The Soup & Sauce Affair

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The food giant H.J. Heinz (NYSE: HNZ), best known for its ketchup reported its second quarter earnings this week. The company outperformed estimates by reporting $0.90 EPS and expected revenues. 

The company has shifted its focus toward emerging markets over developed areas. Sales from emerging markets were reported at 23%: a 10% rise over the past 4 years. Quantitatively speaking, emerging market sales, gross profit margin, and operating profit margin have all risen. 

The Industry and the Competition 

Heinz produces lot more than ketchup, so improved margins are a good sign for other food manufacturers as well as they reflect a growing industry. Organic growth was up 3.3%, with 1.9% from higher prices and 1.4% from volume. Heinz’s performance reflects better overall growth than many other food companies (for example, Campbell Soup, Smucker, and Kellogg). It seems that the management is changing its marketing strategy by cutting on advertisements and enhancing discounts and allowances offered. Similar strategies are known to be adopted by Campbell Soup & Smucker, so it seems to be becoming more of an industrial strategy. I feel the motive is to stimulate volume through prices without actually affecting the latter

While Campbell Soup (NYSE: CPB) faces a challenge of expanding and diversifying its soup offerings to maintain its dominant market position, Heinz has comfortably adopted the trial and error method to grow. It has restructured its enterprise by giving up on less profitable brands and banking on the more revenue generating ones. Campbell's introduction of a line of low-sodium products is keeping in view with the increasing health awareness of its consumers. Campbell does face a drawback being more dependent on developed markets. It should take a cue from HNZ and explore emerging markets.

JM Smucker (NYSE: SJM), like Campbell, is trying to capitalize on the health awareness bug by introducing a basket of low-cal organic products. It is also targeting growth with many new products under various brand names ready for release under its sleeve. It may sound promising, but the reality remains that SJM is facing dwindling sales and low revenues due to low margins and products belonging to slow growing industries necessitating expansion and diversification.

Smart Taxation

While Campbell has reported an effective tax rate for the quarter of 31%, Heinz's tax rate for the same was an enviable 9.6%; less than a third of its competitor.

Heinz routinely makes use of foreign tax benefits to minimize its liabilities. The company estimates its full-year liability to come in at a still-low 20 %. Although keeping lower tax expenses is worthwhile, the mammoth divide from competitors is bound to reduce. Also, it may give rise to contingencies that we are unaware of.

Magnet to Investors

Heinz easily finds its way in portfolios of investors due to its return to shareholders and the defensiveness of the company. Management aims at about 60% return of cash flow to shareholders each year mostly in the form of dividends, buybacks, and M&A for long-term return. It has continuously given a dividend yield of ~3.5%. Heinz seems to be focusing on small acquisitions for long-term growth. Heinz has already acquired Quero, a Brazilian food manufacturer last year and it would not be surprising to hear Heinz acquire a company in the near future. 

Highs & lows

Risks of investing in Heinz include rising commodity costs, Smart Ones brand struggles, and grocery store prices rising. Expected cost inflation of 4% for the year is good news for the food industry that experienced double digit inflation in the previous years. 

The grocery store industry is becoming a rat race with giants sucking in margins. Squeezing suppliers like Heinz and MKC, Grocery stores can make more money. However, in the ever-growing competitive market, retail grocery stores must begin to compete with Wal-Mart and Target and other convenience stores. WMT has accounted for about 10% of sales in the most recent FY and was its largest customer. The food manufacturers must work to keep the big players happy and stay on their racks. A price raise is always difficult, but also inevitable, and the industry saw one in 2011 to maintain margins. It may have hit volumes now, but shall surely reap long term profits. 

A Tricky Stand

The impression, given prima facie, is that the market is not tapping in the complete potential of emerging markets. Heinz doesn’t come cheap in your portfolio either, but, as a less risky candidate, in terms of returns to shareholder with good dividend offerings and not to forget- the emerging market growth potential it is undoubtedly the best buy in its segment. Though a short term stand is not justified; I suggest it as a long term buy.

adityaladha has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend H.J. Heinz Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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