After Kraft’s bid for acquisition was refused by the confectionary giant last week, we take a look at Morningstar stock analyst Erin Swanson’s assessment of Cadbury’s UK-listed stock. (Click here for our take on Kraft’s bid).
Fair value estimate: 585p ¦ Fair value uncertainty: Medium ¦ Economic moat: Wide
Thesis
We are encouraged that Cadbury's
efforts to trim more fat from its cost structure by simplifying its
manufacturing base, reducing stock-keeping units, and centralising its
European supply chain seems to be gaining traction, as the underlying
operating margin expanded by 140 basis points to more than 11% through
the first six months of 2009. That said, weak economic conditions in
developed markets, a heavy reliance on emerging markets, and elevated
commodity costs continue to present challenges for Cadbury. Although we
believe the firm is still likely to achieve midteens operating margins
over the long run, near-term hurdles could extend the time frame over
which these results are realised beyond our initial forecast of 2013.
Cadbury is a leading player in the global confectionery market with nearly 10.5% share, securing its leading position by making more than 40 acquisitions in confectionery and beverages during the last 20 years. Many of its acquisitions were sound from a strategic standpoint. For example, in 2003, Cadbury acquired the Adams portfolio of brands for $4.2 billion, which catapulted it into the second-leading position in the higher-margin gum business and expanded its presence in developed and emerging markets.
Although the acquired confectionery businesses strengthened Cadbury's global foothold, allowing these businesses to run with a high degree of autonomy gave the firm a bloated management structure, too many inefficient manufacturing plants, and a proliferation of stock-keeping units and innovation projects that added unneeded complexity. As a result, the company's low-double-digit operating margins trail the midteens to high-teens margins enjoyed by other confectionery stalwarts.
Despite posting impressive top-line results, Cadbury's inability to improve its margins has been a thorn in the side of the firm's investor base. The question today is how Cadbury can deliver on its goals to improve its margins to the midteens. Although commodity pressures remain difficult, the firm is now increasing prices more aggressively. Second, the firm doesn't have to play catch-up in its investments to drive sales. Finally, we believe that the firm is making aggressive strides to remove a lot of low-hanging fruit that remained in the organisation. For example, bloated central costs reflect the legacy of supporting both the confectionery and beverage businesses and the company's pricey central office.
Even in the face of near-term head winds, we believe that Cadbury's position as one of the world's leading players in the attractive confectionery industry will enable the firm to generate solid cash flows over the longer term.
Valuation
We are lowering our fair value estimate to 585p per share from 633p to
account for erratic foreign currency rates. In our opinion, difficult
economic conditions in the firm's developed and emerging markets and
elevated input costs could pressure near-term results. Further, though
we continue to believe the firm should achieve its operating margin
targets, near-term hurdles could extend the time frame over which these
targets are realised. We believe the company is positioned to increase
internal revenue between 4% and 5% annually over the next five years.
Our forecast excludes acquisitions, which may cause future results to
differ materially from our estimates. We have included the firm's
planned product streamlining into our model, which we expect will lower
revenue growth by 50-75 basis points. We believe Cadbury's
cost-reduction efforts will yield significant bottom-line benefits, but
our forecast relies on the firm delivering on the lower end of its
midteens target. In our forecast, the operating margin approaches 14% by
2013 (which is up from an adjusted operating margin of around 11% in
2008).
Risk
Cadbury's ongoing restructuring efforts may prove to be disruptive to
the firm's operations, and it is still highly unclear whether the
company will achieve the significant margin improvement management
anticipates. Further, Cadbury's profitability may be hurt by elevated
commodity costs, particularly cocoa, sugar, and fuel costs. Finally,
with nearly 40% of its sales resulting from developing and emerging
markets, the firm is exposed to volatile political and economic climates
that could pressure sales.
Strategy
Cadbury's primary objective is to drive margin gains by improving the
efficiency of its business. To achieve this, the firm is reducing
stock-keeping units and scrapping 15% of its manufacturing and
distribution centers by 2011. In addition, Cadbury is placing increased
emphasis on its key brands, markets, and customers. Finally, the firm is
concentrating on enhancing operations in Russia and China, which have
been a drag on profits.
Management & Stewardship
Todd Stitzer is the CEO at Cadbury, while Roger Carr assumed the
chairman role in July 2008. In our opinion, the separation of these
roles between two individuals is a positive. We also believe that
Stitzer's experience of more than 20 years at the firm, most recently as
chief strategy officer, is beneficial as Cadbury faces several
challenges. Overall, we believe compensation is fair. Two thirds of
compensation is variable and performance-based, which is a plus in our
eyes. In addition, we believe the metrics by which management is
critiqued--underlying earnings per share and returns on invested
capital--appropriately align management's interests with shareholders'.
We are further encouraged that Cadbury has put share ownership
guidelines in place for its executive management group. However, we
would prefer if directors were elected on an annual basis, rather than
the current three-year staggered structure. It is also worth noting that
Ken Hanna stepped down as CFO in April 2009. We liked Hanna, and he will
surely be missed. However, we believe the appointment of Andrew Bonfield
(most recently CFO of Bristol-Myers
Squibb) was a sound decision. Although Bonfield is new to the
confectionery industry, we contend that his financial experience should
be a plus as Cadbury seeks to trim the excess fat from its operating
structure and enhance its profitability.
Profile
Cadbury operates as the leading competitor in the global confectionery
market, with product lines spanning the chocolate, candy, and gum
segments. The firm distributes its well-known brands (such as Halls,
Trident, Green & Black's, and Dentyne) in more than 80 countries around
the world. After completing the sale of its Australian beverage segment
in April 2009, Cadbury is now exclusively focused on its confectionery
operations.
Growth
More than $10 billion of acquisitions have diversified Cadbury's
business into faster-growing, more-profitable segments of the
confectionery market. Going forward, we expect that the firm will seek
to drive growth through small bolt-on acquisitions as well as further
penetration of its existing brand portfolio.
Profitability
Management projects a midteens operating margin by 2011. Although we
believe Cadbury will be able to cut a lot of low-hanging fruit,
particularly in the early years of its initiatives, we assume the firm
will achieve the low end of its midteens margin target and most likely
over a time frame beyond management's forecast.
Financial Health
We're not concerned by Cadbury's debt levels, as the firm operates with
nearly £1.4 billion of long-term debt, and adjusted earnings before
interest and taxes of more than 4 times through the first six months of
2009.
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