One number jumps out at me from the deal between Kraft Foods Group (KRFT) and H.J. Heinz.
It’s not the $16.50 a share special cash dividend that Kraft shareholders will receive in the deal.
It’s not the $1.5 billion in annual cost savings that Berkshire Hathaway (BRK.B) and 3G Capital estimate by 2017. (Can you say layoffs?)
And it’s not even the huge 36.7% pop in Kraft shares on March 25, the day the deal was announced.
No, the number that draws my attention is the $28 billion in annual revenue at the combined company.
It’s that number that leads me to add shares of Hain Celestial Group (HAIN) today, March 26, to my Jubak’s Picks portfolio. Yesterday the shares closed up just 0.58% after being ahead almost 4% during the day. The stock was off 0.99% at the March 26 close.
To understand why the Kraft-Heinz deal leads me to a buy of Hain Celestial Group, you’ve got to understand this deal in the context of an extreme challenge to all the big U.S. food companies from Kraft to McDonald’s (MCD). Trends in the market are moving away from them as an increasing number of customers, especially millennials (the generation of consumers who reached adulthood around 2000), increasingly demand healthier, more environmentally friendly, more local food. This trend is part of why Chipotle Mexican Grill (CMG) has been growing and McDonald’s hasn’t.
Plan A at Kraft was to try to re-invigorate growth. Revenue has been essentially flat at near $4.7 billion a quarter since the second quarter of 2013. Revenue growth was forecast at 0.9% for 2015 by Standard & Poor’s before the deal announcement.
The problem boils down to this: How to you get faster growth, given trends in the food market, out of brands such as Planters nuts and Jell-O?
The company has been trying, but the results haven’t been encouraging.
Hence Plan B.
Which is, especially given trends in the sector, a pretty good plan. Cost cutting at Heinz, which 3G acquired in 2013 have taken EBITDA margins (earnings before interest, taxes, depreciation, and amortization) up to 26% from 18%. Kraft’s current margin of 20% should see a significant improvement from 3G’s cuts. The deal will also cut interest payments at Heinz since Kraft’s investment grade credit rating will lower the interest rates that a highly indebted Heinz has to pay. The deal won’t add to the combined company’s debt load and 3G expects to be able to refinance $17 billion in Heinz debt, saving about $1 billion. The deal should also boost Kraft’s international sales since Heinz has much stronger overseas distribution than Kraft does after spinning off its snack division as Mondelez International (MDLZ) in 2012. (Only about 11% of Kraft’s revenue in 2013 came from outside the United States and most of that was from Canada.)
But Plan B is likely to make adapting to a changing food market and reigniting growth more difficult. With $28 billion in revenue it becomes hard to move the needle with internal growth and it becomes hard to find acquisitions that are big enough to provide much of a boost.
Which is where Hain Celestial comes in. The faster growing part of the food industry—those companies that emphasize natural, organic, health, and/or local—is characterized by the small size of individual players. At a market cap of $6.45 billion and annual revenue of $2.15 billion in fiscal 2014 Hain Celestial is one of the bigger companies in the natural/organic food sector. As such it’s one of the few potential acquisition targets big enough to make an attractive target for a big conventional food company looking for growth. That logic led to the immediate pop in the stock after the Kraft-Heinz story broke. And it provides substantial support for the shares.
But I’m actually more interested in Hain Celestial as a consolidator in the fragmented natural/organic good sector. At $2.15 billion in sales the company is small enough so that deals like the 2013 acquisition of Rudi’s Organic Bakery ($60 million in sales) or the 2014 acquisition of Tilda, a basmati rice brand with $190 million in sales, make sense. Hain can use its existing distribution clout to expand the customer base for acquired brands and to get them more shelf space at existing customers—and also use efficiencies of scale to cut costs. It’s a food version of the consolidator strategy that Middleby (MIDD), a member of my Jubak Picks 50 portfolio, has followed so successfully in the restaurant equipment market for years.
Standard & Poor’s projects revenue growth of 23% for Hain Celestial in fiscal 2015 including acquisitions and internal growth (I’d call it “organic” growth but that seems confusing in this context) in upper single digits.
I’ve been looking at Hain as a buy for a while but had put it off because the stock certainly isn’t cheap. It trades at a PEG ratio (PE to growth rate) of 2.14—which is expensive although Kraft trades at a PEG ratio of 3.82. But the Kraft-Heinz deal gives Hain some extra upside as a potential acquisition candidate and reduces the downside risk in the stock as well.
I’m adding it to the Jubak’s Picks portfolio with a target price of $72 a share by October 2015.