Nestle should navigate macro headwinds with its diverse product portfolio and geographic reach.

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 12/15/11Despite 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.
ValuationAfter 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.
RiskNestle'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 & StewardshipAlthough 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
Financial Health: 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.