Financial Management Heinz Case Study

1 HEINZ CASE STUDY 2 Executive Summary The purpose of the Heinz case study is to analyze the decision making and potential outcomes for the company’s future investments and growth strategies. The specified time period of the case is 2008-2010. Heinz experienced topline growth, but operating margins declined because of an increase in Cost of Goods Sold (COGS). These factors led to a lower Return on Assets (ROA) which negatively affected the internal growth rate. In order to support future sales growth, the firm needs to secure external financing. The first step to identify needs for a positive turnaround is to calculate the Weighted Average Cost of Capital (WACC). The WACC determines the appropriate discount rate. According to the Corporate Finance Institute, “WACC represents its blended cost of capital across all sources, including common shares, preferred shares, and debt” (N.D.). The approximate discount rate represents the overall required return on the firm as a whole. It is also necessary to identify the internal and external factors affecting the market value of Heinz equity and debt. We will discuss terms such as risk free rate, market premium, and beta. It is uncommon for consumer goods companies to be impacted by volatility of market conditions and the overall economy. Indeed, Heinz is undergoing some consumer-based transitions such as an increased focus on organic products with higher nutrition value, budget-oriented purchasing decisions, and privatelabel growth (2009 Heinz Annual Report). More significantly, the global economic environment continues to present challenges; however, we are uncertain as to why the change in WACC may be occurring when the company reports strong sales during the past three years. Therefore, we will also evaluate the financial health of Heinz’ major competitors – Kraft Foods, Campbell Soup Company, and Del Monte Foods – to gain a better understanding of WACC industry averages. The case study analysis will address the following metrics during 2009-2010: risk free rate, market premium, and beta; yields for outstanding debt issues; the WACC for the company and its competitors; and the timespan of infrastructure investments and capital projects. With this information we will have a better understanding of the company’s cost of capital and Return on Equity (ROE). Company Overview Heinz, established in 1869, is recognized as a blue-chip, value stock. The company culture advocates values of ownership, high performance, empowerment, and other employee-centric philosophies (“We Are Kraft Heinz,” N.D.). Indeed, these are key principles embodying a long-standing, successful company; but to the general consumer, the iconic brands far outweigh the company ideologies. For generations, 3 Heinz has delivered superior foods to households and restaurants that provide strong customer satisfaction (“We Are Kraft Heinz,” N.D.). As one of America's biggest food companies, Heinz celebrated 140 years in 2009. The company goals remain poised to provide consistent growth and increase shareholder value. The core categories of ketchup and sauces continue to hold the first or second brand spots across the globe. Heinz’s principles – quality, innovation, integrity, and food safety – in combination with an impressive product portfolio should continue to deliver results leading into the next decade (2009 H.J. Heinz Company Annual Report). The product line started with condiments and expanded over the years to packaged goods and frozen foods. The most recognizable brands and kitchen staples include Heinz Tomato Ketchup, Ore-Ida potatoes, Lea & Perrins and HP sauces, and Heinz Beanz. In 2009, the company reported $10.1 billion in sales and $923 million in operating income. International sales represent 60% of revenues (2009 H.J. Heinz Company Annual Report). Figure 1: “2009 H.J. Heinz Company Annual Report.” The 2009 annual report highlights the four strategic initiatives: “Grow our Core Portfolio; Accelerate Growth in Emerging Markets; Strengthen and Leverage our Global Scale; and Make Talent an Advantage” (H.J. Heinz Company Annual Report). Other important topics addressed in the annual report include shifts in consumer behavior, acquisition strategy, and sustainability (2009 H.J. Heinz Company Annual Report). Industry Overview Heinz is in the middle of the pack, ranked 49 out of 100, by the 2008 Consumer Goods Registry. Key competitors ranked in the top ten of consumer packaged goods (CPG) by revenue include Nestle, PepsiCo, Kraft Foods, and Coca-Cola (Ackerman & Padilla, 2008). William R. Johnson, Heinz’ Chairman, President, and Chief Executive 4 Officer, reported to shareholders in the 2009 Annual Report: “In this value-oriented economy, Heinz continues to connect with consumers. Our Top 15 brands delivered excellent growth in Fiscal 2009 while contributing about 70% of the Company’s total sales.” This seemingly contradiction is one of the areas we will explore in the case study – how Heinz is able to report record sales, profits, and attractive earnings per share for the past three years. Illustrated in the graphic above, operating free cash flow declined $15B from 2008 to 2009 (2009 Heinz Annual Report). The financial calculations included in the case study evaluation will address competitive comparisons such as discount rates and ROA. There is an interesting data point in Campbell’s 2009 Annual Report – a graph depicting the company’s five-year cumulative total