Sunday, September 18, 2005

Tasty Outlook


ASSET-RICH NESTLÉ IS STARTING TO ATTRACT greater U.S. investor interest, due to the strength of its global food business, an increasingly shareholder-oriented management and the huge combined value of its stakes in Alcon, the world's top eye-care company, and international cosmetics colossus L'Oréal. Nestlé's U.S.-listed shares (ticker: NSRGY) have risen 9%, to 72, this year, but they still could have significant upside because the Swiss giant is a bargain relative to other major food companies when its Alcon (ACL) and L'Oréal (12032.FR) stakes are stripped out. This makes Nestlé an attractive sum-of-the-parts story. - The shares trade for a moderate 17 times projected 2005 profits of $4.15, but Nestlé's 2005 price-earnings ratio is just 12.7, excluding the market value and earnings contribution of its Alcon and L'Oréal holdings. That's a cheap price for the world's largest and, arguably, best-positioned food company. Nestlé has exposure to fast-growing products like bottled water, pet food and ice cream, as well as the industry's most extensive presence in the developing world, where the growth outlook is better than in the mature Western Europe or U.S. markets. Nestlé gets almost 30% of its sales in Latin America, Asia and Africa. Nestlé's 2005 P/E, adjusted for Alcon and L'Oréal, is much lower than the average multiple of 16 for major U.S. food stocks like Kraft (KFT), General Mills (GIS) and Kellogg (K). The American depositary shares of France's Groupe Danone (DA), meanwhile, at their recent price around 22, have risen 21% this year and fetch a rich 22 times estimated 2005 net income amid continued speculation that PepsiCo is interested in buying the company.

The global food industry clearly faces challenges, including the growth of discount retailers in the U.S. and Europe, the rising popularity of private-label brands, limited pricing power, the trend toward eating away from home, as well as rising commodity and packaging costs. Food tastes differ widely around the world, making it difficult for companies to develop truly global brands. Among the limited number of goods with worldwide appeal are coffee, chocolate, soda, scotch and cigarettes. Food remains one of the most fragmented businesses in the world. Nestlé's No. 1 position and $74 billion in annual sales translates into just a 2% share.

Highlighting the troubles in the food business are the struggles of Kraft, General Mills and Campbell Soup (CPB) to generate growth in both sales volume and profits. Kraft stock, at 31, is back where it stood at its initial public offering in 2001.

Nestlé has performed well since chief executive Peter Brabeck, 61, took over in 1997: The Vevey, Switzerland-based company has delivered 5.7% organic revenue growth -- 7%-plus, if acquisitions are included. That's impressive by the food industry's slow-growth standards. Nestlé shares have doubled since 1997, but haven't risen much in recent years.

Bulls are betting that Nestlé will hit its goal of 5% to 6% annual organic revenue growth, which could translate into yearly profit gains around 10%, based on a widening in Nestlé's profit margin, now at 12%, and share buybacks. During the first half of 2005, organic revenue growth was 5.2% and earnings were $2 a share, up 11% from the level in the same period a year ago. The company also pays out about 40% of profits in dividends, and typically lifts payouts annually. The current yield is 2.2%.

Several analysts covering the 139-year-old Nestlé see modest upside potential of 10% to 15% in the next 12 months. The appreciation could be much greater over the next few years if Nestlé's financial performance stays strong and its story becomes more widely known.

Andrew Wood, a Sanford Bernstein analyst, has come up with a sum-of-the-parts value on Nestlé of around 480 Swiss francs per share, or $95 for the U.S.-listed shares. The Swiss shares traded Friday at 367 Swiss francs. Each U.S. share equals a quarter of a Swiss share.

Nestlé's fans like what they see in its food business and its not-so-hidden other assets. "We used to see Nestlé as a slow-moving animal that was less concerned with driving profitability than in getting bigger," says David Herro, manager of the Oakmark International Fund, a Nestlé holder. "Quietly, and somewhat masked by currency swings, there has been a change in emphasis to running top-notch businesses focused on returns, not on size," says Herro. He maintains that the shares could rise at least 50% over the next few years.

