by Erin Lash, CFA
Nestle NESN/NSRGY announced its intentions to acquire Pfizer's PFE
infant nutrition business for $11.85 billion in an all-cash deal valued
at 5 times fiscal 2012 sales and 19.8 times fiscal 2012 EBITDA. While
the deal makes strategic sense for both parties, the price seems rich to
us at first blush. However, the acquisition does not affect our fair
value estimate for Nestle, given that the target segment's annual
revenue of about $2.4 billion represents just 3% of packaged food firm's
top line. We had initially estimated that the ultimate price for the
Pfizer unit would be about $9 billion to $10 billion, but we expect that
the higher price reflects the fact that Nestle wanted to keep this
valuable asset out of its competitors' hands (namely Danone BN and Mead Johnson MJN).
From Pfizer's perspective, while Pfizer sold the nutrition unit for a
slightly higher than expected price, we don't expect to change the fair
value for the company. However, we believe Pfizer will likely use the
proceeds to repurchase shares, which will likely increase its 2013
earnings per -share growth by 300 basis points.
We aren't
surprised that Nestle would look to scoop up this attractive asset. The
infant nutrition business is high growth (with Pfizer's unit generating
about 85% of sales from faster growing emerging markets like China) and
high margin (with EBITDA margins in the mid-20s). This follows on
Nestle's purchase of a 60% stake in Chinese confectionery manufacturer
Hsu Fu Chi, the producer of the popular breakfast bar Sachima, last
summer. China--along with other growing Asian economies--is an
attractive market for Western manufacturers, whose domestic markets
offer very few growth opportunities, and this growth opportunity is
reflected in the rich multiple Nestle is paying for the investment. When
Nestle sold its stake in Alcon to Novartis NVS
for $28 billion pretax, we argued that it should invest the cash in
extending its footprint in emerging markets. In addition, the packaged
food firm has repeatedly expressed its interest in building out its
health and wellness offerings, and this acquisition fits that
initiative. We continue to expect Nestle to make bolt-on acquisitions of
health and wellness brands, as well as to look to further build out its
presence in faster growing emerging and developing markets. From our
perspective, the firm's balance sheet would support further leverage for
a large acquisition.
Thesis 12/15/11
Despite
its position as a leading global consumer product firm, Nestle is not
without its share of challenges, namely soft consumer spending and
persistent input cost inflation. However, with an expansive global
distribution network and well-known brands, Nestle has garnered a narrow
economic moat, and we expect that the firm will continue generating
solid cash flows and returns for shareholders over the longer term.
As the largest packaged food and beverages firm in the world by
revenue, Nestle is one of the leading players in several categories,
including beverages, dairy products, confectionery, and pet care. The
breadth of the firm's product portfolio, which spans packaged food,
beverages, pet care, and nutritional and pharmaceutical products, makes
Nestle a core supplier to grocery stores across the world, and its
distribution network is extensive. More than 20 of Nestle's brands each
generate in excess of CHF 1 billion in annual sales, and the firm is
particularly dominant in the bottled water category, fending off
competition from beverage behemoths Coca-Cola KO and PepsiCo PEP. As a result, Nestle is in a relatively strong position to negotiate with retailers for primary shelf space in stores.
However, competitive pressures (from both other branded players as
well as private-label products) remain intense. Amid an environment of
elevated unemployment, consumers are still price-sensitive in grocery
stores. The frozen foods category in particular, has been a fierce
battleground. The quality of lower-priced products has improved in the
last 10 years, and this could erode the premium that consumers are
willing to pay for branded food products. Nestle's growth could slow
because consumers who are switching to private-label products during the
downturn may not revert to leading brands when the economy recovers.
Similar to other consumer product firms, we anticipate that Nestle's
presence in faster-growing emerging markets will ultimately offset more
sluggish developed market growth. In these regions, consumers' wealth
and spending power continues to grow, leading to increased per capita
consumption of some of Nestle's discretionary products, such as
confectionery. While some investment in manufacturing and distribution
infrastructure will be necessary (management expects to spend CHF 2.5
billion in emerging markets capital expenditure in 2011, which seems
reasonable to us), we think Nestle can create more meaningful economies
of scale by growing its emerging market unit volumes. Nestle can
also utilize its impressive balance sheet, in our view, to make bolt-on
acquisitions to build out its presence in these regions. By 2020, Nestle
expects to generate 45% of consolidated sales from developing markets,
up from just 36% in fiscal 2010.
While we recognize that opportunities for additional growth and
margin expansion exist, we are skeptical that the company can meet
management's goal of 5%-6% internal annual growth and generate margins
comparable with its smaller peers, given the sheer size of the firm and
its decentralized operating structure. That said, Nestle offers broad
exposure to the consumer staples industry, and we recommend the shares
to investors who wish to rotate some assets into a defensive sector amid
the current market volatility. Despite this, we don't believe the
shares represent a compelling risk/reward proposition at current market
prices.
