Kraft Heinz Is A Reasonable Defensive Refuge (NASDAQ:KHC)

Kraft Heinz Company (NASDAQ:KHC) has bucked the overall market trends in 2022, with a total return of 16.4% for the YTD, as compared to 3.9% for the packaged food industry (as tracked by Morningstar) and -17.4% for the S&P 500 (SPY). Much of the outperformance is attributable to the broad rotation from growth to value (KHC is a value stock). The iShares S&P 500 Growth ETF (IVW) has returned -28.3% so far in 2022, as compared to -5.2% for the iShares S&P 500 Value ETF (IVE). Over the past 5 years, KHC has annualized return of -8.8% per year, markedly lower than the return from the packaged food industry (1.5% per year) and the S&P 500 (SPY, 9.5% per year). Growth outperformed value over the 5-year period (IVE: 7.4% per year, IVW: 10.3% per year).

12-Month price history and basic statistics for KHC (Source: Seeking Alpha)

KHC has been supported by maintaining stable earnings in recent years and has consistently beaten expectations, albeit without any growth. The quarterly EPS has exceeded the consensus expected level for 14 consecutive quarters. The consensus outlook indicates lower earnings in the next few years. The consensus expected EPS growth is -1.25% per year, contributing to the Seeking Alpha Growth Grade of F.

Trailing (3 years) and estimated future quarterly EPS for KHC. Green values are amounts by which EPS beat the consensus expected value (Source: ETrade)

KHC has fared reasonably well in the inflationary environment of recent quarters. As with a range of other major processed food companies, KHC has been able to increase efficiency and raise prices sufficiently to “more than offset higher supply chain costs (reflecting inflationary pressure in procurement, logistics and manufacturing costs) and higher commodity costs (mainly in dairy, packaging materials, soybean and vegetable oils, and energy)”

See slide 35 here. Earnings have been reduced by the strength of the dollar, however. It is worth noting that organic net sales growth has been robust, up 11.6% YoY (see slide 33). Management noted the company’s significant pricing power and that results indicate a smaller-than-expected share of customers are switching to lower-priced brands.

The forward dividend yield of 3.98% is quite attractive, although the company is not a consistent dividend grower. The forward P/E of 14.85 is moderate compared to historical values.

I last wrote about KHC on June 1, 2023, at which time I maintained a hold rating on the shares. At that time, the Wall Street consensus rating was a hold, although the consensus 12-month price target was 12.6% above the share price at that time, for an expected total return of 16.8% over the next year. Along with looking at fundamentals and the Wall Street consensus, I also consider the market-implied outlook for a stock, a probabilistic price forecast that represents the consensus view among buyers and sellers of options.

The market-implied outlook to the middle of January of 2023 was neutral to slightly bullish, with expected volatility of 32% (annualized). As a rule of thumb for a buy rating, I want to see an expected 12-month total return that is at least ½ the expected volatility. The Wall Street consensus price target, corresponding to a 16.8% total return, is slightly more than ½ the expected volatility. The weak consensus outlook on earnings growth and neutral Wall Street consensus rating led me to maintain my hold rating, even though the consensus price target and market-implied outlook were somewhat favorable. In the 6.7 months since the June 1 closing price, KHC has returned a total of 9.2%, as compared to -7.1% for the S&P 500.

For readers who are unfamiliar with the market-implied outlook, a brief explanation is needed. The price of an option on a stock reflects the market’s consensus estimate of the probability that the stock price will rise above (call option) or fall below (put option) a specific level (the option strike price) between now and when the option expires. By analyzing the prices of call and put options at a range of strike prices, all with the same expiration date, it is possible to calculate the probable price forecast that reconciles the options prices. This is the market-implied outlook. For a deeper discussion than is provided here and in the previous link, I recommend this outstanding monograph published by the CFA Institute.

I have calculated updated market-implied outlooks for KHC and compared these with the current Wall Street consensus outlooks in revisiting my rating.

Wall Street Consensus Outlook for KHC

ETrade calculates the Wall Street consensus outlook for KHC using price targets and ratings from 10 ranked analysts who have published opinions within the last 3 months. The consensus rating is a buy, having shifted from a hold in late October. The consensus 12-month price target is $42.20, 5.8% above the current share price, as compared to $42.18 when I analyzed KHC at the start of June. The spread in the individual price targets is relatively low, with a ratio of 1.3 between the highest ($49) and lowest ($37).