Nestlé offers a hedge against a weakening dollar, because its underlying shares are denominated in Swiss francs, historically one of the world's strongest currencies. The downside: A stronger franc crimps reported revenue and profit growth. This happened last year when the dollar weakened.

MEANWHILE, "NESTLÉ'S MANAGEMENT ACTS as if it were a family company. They look out generationally," says Thomas Russo, a partner at Gardner, Russo and Gardner, a Lancaster, Pa., investment firm that has a position in Nestlé. Russo happily notes that Brabeck talks about an investment time horizon of 35 years.

Russo also points to Nestlé's success in China, where it has $1 billion in annual sales and is the largest foreign food company. Overall, Nestlé's sales dwarf those of its rivals. Kraft, the No. 1 U.S. food maker, probably will have 2005 sales of $33 billion, less than half Nestlé's.

The Swiss company's scale is enormous. It operates in more than 100 countries, runs 500 factories and employs 247,000 people. Its products include Stouffer's frozen foods, Nescafé coffee, Dreyer's and Häagen Dazs ice cream, plus Poland Spring, Perrier and San Pellegrino water. Nestlé is the leading global maker of infant formula, the No. 1 pet-food maker, and a major chocolate producer. Nestlé generates about 60% of its sales from six key brands: Nestlé, Nestea, Nescafé, Purina, Maggi and Buitoni.

Table: Hidden Value

The Nestlé story still isn't well-known in the U.S. investment community. One of the major reasons: The shares are traded on the Pink Sheets, limiting institutional ownership and research coverage. As an over-the-counter stock, Nestlé is less liquid and carries a lower profile than the shares of such other major European companies as BP, Royal Dutch Shell, Vodafone and Unilever, which are New York Stock Exchange-listed. Average daily volume in Nestlé's American depository receipts is modest, at about 150,000 shares. The Swiss shares are more liquid.

A Pink-Sheet listing means investors can't find Nestlé's share price in newspapers, although quotes are easily available online through Yahoo!, Dow Jones' MarketWatch and other sources. It reports results semi-annually, and they conform to Swiss accounting standards.

Nestlé could easily meet NYSE listing requirements by reporting its results based on U.S. accounting standards in addition to Swiss standards, but has opted not to. "We don't perceive any benefit," says a Nestlé spokesman, noting that there are an ample 100 million U.S. ADRs outstanding; Brabeck wasn't available to speak to Barron's.

The listing issue doesn't bother Russo. "Nestlé's accounting is perfectly sufficient for me. U.S. GAAP isn't the only pure standard of accounting."

While there may be a strong asset story here, there isn't yet a break-up story. Nestlé management has shown no willingness to part with its 75% interest in Alcon, now valued at $28 billion, or its 27% interest in L'Oréal, now worth $14 billion. Those stakes account for almost 40% of Nestlé's $111 billion market value. Our calculation doesn't reduce the value of the Alcon and L'Oréal interests to account for any capital-gains taxes. Both Alcon and L'Oréal have been phenomenal investments for Nestlé since they were made in the 1970s. The big Swiss food outfit acquired Alcon for $276 million, and it paid a similar amount for its one-quarter stake in L'Oréal. While it's unclear whether Nestlé would pay any tax on the sale of either holding, it's notable that the Swiss didn't require any tax to be paid when Nestlé sold 25% of Alcon in a 2002 U.S. initial public offering.

Under an agreement with the Bettencourt family, a key L'Oréal shareholder, Nestlé can't buy additional L'Oréal shares before 2007 at the earliest, or sell or transfer L'Oréal stock through 2009.

No such restrictions exist with the Alcon stake. Alcon is a low-profile but phenomenal success story. It sells a range of eye-care products, including treatments for glaucoma, cataracts and infections; intraocular lenses; contact-lens solution; and artificial tears. Its shares have surged to 121 from 33 at the 2002 IPO. Alcon, however, isn't cheap, selling for 35 times estimated 2005 profits. Its $38 billion market value is equal to a stiff eight times annual sales.

Many U.S. investors are biased against European companies because they consider them weakly managed, relative to their American counterparts, and less oriented toward shareholders' interests. Just compare top-notch Procter & Gamble (PG) to its European rival, Unilever (UN) -- which only recently seems to have righted itself after years of restructurings.

