Kraft Heinz (KHC) has left investors shocked after reporting a big loss in Q4 2018, fueled by a staggering $15.4 billion writedown to a number of its brands. The company also disclosed an investigation by the SEC into its accounting practices.
The market sent shares tumbling in the wake of the news. A few intrepid investors have suggested buying the dip, but we are not so sure. Indeed, the world’s fifth-largest food and beverage company may very well unsettle investors’ stomachs even further. A closer inspection of both the writedown and the SEC investigation suggests that things may actually be worse than they already appear to be.
Not Your Average Writedown
On the grounds of sheer size alone, the Kraft Heinz writedown is noteworthy. At $15.4 billion, it is the seventh largest impairment since 2009. The writedown came from two sources: $8.3 billion from an intangible asset writedown of the Kraft and Oscar Mayer brands and $7.1 billion from a goodwill impairment to its North American refrigerated and retail business.
But size is not the issue here. The reason this writedown is so unusual is that it appears to have come virtually out of nowhere. Kraft Heinz conducts regular assessments of its various business units, including annual impairment testing. This leads to fairly regular recognition of impairment of goodwill, with the attendant adjustment to the balance sheet.
Kraft Heinz conventionally performs its main impairment testing during the second quarter of each year, and 2018 was no exception. When the company reported Q3 earnings, it recognized considerable impairment costs:
“We test goodwill for impairment at least annually in the second quarter or when a triggering event occurs. We performed our 2018 annual impairment test as of April 1, 2018. As a result of our 2018 annual impairment test, we recognized a non-cash impairment loss of $164 million in SG&A related to our Australia and New Zealand reporting unit. This impairment loss was primarily due to margin declines in the region. The goodwill carrying value of this reporting unit was $509 million prior to its impairment. Additionally, five of our 20 reporting units each had excess fair value over its carrying value of less than 10%. As of the impairment test date, the goodwill carrying values associated with these reporting units were $4.7 billion for Canada Retail, $424 million for Latin America Exports, $407 million for Northeast Asia, $326 million for Southeast Asia, and $232 million for Other Latin America.”
With “five out of 20” of its reporting units apparently carrying significant excess value, there was always a chance that things could get worse. But for the situation to have changed so dramatically in the course of less than six months is shocking. Clearly, Kraft Heinz was either walloped from out of the blue or it has been reticent to recognize the true scope of impairment until now. While the company may try to assert confidence that this is a one-off adjustment, the fact that it was not telegraphed – and was triggered in such a short time – should be considered a serious red flag and warning sign that this might not be the end of the matter.
SEC Digging into the Books
The writedown was not the only thing that blindsided investors this week. Kraft Heinz also disclosed that its accounting practices had come under SEC scrutiny and received a subpoena from the regulator. The company stated that it had launched its own internal investigation in response to the SEC’s probe, recording $25 million in additional costs:
“Following this initial SEC document request, the Company together with external counsel launched an investigation into the procurement area. In the fourth quarter of 2018, as a result of findings from the investigation, the Company recorded a $25 million increase to costs of products sold as an out of period correction as the Company determined the amounts were immaterial to the fourth quarter of 2018 and its previously reported 2018 and 2017 interim and year to date periods. Additionally, the Company is in the process of implementing certain improvements to its internal controls to mitigate the likelihood of this occurring in the future and has taken other remedial measures. The Company continues to cooperate fully with the U.S. Securities and Exchange Commission.”
While an SEC investigation is never something an investor wants to see. Yet, Kraft Heinz makes it sound like it is doing everything the right way: collaborating, launching an internal investigation, promptly recognizing cost adjustments, and promising new controls to prevent any repetition of the errors. So far, so good.
But, again, there is more to this story if we dig a little deeper. According to the company’s own timeline of events, it would appear that the SEC may have been sniffing around for reasons other than the $25 million adjustment reported for the quarter. Audit Analytics, a specialist research outfit, concludes that the story is far from over:
“In other words, there was another outstanding issue that triggered SEC scrutiny. The details of what that issue could be were not provided in the earnings release or on the conference call.”
If there is more to the SEC investigation, which has certainly not ended, it could mean more nasty surprises down the road.
Investor’s Eye View
Kraft Heinz was down a whopping 27.5% on Friday amid a raft of analyst downgrades. The violent market reaction would usually cause us to sniff around for a buying opportunity. However, in this instance, we suspect there may be more trouble ahead.
The core business has obviously taken a serious hit. A myopic focus on cost reduction has led Kraft Heinz to lose focus on sustaining its brands, even as consumer tastes continue to change. Its current brands are failing to resonate with a new generation of consumers. Meanwhile, it has seen little success in introducing new and profitable demands.
Kraft Heinz has promised a return to strong revenue growth and improving margins, with a focus on improving its brands, reasserting its market position, and forging new opportunities. Given how rapidly the consumer market has evolved, these pledges seem somewhat dubious.
And, even if the company follows through on its operational promises, other issues lurk under the surface. Further brand impairment could dent the stock price and, given the latest surprise, there is little reason to be confident that this was the last significant writedown in the cards. The SEC investigation raises even more red flags. It is a big question-mark and Kraft Heinz has done little to allay investor fears thus far.
While investors might think this dip is worth buying, we will be sticking to the sidelines until we get more clarity on the company’s long-term prospects in a rapidly changing world.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.