Wall Street analyst consensus rating and 12-month price target for KHC (Source: ETrade)

Seeking Alpha’s version of the Wall Street consensus outlook combines the views of 21 analysts who have published ratings and price targets in the last 90 days. The consensus rating is a buy, having changed from a neutral rating at the end of September, and the consensus 12-month price target is $42.92, 7.6% above the current share price.

Wall Street analyst consensus rating and 12-month price target for KHC (Source: Seeking Alpha)

While the consensus 12-month price target is very close to the value from the start of June, the increase in the share price leaves reduced potential upside relative to the target. The expected total return over the next year (averaging the Seeking Alpha and ETrade price targets and adding the dividend) is 10.7%.

Market-Implied Outlook for KHC

I have calculated the market-implied outlook for KHC for the 6.9-month period from now until July 21, 2023 and for the 12.8-month period from now until January 19, 2024, using the prices of call and put options that expire on these dates. I selected these two dates to provide a view to the middle of 2023 and through the full year.

The standard presentation of the market-implied outlook is a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Market-implied price return probabilities for KHC for the 6.9-month period from now until July 21, 2023 (Source: Author’s calculations using options quotes from ETrade)

The outlook for KHC to July 21, 2023 is generally symmetric, with comparable probabilities of positive and negative returns of the same size. The expected volatility calculated from this distribution is 25% (annualized). This is a low level of volatility for a large cap stock.

To make it easier to compare the relative probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).

Market-implied price return probabilities for KHC for the 6.9-month period from now until July 21, 2023. The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from ETrade)

This view shows that the probability of having a positive return is consistently higher than the probability of a negative return of the same size (the solid blue line is above the dashed red line over almost the entire range of possible outcomes on the chart above). This difference in the probabilities indicates a slightly bullish view among buyers and sellers of options.

Theory indicates that the market-implied outlook is expected to have a negative bias because investors, in aggregate, are risk averse and thus tend to pay more than fair value for downside protection. There is no way to measure the magnitude of this bias, or whether it is even present, however. The expectation of a negative bias reinforces the bullish interpretation of this outlook.

The market-implied outlook for the next 12.8 months, from now until January 19, 2024, is qualitatively very similar to the shorter-term outlook. The probabilities of positive returns are consistently, albeit modestly, higher than the probabilities of negative returns of the same size. This is a slightly bullish outlook for 2023. The expected volatility calculated from this distribution is 26.6% (annualized). For comparison, ETrade calculates a 24% implied volatility for the options expiring on January 19, 2024.

Market-implied price return probabilities for KHC for the 12.8-month period from now until January 19, 2024. The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from ETrade)

The market-implied outlooks to the middle of 2023 and into the start of 2024 are both slightly bullish, with low volatility. As an additional check, I calculated the outlook using options that expire on April 21, 2023 (but without including the graph here), and the results were similar to the two longer periods discussed above.

Summary

KHC has performed well over the past year, boosted by several factors. First, the rotation from growth to value and, specifically, towards defensive stocks has been good for KHC. Second, management has been able to boost prices beyond the higher costs of inputs, such that organic growth is maintained. The strong dollar has been a drag on earnings. The challenge for KHC is being able to grow earnings, and the consensus outlook is not very good.

The consensus for EPS growth over the next 2 to 5 years is slightly negative. Even so, investors are favoring the stock because of its defensive attributes and the demonstrated ability to maintain earnings in a period of major macroeconomic upheaval. The Wall Street consensus rating is a buy, having shifted from a hold in the last couple of months, with a consensus price target that corresponds to a 10.7% total return over the next year.

This expected return is 0.4 times the expected volatility calculated using the January 2024 options (26.6%), below the 0.5 threshold that I look for in identifying stocks with attractive risk-return characteristics. Using ETrade’s 24% implied volatility, the ratio rises to 0.45. The market-implied outlooks to the middle of 2023 and into the start of 2024 are both slightly bullish. I am changing my rating on KHC from a hold to a buy because of the combination of the earnings stability, management’s success in navigating the surging inflation of the past year, the Wall Street consensus buy rating and the bullish market-implied outlooks.