Among the knocks against Nestlé is that it's too European, too long-term-oriented, too bureaucratic and too difficult to understand. And Brabeck, a 37-year Nestlé veteran, may not have the charisma of Gillette CEO Jim Kilts, or Hershey's Rick Lenny. That's on purpose. Brabeck has contrasted Nestlé's more deliberate management approach with the CEO-fixated "Anglo-Saxon" style, in which new chief executives often feel the need to shake up their organizations. "I get the feeling that in the Anglo-Saxon environment, the company is at the service of the CEO. At Nestlé, the CEO is at the service of the company," Brabeck said at a June investor conference.

By food-industry standards, Nestlé invests heavily in research and development, as it seeks to transform itself into more of a "health and nutrition company." One of its innovations is Dreyer's Slow-Churned ice cream that has half the fat and 25% fewer calories than regular Dreyer's (also sold as Edy's), yet has a premium-quality taste. Nestlé has shown that being environmentally friendly can pay off. It cut its water use by 37% in factories and energy consumption by 24% per unit since 2000. This plays well in eco-friendly Western Europe.

Nestlé has focused on water, ice cream and pet food. It's also a big producer of frozen foods.

Brabeck has countenanced one American innovation: a share buyback: Nestlé began its first repurchase program in July. It's admittedly modest, at 1 billion Swiss francs ($800 million), and is due to end at the close of 2005. But Nestlé has vowed to step up the buybacks in 2006. Analysts estimate that the buyback could total 2 billion Swiss francs in 2006 and perhaps 4 billion francs in 2007. A Swiss franc is worth about 80 U.S. cents.

Another rap against Nestlé is that it's always on the verge of a major, dilutive acquisition. The reality is that Nestlé has shown restraint in recent years. Its last major purchase came in 2002, when it paid $2.6 billion for Chef America, the maker of Hot Pockets frozen foods. Wolfgang Reichenberger, Nestlé's chief financial officer, has said that Nestlé "doesn't see a major acquisition in front of us." Brabeck says that in several critical areas, like pet food, water and U.S. ice cream, Nestlé has all the scale it needs.

The lack of a major deal has allowed Nestlé to begin its repurchase program because the company has been able to pay down debt related to prior acquisitions with its ample cash flow. Nestlé has an old-fashioned attachment to its prized triple-A credit rating. Net debt, now a very manageable $10 billion, had to come down before Nestlé would consider a buyback program.

For all the criticism of Nestlé's acquisitive ways, its three big deals this decade, Ralston-Purina, Chef America and Dreyer's, have turned out pretty well. The $10 billion Ralston deal, completed in 2001, nearly doubled Nestlé's sales in the high-growth pet food market. The company was shrewd enough to put the management of its entire global pet-food business in the hands of Ralston's talented team, based in St. Louis.

Nestlé's profile on Wall Street has risen somewhat in the past year, for an unfavorable reason. The company got into a well-publicized spat with some big institutional investors over whether Brabeck should also assume the role of chairman, following the retirement of Rainer Gut from that post earlier this year. Nestlé prevailed, in what really amounted a tempest in a teapot, or perhaps a coffee pot. (Nestlé is one of the world's largest coffee makers with its Nescafé brand.)

It's true that Nestlé historically has separated the roles of chairman and CEO, and many companies are deciding that one person shouldn't wear both hats. Yet Brabeck's wish to hold both jobs for a limited time hardly seems an affront to good corporate governance. Nestlé is expected to name a new CEO in several years, while keeping Brabeck as chairman.

OPERATING IN EUROPE, Nestlé doesn't have the same flexibility that American companies do to shut factories and lay off workers, if conditions deteriorate. Nestlé, however, is unwilling to cave in to what it views as unreasonable labor demands. Last year, it threatened to sell Perrier because of a disagreement with a union at its Perrier factory in southern France, which was only about a quarter as productive as its San Pellegrino plants. Nestlé decided to keep Perrier after the union agreed to job cuts and to boost productivity.

