Cadbury's latest update supports our thesis

Cadbury's nine-month trading update supports our thesis that following Kraft's unsolicited bid for the confectionery firm, management is likely to be laser-focused on generating further margin improvement in order to ward off an unwanted takeover or garner a higher bid from potential suitors. While Cadbury raised its full-year sales growth outlook to the middle of its 4%-6% forecast (up from the low end of that range) and now expects operating margin expansion of at least 135 basis points (up from 80-100 basis points), we're holding tight on our recently raised fair value estimate, as we believe we have already accounted for this improvement.

Underlying sales growth through the first nine months of 2009 amounted to 5%, primarily reflecting the higher prices Cadbury is charging for its products. Even though consumers seem to be taking these higher prices in stride, we aren't convinced that this will continue to be the case, particularly during the upcoming Halloween and holiday seasons.

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 seem to be gaining traction, as the firm reported operating margin growth of 180 basis points through the first nine months of 2009. We continue to believe that these efforts have probably intensified (as the confectionery firm remains a takeover target) and it is more likely now that Cadbury will realise its stated goal of generating midteens operating margins by 2011.

While Cadbury has rejected Kraft's initial offer, we believe this saga is far from over. Kraft has until November 9 to make a formal offer. We believe Kraft will have to enhance its bid, either by paying a higher price or by increasing the cash portion of the offer, which currently stands at 40%. Although a higher bid seems necessary, we stress that the deal could become value-destructive for Kraft at too high a price and may be limited by Kraft's desire to retain its investment-grade rating. We will update our analysis as we gain more insights.

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