Buy, Sell or Hold: H.J. Heinz Co. (NYSE: HNZ) Is a Long-Term Keeper, but Will Struggle in the Months Ahead

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H.J. Heinz Co. (NYSE: HNZ) dominates in the ketchup market.  There is no second.  And Heinz has taken advantage of its revered ketchup brand over the years to develop organically and acquire other brands.

However, its overdependence on developed markets and a sluggish U.S. consumer are currently holding the company back.

Emerging markets are where growth is today. It’s clear that Heinz understands that, because emerging markets now account for about 14% of the company’s sales.  But the rate of Heinz’s emerging market sales growth is still disappointing.

Heinz has been growing this category, but only at a rate of about 1% to 2% of its total sales per year – even with the company’s brand acquisitions. And to make matters worse Heinz was hit with currency losses in its most recent quarter, and these currency dynamics will likely persist.

Heinz’s emphasis on China, Russia, India, as well as other emerging markets like Poland and the Middle East is encouraging.  But it is disappointing to see a lack of emphasis on Brazil.

In addition to the challenges Heinz faces in penetrating new markets, the company is up against strong headwinds at home. Heinz’s vulnerability to upswings in commodity prices poses a risk to margins.  And while Heinz has been confident enough in the strength of its brands to increase prices, more cash-strapped consumers are switching to generic brands to increase savings.  The result has been a 4% drop in volumes.  Consumer habits do not change easily, so this trend will be difficult to reverse.

Looking forward, the consumers in the United States and other advanced economies will remain weak.  American consumers, in particular, continue to struggle with high levels of debt, surging unemployment, and depleted nest eggs.  In fact, the wealth effect of seeing an average 15% drop in the value of their homes – which comprises some 70% of the equity of a typical U.S. household – and the huge drop in the equity markets – which represents another 20% of the wealth of households – has prompted consumers to increase their savings rate for the first time in decades.

The personal savings rate is near 5%, and it could exceed 8%.  This means that consumption will remain depressed and consumers will remain focused on cost savings for the foreseeable future.  Therefore, the shift at supermarkets to generic labels will continue.

This trend also will have a negative impact on Heinz’s food-service segment, which comprises almost 15% of its sales.   Food-service sales will suffer disproportionately as people stay more at home instead of dining out.

Longer term, as the U.S. and other advanced economies recover, and Heinz achieves stronger market penetrations in fast-growing markets, I believe it will indeed be able to produce above-average returns.  But in the meantime, very strong cashflows from its existing brands will support Heinz stock and allow the company to return an attractive dividend.

And right now, the 4.2% dividend yield that Heinz’s stock offers is very appetizing.  So long term holders should keep holding the stock.

However, the current headwinds for the company and challenges in the U.S. market, foreign exchange, commodity costs and other costs involved in penetrating new markets will keep limiting the stock’s appeal — even as a defensive play in down market periods.

The stock’s Price/Earnings to Growth (PEG) ratio, which is above 2, is a strong warning sign.  It says that buying at these levels is paying too high a premium for the Heinz’s earnings growth rate.  That is symptomatic of the headwinds in earnings that I mentioned previously.  Thus, it is not advisable to go into this stock right now.

I would stick with our many defensive stock recommendations, like Campbell Soup Co. (NYSE: CPB), The Coca-Cola Co. (NYSE: KO) and Goldman Sachs Group Inc. (NYSE: GS), which have outperformed and are executing strongly in emerging economies.

Recommendation: Hold H.J. Heinz Co. (NYSE: HNZ) long term.  Short term-oriented buyers should abstain for the moment (**).

(**)  Special Note of Disclosure: Horacio Marquez holds no interest in H.J. Heinz Co.

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