The Kraft Heinz Co. (KHC, Financial) has been in the hot seat for more than a year. In 2019, sales continued to fall and profits dwindled as the packaged food company struggled to adapt to changing consumer tastes. Warren Buffett (Trades, Portfolio), whose Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) was a key player in the 2015 merger of the Kraft and Heinz companies, has seen much of his investment evaporate. Things got worse on Feb. 14, when two credit ratings agencies, Fitch Ratings and S&P Global Ratings, downgraded Kraft Heinz’s debt, officially relegating it to junk status.
Writing on the wall
Kraft Heinz’s debt has been trading toward junk status for a while, and the recent downgrades have evidently accelerated the process. Indeed, the company had the dubious honor of being the worst-performing issuer across all U.S. and European markets last Friday.
The downgrade could hardly have been the Valentine’s Day present Buffett and company were hoping for. But, as Thornburg Investment Management’s Christian Hoffmann observed, it was richly deserved:
“Kraft is to investment grade as Velveeta is to cheese. The ingredients dictate what something is and Kraft Heinz is junk.”
Kraft Heinz certainly looks out of place among the BBB bonds that make up the lowest investment-grade tier. While the average yield on a BBB-rated corporate bond is less than 3%, the ailing food company’s 2029 bonds are hovering in the vicinity of 3.5%.
Not touching the dividend
The downgrades came a day after Kraft Heinz announced it would be maintaining its quarterly dividend of 40 cents per share. According to its published dividend announcement, the company believes it can keep its dividend intact, despite its weakening financial position:
“The Board and the Management Team believe that maintaining a strong payout is an important commitment to shareholders of the company, particularly during this important period of transformation. The Company also expects to reduce leverage as it repositions itself for sustainable growth and returns.”
The decision to keep the dividend clearly contributed to Fitch and S&P finally pulling the downgrade trigger, but it has not caused Kraft Heinz to blink. On Feb. 14, company spokesman Michael Mullen said that while Kraft Heinz is committed to working to reduce its leverage, the process will happen “over time” – and not at the expense of the dividend:
"We believe it's important to Kraft Heinz shareholders to maintain our dividend during this time of transformation."
After the savage beating Kraft Heinz stock has taken over the past year, it is understandable that the company would avoid another severe selloff, which a dividend cut would undoubtedly precipitate.
Angels falling
Losing investment-grade status makes Kraft Heinz the latest corporate debt fallen angel, joining the ranks of a number of once-blue-chip names that have struggled to adapt to new competition and changing consumer preferences. Indeed, the company's recent woes are indicative of a broader – and increasingly worrying – trend in the corporate bond market.
At the start of 2019, many analysts were fearful that a proliferation of fallen angels would threaten the entire corporate bond market. As I observed in December, a distressing amount of corporate debt is on the cusp of junk status:
“About 70% of BBB-rated bonds are currently at risk of losing their investment grade status. A slight shock to the credit market could spark exactly the sort of mass exodus that would result in a financial firestorm.”
According to the latest analysis by UBS (UBS, Financial), there is now as much as $90 billion of investment-grade corporate debt at risk of being downgraded to junk in 2020. Kraft Heinz’s descent from the financial firmament has added yet another fault line to this ever shakier environment.
New game plan needed
The challenges facing Kraft Heinz have persisted into 2020, and are not likely to disappear anytime soon. The company may succeed in executing a turnaround, but its game plan remains very much up in the air. Investors will not even get an update on the turnaround strategy until May, when quarterly earnings are reported.
Buffett seems committed to holding onto his position, but that position is very tough to recommend. Investors are likely better off taking a wait-and-see stance on the sidelines.
Until there is greater clarity on the turnaround plan, I cannot recommend investing in Kraft Heinz.
Disclosure: No positions.
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