shareholder return as double the peer group average. Campbell reports a 37.3% shareholder return versus the S&P Packages Foods Index of $18.2% (Campbell Soup Company 2009 Annual Report). Another area of interest pertains to a key competitive differentiator. As previously discussed, an important market trend for CPG manufacturers is adapting products and marketing strategies to cater to consumers’ who seek healthier diets and lifestyle. Campbell’s seems to be ahead of the market in identifying this inflection point in consumer behavior. Heinz continuously scores highly in customer satisfaction and brand recognition. The infographic below shows the leading consumer brands. Although we are curious as to why the Heinz product portfolio is not included; the illustration shows the product breath and scale of companies in the $2 trillion CPG industry. Figure 2: (“These 10 Companies Control Enormous Number of Consumer Brands,” 2012.) 5 Financial Introduction The purpose of this introduction is to explain the financial process breakdown. The goal is to estimate the weighted average cost of capital (WACC) for Heinz Company using data from 2008-2010 to estimate the future cost of capital internally; as well as in relationship to its industry competitors. In order to understand how WACC is derived, it is important to review the capital budgeting concepts of finance. The sequence of how these concepts affect each other and the goal of WACC is explained below. Capital Budgeting At the foundation of corporate finance is capital budgeting. Capital budgeting involves the purchase of fixed assets and the allocation of funds towards a firm’s new and existing projects. Capital budgeting is also referred to as Strategic Asset Allocation since fixed assets are the most important component of corporate finance. Decisions on assets make up the capital budgeting question and decision on project make up the capital budgeting decision. A firm’s projects (such as services or product lines) begin with the capital budgeting decision, where launching a new product/service or entering a new market undergoes strategic decision tools. These capital budgeting tools (payback method, net present value, and internal rate of return) will support whether a firm accepts or rejects a new proposal (Corporate Finance, 2018). Further capital budgeting matters involve the capital structure question (how a firm finances its operations) and the working capital question (management of a firms short-term operating activities). At the core of capital budgeting is identifying that an investment today is worth more than the present value of its future cash flows. The value that this creates is the same value that is created for stockholders. Projects with positive net present values allow this to happen. Net Present Value, Cash Flows and Discounting Net present value (NPV) is defined as “the difference between an investment’s market value and its cost” (Corporate Finance, 2018). NPV’s relationship to capital budgeting means that a positive calculated NPV for a proposal is also a positive value to shareholders (Corporate Finance, 2018). Estimating the NPV involves estimating the value of a project via future cash flows then finding the present value by means of 6 discounting those future cash flows (FCF). The NPV can be calculated as cash flows less discounted cash flows less initial investment. What is important to note when performing an NPV model, is the discount rate and where it evolves from. One way to determine a discount rate is to use the future and present value formulas (reciprocals of each other). Other ways to calculate discount rates involve more riskiness, or in other words, market riskiness. To place this in perspective we can look at the concept of IRR. The internal rate of return (IRR), another capital budgeting method used to make decisions, depends solely on internal cash flows and only comes from within the company and its cash flow projections. Using NPV as a tool for deciding can include a discount rate externally extracted from financial markets of similar risk. Having a positive NPV after using a discount rate that involves a market capital rate means the investment’s return (sometimes referred to as cost of capital) exceeds investments of similar risk within the same market. Risk and Return The formula for weighted average cost of capital (WACC) derives from concepts of risk and return. Some of the rewards that will affect the WACC include risk-free rate and risk premium. In theory, the risk-free rate is the rate of return when the potential risk is zero. However, in practice, the risk-free rate is the same as the three-month interest rate on U.S. based Treasury bills (Investopedia, 2018). Treasury Bills (T-Bills) are issued by the government as bonds which are free of market risks. Essentially, TBills are risk free, since the government can raise taxes to support its interest dues (Corporate Finance, 2018). Since the stock market is volatile and risky, risk premium is introduced as the rate of return (from T-Bills) minus the risk-free rate (from the stock market). Risk premium is the excess return from an investment exploiting both types of risk (non-risky and risky). It is considered a reward because it still accepts risk (Corporate Finance, 2018). Cost of Capital The cost of capital, a necessary component of capital budgeting, involves the cost of equity and the cost of debt. Simple stated, the cost of capital is how a firm chooses to economically