The Swiss food conglomerate was founded in 1866 by Henri Nestlé, who had developed a cereal-based infant formula for babies whose mothers had died or couldn't breast-feed. This was a breakthrough, because the children of such mothers sometimes died, since the other breast-milk alternatives used until then weren't sufficiently nutritious. Nestlé grew by acquisitions into the early 20th century, focusing on milk. Milk-related products remain the company's largest revenue source, followed by beverages (mostly water and coffee), frozen and other prepared foods, candy and pet food.

Nestlé entered the chocolate market in the 1920s and developed the first instant coffee, Nescafé, in the 1930s. Nescafé got a big boost during World War II when the U.S. army provided it to the troops.

After the war, Nestlé began expanding into Latin America and the rest of the developing world. Nestlé is now the dominant maker of infant formula outside the U.S. But in the American market, it badly trails Bristol-Myers Squibb (BMY), the maker of Enfamil, and Abbott Laboratories (ABT), the producer of Similac.

Brabeck: "In the Anglo-Saxon environment, the company is at the service of the CEO. At Nestlé, the CEO is at the service of the company."

Nestlé's overseas formula business ignited controversy in the 1980s after critics attacked Nestlé for urging poorly educated mothers in the developing world to forsake superior breast milk for formula -- leading to isolated boycotts of the company's products. Worse, Nestlé's powdered formula required water, which often was unclean. Nestlé has largely defused the formula issue with strict marketing rules. For example, the company acknowledges the superiority of breast milk, and won't advertise or give out free samples in the developing world.

Size can breed arrogance. In infant formula, Nestlé took a long time to reach an agreement with Martek Biosciences (MATK), which produces DHA, a fatty acid critical to brain and eye development that is present in breast milk but not cow's milk, the basis for formula. While Nestlé's rivals, notably Bristol-Myers Squibb and American Home Products, embraced DHA a decade ago, Nestlé didn't seal its deal with Martek until 2003. Nestlé's view, apparently, was that it was so big, it didn't need DHA. DHA-boosted formula now dominates the U.S. market and is growing abroad.

Nestlé is battling throughout the world to maintain its market-leading positions. In the U.S., Nestlé is the No. 1 seller of bottled water, with an estimated 40% share, thanks to a portfolio of solid regional brands, including Poland Spring in the Northeast and Arrowhead in the West. But Coca-Cola (KO) and PepsiCo (PEP), faced with an eroding soda market, have been seeking to expand into the growing water market, using their powerful bottling networks. Coke has Dasani; Pepsi, Aquafina.

"Nestlé's goal is to maintain and defend its share, and it has done a good job," says Bill Pecoriello, the beverage analyst at Morgan Stanley. "Nestlé is the low-cost product because it owns its own springs and produces its own packaging." Nestlé, for instance, dominates the important warehouse-club market, which has a rising share of the U.S. water market.

Looking ahead, analysts and investors see several potential merger opportunities for Nestlé. One scenario floated by Sanford Bernstein's Wood is that the company could ultimately buy the rest of L'Oréal. That likely would cost $40 billion or more. Yet Nestlé could finance nearly all the cost with the sale of its Alcon stake and L'Oréal's 10% interest in the European drug maker Sanofi-Aventis. Such a deal would create a "mammoth" consumer-goods company, with 50% more sales than Procter & Gamble, Wood wrote in a research note. Any action on L'Oréal would have to wait until at least 2007.

A final, mega-deal could involve Coca-Cola. This would be the ultimate merger of equals, since Coke and Nestlé have similar market values. Combining the two would give Nestlé's water and beverage units access to Coke's global bottling network, while providing diversification for Coke at a time when its core soda franchise is eroding. But insular Coke is unlikely to make such a move any time soon.

Then again, Nestlé could keep prospering without making any deals. While many of its rivals are in the doldrums, Nestlé's strong brands and developing-world exposure probably give it the food industry's best outlook.

Making the story even better: Nestlé's Alcon and L'Oréal interests effectively give its stock one of the sector's lowest P/E multiples. It's unusual to find an industry leader with a cheap valuation. Nestlé holders should be dining well in the coming years.


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