a premium valuation.

SEE: 5 Must-Have Metrics For Value Investors

Heinz is not the only apparently over-priced food company out there, but with shoppers increasingly choosing private label brands to save money, I don't want to pay that premium. I see fair value in the low $50s and would not be an enthusiastic buyer of Heinz shares today.

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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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