Kraft Heinz Company — Q2 2019 Form 10-Q Summary
Business context and reporting period
The filing covers the quarter and six months ended June 29, 2019. Kraft Heinz manufactures and markets food and beverage products globally through the United States, Canada, EMEA, and Rest of World segments. The company is reevaluating its segment structure following organizational changes announced June 20, 2019, with completion expected in the third quarter of 2019.
Comparative 2018 financial information has been restated for procurement-related supplier rebate, contract, lease, tax, impairment, and other misstatements. The restatement followed an internal investigation prompted by an SEC subpoena concerning procurement practices.
Key financial metrics
| Metric | Q2 2019 | Q2 2018, as restated | Change |
|---|---|---|---|
| Net sales | $6,406 million | $6,690 million | -4.2% |
| Gross profit | $2,082 million | $2,347 million | -11.3% |
| Gross margin | 32.5% | 35.1% | -2.6 percentage points |
| Operating income | $734 million | $1,357 million | -45.9% |
| Operating margin | 11.5% | 20.3% | -8.8 percentage points |
| Net income attributable to common shareholders | $449 million | $754 million | -40.6% |
| Diluted EPS | $0.37 | $0.62 | -40.3% |
| Adjusted EBITDA | $1,600 million | $1,949 million | -17.9% |
| Adjusted EPS | $0.78 | $0.99 | -21.2% |
For the six months ended June 29, 2019, net sales were $12,365 million, down 4.8%; operating income was $1,296 million, down 54.6%; net income attributable to common shareholders was $854 million, down 51.4%; diluted EPS was $0.70, down 51.0%; Adjusted EBITDA was $3,031 million, down 19.3%; and Adjusted EPS was $1.44, down 23.8%.
Q2 organic net sales declined 0.3%, reflecting lower pricing of 0.3 percentage points and flat volume/mix. Six-month organic net sales declined 1.5%, reflecting lower pricing of 1.3 percentage points and unfavorable volume/mix of 0.2 percentage points.
Cash flow, liquidity, debt, and capital allocation
- Six-month operating cash flow was $1,325 million, compared with $216 million in the restated 2018 period. The improvement primarily reflected higher collections after the company unwound its receivables programs.
- Six-month investing cash flow was an $18 million use, including $448 million of capital expenditures, $200 million for the Primal Nutrition acquisition, and $640 million of proceeds from the Heinz India divestiture.
- Six-month financing cash flow was a $977 million use, including $976 million of dividends.
- Cash and cash equivalents were $1,452 million at June 29, 2019, including $742 million held by international subsidiaries. Cash, cash equivalents, and restricted cash totaled $1,458 million.
- Long-term debt, including the current portion, was approximately $31.1 billion. Total debt carrying value was approximately $31.1 billion, versus a fair value of $32.2 billion.
- No commercial paper was outstanding at quarter-end, no amounts were drawn on the $4.0 billion Senior Credit Facility, and the company stated that it was in compliance with financial covenants during the quarter.
- The company repaid approximately $350 million of senior notes on August 9, 2019. Approximately $900 million of senior notes mature in February 2020, with additional maturities of approximately C$800 million and $1.5 billion in July 2020.
- Management expects 2019 capital expenditures of approximately $800 million and believes operating cash flow, cash on hand, commercial paper, and the revolving credit facility will provide sufficient liquidity.
Material changes versus the prior comparable period
- Revenue declined primarily because of unfavorable foreign currency and acquisitions and divestitures. EMEA and Rest of World were the largest sources of reported sales pressure.
- Adjusted EBITDA declined due to higher supply-chain, procurement, manufacturing, and logistics costs; unfavorable foreign currency; lower organic sales; and strategic investments.
- Q2 2019 included $598 million of impairment losses, consisting of $124 million of goodwill impairment and $474 million of intangible asset impairment. Six-month impairment losses totaled $1,218 million, compared with $234 million in the restated 2018 period.
- The Q2 intangible impairment primarily affected Miracle Whip, Velveeta, Lunchables, Maxwell House, Philadelphia, and Cool Whip. Goodwill impairment included the U.S. Refrigerated reporting unit.
- The company acquired Primal Nutrition for $202 million in January 2019 and completed the Heinz India sale for approximately $655 million, recognizing a $246 million pretax gain. The Canada natural cheese transaction closed July 2, 2019, and management expected to recognize a gain in the third quarter.
- Restructuring expenses were $14 million in Q2 and $41 million in the first six months, versus $157 million and $247 million, respectively, in the comparable 2018 periods. The company expects to eliminate approximately 400 positions, with 200 eliminated during the first six months.
- The company adopted the new lease standard in 2019, recognizing $821 million of lease assets and $887 million of lease liabilities at adoption, without an opening retained earnings adjustment.
Guidance, outlook, commentary, and risks
- Management provided a 2019 capital expenditure expectation of approximately $800 million but did not provide clear full-year revenue or earnings guidance in the filing.
- Management identified significant sensitivity in goodwill and brand valuations. Reporting units with 10% or less excess fair value had aggregate goodwill carrying value of $33.0 billion, and brands with 10% or less excess fair value had aggregate carrying value of $26.4 billion after impairment.
- The company continues to face risks from weak revenue growth, pricing pressure, consumer preference changes, retailer negotiations, input-cost inflation, foreign currency volatility, and potential additional impairments.
- The SEC investigation and related governmental review concern procurement accounting, internal controls, impairment assessments, financial reporting, disclosures, and communications with shareholders. The company stated that it cannot predict the scope, duration, outcome, or potential financial impact.
- The company disclosed material weaknesses in risk assessment, supplier contracts and related arrangements, and goodwill and indefinite-lived intangible asset impairment testing. Disclosure controls and procedures were therefore not effective as of June 29, 2019.
- Management expects to implement the remaining remediation actions by early 2020, including enhanced procurement controls, contract documentation, training, software, performance targets, and impairment-testing review procedures.
- The company is defending securities class actions, an ERISA class action, and shareholder derivative litigation. The potential loss range cannot reasonably be estimated because the proceedings are at an early stage.
- Venezuela remains subject to highly inflationary accounting, government controls, currency restrictions, and operational uncertainty. Six-month nonmonetary currency devaluation losses were $6 million.
Most important facts for an investor to verify
- Whether management completes remediation of the disclosed material weaknesses by early 2020 and whether additional restatements, control deficiencies, SEC actions, or litigation follow.
- Whether the company can stabilize organic sales, pricing, volume/mix, and segment margins, particularly in the United States, EMEA, and Rest of World.
- Whether further goodwill or brand impairments occur given the limited valuation headroom and sensitivity to discount rates, growth assumptions, margins, and market capitalization.
- How the company funds the approximately $3.2 billion of stated senior-note maturities in 2020 while maintaining dividends and planned capital expenditures.
- The final gain and cash proceeds from the Canada natural cheese divestiture and the effects of the pending segment reorganization.
- The scope and potential financial consequences of the SEC and related governmental inquiries and securities, ERISA, and derivative lawsuits.