Kraft Plunges With Analysts Wondering If Higher Spending Is the New Norm

(Bloomberg) -- Kraft Heinz Co. sank 10 percent as the market opened, on track for its biggest drop since the two companies merged in 2015. Analysts honed in on management's comment that higher investments in the third quarter were largely one-time in nature. Bulls are buying it, while those with lesser ratings prefer to make Kraft prove itself. Another concern raised by some analysts is that as Kraft's equity value declines and its debt-to-Ebitda leverage ratio expands, transformative M&A may be further away than many had hoped.

Here's what Wall Street analysts are saying:

Morgan Stanley, Dara Mohsenian

Rates underweight, price target to $49 from $52

Kraft's "growth-challenged U.S. end markets, coupled with limited margin expansion potential post large-deal synergy realization, creates downside risk to consensus." Meanwhile, Kraft's rising leverage ratio and "a less valuable equity currency" limit its ability to "drive value via M&A."

While the company pointed to one-time items as the driving force behind the weak third-quarter profit, Mohsenian retains his "cautious profit outlook and forecasts flat Ebitda growth in FY19, noting a litany of guidance misses in the food sector recently."

The 3.5 percent volume growth is "encouraging," but he's worried that the cost of growth will "remain higher than the market expects, with greater investment spending and lower price realization necessary to sustain volume momentum." In fact, the U.S. segment saw a "striking deceleration" in pricing to negative 2.0 percent from up 0.6 percent in the first half of 2018, he said.

Goldman Sachs, Jason English

Rates neutral, price target to $55 from $64

Many of Kraft's "problems are idiosyncratic." Over the past year, a combination of elevated inflation, limited pricing power (an industry-wide issue), and execution challenges have led to Kraft falling short of consensus estimates.

"Its prior supply chain issues on frozen potatoes and sliced lunch meat are now largely behind it, but this quarter the company disclosed new service level headwinds combined with delayed productivity initiatives and supply chain transition challenges in the Middle East." These issues are resulting in margin compression "as its best-in-class margin profile falls closer to the industry average."

Kraft "has pivoted from a top-line oriented show-me story to a margin oriented show-me story," and for now, consensus estimates "are too high."

Stifel, Christopher Growe

Rates buy, price target to $72 from $85

"Another mixed-bag performance" from Kraft this quarter, highlighted by "much stronger sales growth momentum but a much weaker EBITDA performance."

"After heavy investments (marketing/promotion), new product activity, lapping some unique items, and a few false starts, the business finally started to perform (on the top-line) up to its potential. However, a host of unique factors converged in the third quarter to really weigh on Ebitda growth."

That said, the negative factors aren't expected to weigh on fourth-quarter profitability, and Growe expects the strong revenue growth seen in third quarter to continue.

"The stronger sales momentum and Ebitda outlook should limit the downside potential for the shares."

RBC Capital, David Palmer

Rates outperform, price target to $68 from $73

While Kraft's "solid" third-quarter volume/mix growth of 3.5 percent globally (3.8 percent in the U.S.) may prove to be "the best among large cap food names" this quarter, the roughly $100 million Ebitda shortfall "left some ambiguity about the quality/sustainability" of the
volume/mix growth.

Palmer expects "a sustainable turn" in results in the fourth quarter "as revenue growth is accompanied by Ebitda growth," with profit growth supported by: the fading impact of expensive spot trucking expense; more comparable bonus accrual; slower growth in commercial investments and marketing; diminishing supply chain expense in Europe; and easy first-half comparisons from capacity constraints or exited businesses.

Susquehanna, Pablo Zuanic

Downgraded stock to negative from neutral and cut price target to $47 from $59. A further P/E derating and downward earnings revisions are likely amid "limited visibility."

"While KHC spoke of ‘one-offs' in 3Q, the increased spending after two years of steep cost cuts may be mostly about catching up."

Kraft Heinz is valued "at the bottom of the large-cap food group given the nature of the portfolio, and shaken confidence in management," the analyst writes in a research note.

Furthermore, Zuanic doesn't think another M&A deal is very likely in the near or medium term amid "continued questions about the state of the relationship between 3G and
Warren Buffett," Anheuser-Busch's "own travails," and its high net debt-to-Ebitda ratio.

Bloomberg Intelligence, Kenneth Shea

"Stepped-up investments in 2018 through 3Q, emphasizing marketing capabilities and new-product innovation to boost sales, should stimulate modest growth into 2019."

"Heavy investment spending, though, which is exacerbated by pockets of input inflation, including logistics, may keep pressuring near-term operating margin."

To contact the reporter on this story: Janet Freund in New York at jfreund11@bloomberg.net

To contact the editors responsible for this story: Catherine Larkin at clarkin4@bloomberg.net, Steven Fromm

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