In his five years as chief executive of Vevey, Switzerlandbased Nestlé, Peter Brabeck-Letmathe has turned the 136-year-old company into the fastest-growing giant in the slow-growth food business. Even so, he has never managed to eliminate investor skepticism about his ability to fatten profit margins. Now, after years of eschewing big purchases, Nestlé has spent roughly $15.5 billion on three acquisitions since December, prompting some shareholders to wonder whether Brabeck-Letmathe has forsaken organic sales and earnings growth in a grab for market share.
The criticism seems overblown. Two of Nestlé's purchases -- Ralston Purina Co., the world's largest producer of dry pet food, acquired for $10.3 billion last December, and Chef America, the leading maker of frozen snacks in the U.S., bought for $2.6 billion in August -- should enhance the renowned Swiss chocolate maker's sales and earnings growth.
However, the same can't be said of Dreyer's Grand Ice Cream. In a complex deal Nestlé will pay between $2.6 billion and $2.77 billion in stock for the company. The Dreyer's purchase seems wildly expensive, considering that the company had just $8.8 million in net profit last year on revenues of $1.4 billion, and $24.5 million in 2000 on sales of $1.2 billion. Nestlé, combined with Dreyer's, will lead the premium end of the U.S. market with brands like Häagen-Dazs and Edy's Grand Ice Cream, but American demand for ice cream has been growing at only 2 percent a year since 1996.
"It is hard to escape the conclusion that while Nestlé may have got the key strategic asset in the U.S. ice cream market, the financial benefits of the merger have all gone to the minority shareholders of Dreyer's," says Martin Dolan, food industry analyst at Credit Suisse First Boston in London. Adds another London-based analyst, "Before Brabeck-Letmathe came in, this was a company that had a habit of paying up for acquisitions, and people are clearly worried that could happen again." Contributing to this concern: Nestlé made a $10.3 billion run at Hershey Foods Corp. in September with London's Cadbury Schweppes. The two indicated that they would have sweetened the offer had not America's chocolate leader been withdrawn from sale by the trust that owns it.
At least some of these recent moves seemed to signal a shift in strategy. Previously, Brabeck-Letmathe, 58, achieved industry-leading sales gains by snapping up growing brands and unloading laggards. He spun off Nestlé's European frozen-food business, tomato processing and Italian meats, creating a company capable of regularly hitting a 4 percent annual internal growth target, almost double the food sector's average and better than any of its major European competitors. Although Nestlé's estimated 2002 revenues of Sf89.9 billion ($59.5 billion) represent a slightly lower 3.8 percent growth rate, analysts expect the company to grow 4.2 percent in 2003 and 2004.
Yet Nestlé stock still trades at a discount to the sector, in part because it only reports profit twice a year. Of greater importance is the fact that its overall operating margin doesn't match that of European food companies like the U.K.'s Reckitt Benckiser and Anglo-Dutch rival, Unilever, let alone the estimated 30 percent operating margin of its own instant coffee business. Nestlé shares have risen 77.5 percent under Brabeck-Letmathe, but the company's enterprise value as a multiple of earnings before interest, taxation, depreciation and amortization (a common measure of value used by European food analysts) is 8.4, lagging Unilever's 9.1 and the U.S.'s Kraft Foods' 10.9.
Nestlé's operating margin could improve considerably over this year's estimated 10.7 percent if the company can successfully implement a common information technology system between now and 2006. The project, known as Globe, for "global excellence," is budgeted to cost Sf1.5 billion and is expected to produce annual savings of Sf3 billion. But as the largest corporate IT system ever built from scratch, it is an enormously complicated project. Shakedown problems would mean sharply lower savings.
A Nestlé lifer, Brabeck-Letmathe was born in Villach, Austria, and studied economics at Vienna's University of World Trade. Lively in argument, he doesn't give an inch, which can sometimes intimidate analysts.
Brabeck-Letmathe recently discussed Nestlé's challenges with Institutional Investor Staff Writer David Lanchner.
Institutional Investor: Could acquisitions put at risk your ability to hit Nestlé's 4 percent internal growth target, as some investors fear?
Brabeck-Letmathe: No, absolutely not. The first priority for us is to achieve real internal growth. Five years ago I pointed out that in pet food, water and ice cream, we would be using acquisition as an additional tool to accelerate internal growth. With the acquisition of Ralston Purina, we are now on par with the global leader in pet food [McLean, Virginiabased Mars], and there will be no other major mind-blowing acquisition. In water we still have acquisitions ahead of us, but they will be small and they will help us achieve the 4 percent target. We have also come to an end of big acquisitions in the ice cream business. In the future we will be doing fewer acquisitions, and none of them will put this target at risk.
Will we see higher profit margins?
Historically, we had a net profit margin of 5.5 percent. Over the past few years, we improved that to 7.5 percent as manufacturing efficiency increased and we sold off less profitable commodity businesses. At the same time, we have outperformed by almost twice the industry average in top-line growth. Personally, I would rather have a slightly smaller share of a rapidly growing pie than a slightly bigger share of a slower-growing pie. Nestlé is undervalued because it is a relatively complex company doing many things, not because of its margins.
What are you doing to improve Nestlé's financial transparency?
We began reporting results separately for water and pet food operations this year. These were huge steps that should give people a better understanding of the real performance of our businesses. Over time, moves like this will eliminate the discount.
Wouldn't reporting profits quarterly and providing breakdowns of sales by category more than once a year help?
Not having quarterly profit statements and not going into the kind of detail you are talking about is a strategic decision. We feel it is part of our strength not to do it. Quarterly profit statements take you to short-term decision making. You start to ignore the long term, and that is bad for the business.
Does the new Sarbanes-Oxley Act [making chief executives legally liable for the accuracy of company accounts] make a U.S. listing less attractive?
I have not really considered it. But speaking generally, the important signature for the shareholder, in my opinion, is the external auditor's. This new law means that suddenly we don't believe anymore in external auditors. I sign my documents for my board, and I assume full responsibility, but what would make the most sense for shareholders would be to take more steps to safeguard the honesty of external auditors.
What are you doing to minimize glitches in the execution of Globe?
In order to limit the execution risk, we are rolling out Globe in three pilot areas first: Malaysia-Singapore, Switzerland and the Chile-Bolivia-Peru region. By the end of this year, when we've successfully brought the pilot areas onto a common IT platform and optimized their purchasing and accounting, we should be able to unite our other markets as well. As more countries come on board, we gain experience, and the danger of Globe not working as planned diminishes.
Someone involved with Hershey obviously thought it was a better time to sell a chocolate company than to buy one. Obviously you don't agree. Why?
It makes a lot more sense to keep chocolate. Our chocolate sales grew 11.3 percent over the past two years, while the operating margin increased to 10.3 percent from 8.8 percent. If people looked at these figures, no one would say that this is a value-destroying business. Confectionery, water and nutrition are now our priority areas for growth. The emphasis will be on organic growth with acquisitions used to accelerate it. Don't forget, it was Switzerland and our company that invented modern chocolate at the beginning of the 20th century. We are very proud of that.