After
reviewing Nestle's results through the first nine months of 2011 and
transferring coverage to a new analyst, we are lowering our fair value
estimate to $57 per ADR from $59, which implies forward 2012
price/earnings of 17 times, enterprise value/EBITDA of 11 times, and a
free cash flow yield of 4.7%. Our updated outlooks incorporates a more
conservative view of the firm's sales growth potential in fiscal 2011 in
light of the strength of the Swiss franc and persistent macro pressures
in both the U.S. and Western Europe. We value the firm's stake in
L'Oreal (30%) separately from its core food and beverage business, and
estimate the value of the investment to be $6 per ADR, based on our fair
value estimate for L'Oreal. We value Nestle's core food and beverage
business at $51 per ADR.
We now forecast revenue to decline 10% in fiscal 2011, compared with
our previous forecast of nearly 2% growth. Between fiscal 2012 and 2015
we expect sales to increase nearly 4% on average annually, down from 5%
in our prior forecast. Over the near term, we anticipate that the strong
Swiss franc will hinder reported sales, and we suspect that competition
from other branded products and private label will restrict revenue
growth to inflationary levels over the longer term. Because of the
firm's decentralized structure, and the pressure to continue investing
behind product innovation and marketing core brands, we think that
margin expansion will be limited. We forecast operating margins to
average 13% over the next five years which is about 100 basis points
above the average margin of the past two years. We project Nestle to
generate returns on invested capital including goodwill of around 14%
during our five-year forecast period, comfortably ahead of our 8.8%
estimate of the firm's cost of capital. Our valuation does not take into
account potential acquisitions, which may cause future results to
deviate materially from our estimates. We use an exchange rate of CHF
0.8878 per $1 to calculate our fair value estimate, which is the
one-year average spot rate as of Dec. 14. However, the CHF/USD rate is
very volatile at present as assets flow into the Swiss franc, which is
seen as a safe haven in uncertain economic times. Changes in the CHF/USD
exchange rate could cause our fair value estimate to differ materially
from the prevailing market price.
Nestle's
greatest operational risk is the threat of rising commodity costs,
which could squeeze margins. Although the rate of input cost inflation
has moderated, the prices for several raw materials continue to trend
higher and remain considerably above the level of just two years ago. If
the firm seeks to raise prices to offset margin pressure, volumes could
weaken, as consumers might switch to cheaper private-label
alternatives. Nestle operates in some competitive categories and faces
stiff competition from companies such as Coca-Cola and Pepsi in bottled
water, Kellogg K in breakfast cereal, and Kraft KFT in confectionery.
Management & Stewardship
Although
we have some concerns about the strength of the firm's corporate
governance structure, capital allocation at Nestle has been solid from
where we sit as returns on invested capital exceed our cost of capital
estimate. We applaud Nestle's separation of the roles of chairman and
CEO, but CEO Paul Bulcke has had a 30-year career at Nestle and rose
through the ranks while former CEO and current chairman Peter
Brabeck-Letmathe was at the helm. We are concerned that the two may have
formed a close professional relationship that may jeopardize the
independence of the board from management. Furthermore, we would prefer
if Nestle held annual elections for all directors, rather than the
current three-year staggered structure. In addition, more disclosure
regarding management compensation would be highly valued on our end so
that we could better assess whether the financial incentives of the
executives are truly aligned with shareholders' interests. Having said
that, we think that the board includes a number of directors with
impressive executive, financial, and legal experience, and we like that
12 of the 14 members are independent.
Overview
Nestle
is in solid financial health. The company received an aftertax cash
windfall of around CHF 22 billion following the sale of its Alcon stake
to Novartis NVS,
which it has used to pay down debt, repurchase shares, and pursue small
bolt-on acquisitions. With so much cash at its disposal, we do not
anticipate any liquidity issues in the short term. We forecast Nestle to
generate free cash flow at around 9% of revenue on average during the
next five years, and its debt/EBITDA ratio should amount to 1.3 times
(in line with fiscal 2010). With debt maturities quite well dispersed
during the next five years, the firm should comfortably be able to meet
its repayment schedule. We expect Nestle to make bolt-on acquisitions of
health and wellness brands, as well as to look to further build out its
presence in faster-growing emerging and developing markets. The firm's
balance sheet would support further leverage for a large acquisition,
but with the shares currently fairly valued, we would not be in favor of
additional leverage for share repurchases.
Profile:
With
a history that dates back more than 150 years, Nestle has grown to
be the largest food and beverage company in the world. The firm
generates sales of around CHF 100 billion through its diverse product
portfolio, which includes brands such as Nestle, Nescafe, Jenny Craig,
Perrier, and Pure Life. Nestle also owns just more than 30% of French
cosmetics firm L'Oreal. In January 2010, the firm sold its 52% stake of
Swiss eye-care company Alcon to Novartis in a $28 billion deal.
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