fund its projects and assets via financing thru debt or equity 7 (Investopedia, 2018). The cost of equity can be determined by two different models: the dividend growth model or the security market line model (SML). The dividend growth model includes cost of equity, price of stock, dividends, growth rate, and required rate of return. The SML model involves a risk-free rate, beta variable, and a market risk premium rate. The cost of debt involves the time value of money. Analyzing a bond’s present and future values, payments and yield to maturity will generate a cost of debt. Weighted Average Cost of Capital (WACC) The weighted average cost of capital (WACC) is a combination of financing businesses through both debt and equity. Typically, projects are funded using both costs of capital to form a weighted average. The WACC ultimately represents the main obstacle companies must face regarding the “value” that projects generate for the firm and shareholders. We can call this “value” market success. We have analyzed how the value process starts (the methods of capital budgeting) and how it goes through the market risk to end up at a weighted average cost of capital that is used to determine the point where companies generate value. 8 Analysis When determining the YTM for the 2 bonds, the long term rates were selected for this analysis. One of the bonds has over 20 years remaining, rather than taking an average of the short and long term rates we choose the long term as all coupon payments are reinvested at the current yield. Any selection will carry risk and we viewed the short term rate as too reliant on the recent changes in the market for our long term analysis. These bonds give us a baseline for the cost of debt and the proportion of debt that Heinz has long term vs. current debt is 63% to 37%. There are two outstanding Heinz-debt issues. The debt with 22 years to maturity is a long-term debt and the debt with just a maturity period of 2 years is a short-term debt. The YTL approximation formulas have been used to compute the yields of the two debt issues at the end of April 2010. The formula used is shown in the excel spreadsheet. For 2010, the long-term bond (due 3/15/32) has the coupon rate of 6.750% and the current cost of 95.47%. Future Value is 116.9; payment is 7.89075 and present value is -111.60443. We have a yield of 7.09%. For 2010, the short-term bond (due 10/15/12) has the coupon rate of 6.625% and the current cost of 97.5700%. Future value is 113.7; PMT is 7.532625 and PV is -110.93709. We have a yield of 7.56%. For 2009, the long-term bond (due 3/15/32) has the coupon rate of 6.750% and the current cost of 95.95%. Future Value is 91.4; payment is 6.1695 and present value is -87.6983. We have a yield of 7.05%. For 2009, the short-term bond (due 10/15/12) has the coupon rate of 6.625% and the current cost of 97.9800%. Future value is 116.9; PMT is 7.744625 and PV is -114.53862. We have a yield of 7.12%. The Weighted Average Cost of Capital (WACC) is the market value weighted cost of debt and equity, and is calculated as follows: WACC = E D ∗Rd∗(1−T ) ∗ℜ+ E+ D E+ D E = Market Value of Equity D = Market Value of Long-Term Debt Re = Cost of Equity Rd = Cost of Debt T = Income Tax Rate 9 Competitors The estimated WACC for the competitors (Kraft Foods, Campbell Soup, and Del Monte) are as follows: 7.59%, 6.90%, and 8.49%. WACC ratio represents the minimum rate of return that a company can produce value for its investors. It means that the lower the WACC ratio, the healthier the company is. In order for investor to invest their money into a company, they should look for companies that have lower WACC ratio than its rate of return. By comparing Heinz’s WACC and its competitors, we can see that Heinz’s WACC is in line with the industry. It is lower than Del Monte, which indicates that WACC is investing in its capital more efficiently. The market value for Del Monte is considerably lower and their debt to equity ratio is highest among the four companies. Campbell Soup has the most similar market value, but they carry less debt. As a result their WACC is the lowest amongst the sample competitors. Their beta is also lower which indicates that their stock price is less volatile than Heinz. Kraft is an interesting competitor to analyze. They have the same beta value and the debt to equity ratio is fairly similar. WACC between the companies is 7.64% vs. 7.59% which indicates that debt is a similar cost for the companies. The interesting component is the size of Kraft, which is over three times the market value. Despite their difference in market size, the WACC is most similar to this industry and Heinz and reinforces our recommendation to update the WACC value used at Heinz. Recommendation The stock price of Heinz increased 27% in 2010 while the S&P 500 increased 35%. The increase in share price directly explains the increase in Market Value and Equity in the company. The ratio of debt to equity is reduced primarily because the equity component increased with share value. As described earlier, the ratio of debt and equity are primary components in calculating WACC. Being that the entire market dropped in 2009 and increased in 2010, we determined that the change in WACC is not artificially induced and it is appropriate to adjust the rate for Heinz as a corporation. The 2010 WACC falls in line with the industry and the closet competitors and is reflective of what the firm will likely face in the future. 10 Appendix