Shares of Nestle (OTCPK:NSRGF) have languished over the past year with shares virtually flat and an underwhelming sense of urgency from the senior management team. Activist investor Dan Loeb’s hedge fund, Third Point, has provided its thoughts on the company, its culture, and its approach to capital allocation. Ultimately, Loeb wants a leaner, less bureaucratic company that aggressively shapes its portfolio via M&A. M&A is certain to make Nestle’s bankers wealthier, but I think shuffling the deck could also be quite beneficial for shareholders. Overall, I’m a little surprised at Mark Schneider’s cadence in remaking the company. While I agree with Loeb’s breakdown of core categories, I feel that the current management team may lack the expertise to execute the right strategic plan. Let’s review what the company has done thus far, what I think the company should do, and the performance of a once highly regarded executive. All things considered, I think Nestle is a low downside investment at its current price, but I am not confident the company has the right ingredients to outperform.
Divestitures and a Lack of Growth
Loeb has long called upon Nestle to get rid of non-core assets, which he estimates would be as much as 47% of sales. This would suggest that management could significantly reshape the business while it focuses on its core business. Nestle is on the way to leaning out its non-core base of businesses. Nestle divested its US confectionary business to Ferrero for $900 million. Nestle also sold its Gerber Life Insurance unit to an actual insurance company for $1.55 billion in cash, which makes sense, because why on earth was Nestle in the life insurance business?
In addition, Nestle is now actively shopping its skin health unit, which has sales of $2.8 billion and could fetch upwards of $6 billion. Nestle’s skin care business has several excellent brands, including Cetaphil and ProActive. Though the business probably has some purchasing synergies with other parts of the Nestle business, it is clearly unconnected from the core businesses like food, beverages, and nutrition.
Over the past two years, Nestle has been aggressive in acquiring assets, though not aggressive enough in Loeb’s view. Nestle has clearly targeted coffee as a key growth area, spending $7 billion to acquire the rights to Starbucks’ (SBUX) packaged coffee and tea products with an accompanying $2 billion in sales. Nestle also acquired majority ownership in premium coffee brand Blue Bottle, as well as the ready-to-drink cold brew coffee, Chameleon. Coffee is undoubtedly a key strategic area for Nestle, and I would not be surprised to see additional complementary acquisitions like other ready-to-drink products and coffee chains.
On top of coffee, Nestle has demonstrated a key interest to further its nutritional sciences business. This comes as no surprise, as Mark Schneider is the former CEO of Fresenius, which invested heavily in this space. Key deals thus far include Atrium Innovations, a seller of vitamins and nutritional supplements, and a partnership in microbiome diagnostics. This could be a potentially interesting area as the company focuses on treatments for gastrointestinal diseases like inflammatory bowel syndrome. Pharmaceutical treatments in this space have had mixed results, so any breakthroughs in microbiome technology could encounter quick adoption.
Overall, I believe Nestle has confidence its strategies for nutrition and coffee, but I am not as certain about other categories. There are several strong targets in water, including National Beverage Company (FIZZ) that wouldn’t break the bank for Nestle, and the company has yet to execute. Management also has not taken any big shots thus far in beverages (excluding coffee), prepared meals, and other grocery categories. I suspect Schneider remains uncertain about the best path forward in several of these areas, but he has been at the helm for almost two years, and I would have expected a clear strategy in many of these areas by now.
On the financial front, Nestle’s growth has been unimpressive in FY18. Organic sales growth in FY18 has been about 2.8%, with reported growth of about 2% due to foreign exchange headwinds. The best way to grow this top-line would probably be through purchasing innovative smaller brands, and I would like to see management step up on this front.
On the operating margin front, Nestle is slowly making progress. Though results for operating margin go only through the first six months of FY18, operating margin is up 20 basis points y/y to 16.1% of sales. This is an area where Loeb is greatly disappointed, and I agree. Nestle is targeting an operating margin of 18%, which is below its peers and below the recently restructuring Unilever. Loeb has been a part of impressive cost-cutting projects in the past, and I think the company may need to bring in some expertise in concepts like zero-based budgeting to reduce the company’s cost structure. A 20%+ operating margin seems possible, given Nestle’s existing product mix as well the ability to divest lower margin projects.
In addition to more optimistic margin goals, Nestle should focus on making sure it understands its clear strategic areas. I am indifferent to several categories, but I would prefer that management has steadfast conviction in areas beyond coffee and nutrition. I think the company needs strategic clarity, but I am also unsure why it has taken so long. Schneider might be playing a long game, and his playbook undoubtedly worked quite well at Fresenius. However, Nestle shareholders are getting impatient, and I believe Schneider could be out of a job if he is unable to figure out the strategy quickly.
As Loeb constantly hammers home, Nestle is sitting on a non-strategic position in L’Oreal that is worth at least $26 billion. Monetizing L’Oreal is a no-brainer decision given that L’Oreal currently trades at ~30x earnings and because it would provide Nestle with considerable strategic capital flexibility. I simply cannot understand why Nestle hasn’t focused its resources on finding the most tax efficient way to dispose of this asset.
Valuation: Not Crazy, But Lacking Upside
Nestle is undoubtedly working to get its house in order; however, the cadence is simply too slow, and there are signs that the company may not totally understand what areas are of strategic importance. That being said, the company is currently valued at 16x EBITDA, which is fairly in line with peers like Mondelez (MDLZ) at 18x EBITDA, Kraft Heinz (KHC) at 13x EBITDA, and Coca-Cola (KO) at 21x EBITDA. Nestle has earnings upside, so its actual multiple on a forward-looking basis is probably in the neighborhood of 14-15x.
Overall, this valuation is not crazy, but the company needs to demonstrate the ability to grow its top-line at a faster pace. I think the company could attempt to pursue a major acquisition like Abbott’s (ABT) nutrition business that has struggled, or it could work on smaller deals in its focus areas. Either way, there is a path to faster top-line growth, and it is up to management to figure out how to get there.
Although Schneider has an impressive track record at Fresenius, management skill does not always translate. Further, some of his success at Fresenius could be the result of factors outside of his own doing. This is exactly why Warren Buffett advocates betting on great businesses. Management skill is tough to measure, and one story of success does not always translate.
At its current price, I think Nestle can return 5-7% per annum. Though this is an adequate return, it is not enough upside for me to take a position. I believe this upside could be greater if we receive confirmation from management in the coming months that they have a deep strategic plan to drive the business going forward. However, such a plan has yet to surface, and therefore, I will continue to value the business conservatively.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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