Being ‘overweight’ in this confectioner seems like an unfortunate pun at a time when anti-obesity measures are climbing the political agenda. It’s also unfortunate when you consider the extent to which falling disposable incomes and rising commodity prices will hit profits.
Cadbury Schweppes (CBRY), rated as OVERWEIGHT by JP Morgan
Being “overweight” Cadbury – the world’s largest confectioner and the number-three US producer of soft drinks – seems an unfortunate pun at a time when anti-obesity measures are climbing the political agenda. At its recent results, the group said that rather than being the Chinese Year of the Pig, 2007 had instead been the Year of the Gorilla, referring to the success of its drumming gorilla advertisement, which achieved a record 91% awareness among UK consumers and became one of the most watched videos online.
But this is about as good as it gets – and here’s why. Firstly, while like-for-like sales rose a creditable 6.2% (split 7.1% sweets and 4.4% beverages), most of this was achieved via price hikes. And with raw material costs (such as cocoa, milk and grain) set to rise another 5% in 2008, Cadbury is being forced to lift prices again to protect earnings. This tactic should be fine during the buoyant Easter chocolate season, but in the hotter summer months when demand wanes, cash-strapped consumers might trade down to own-label products. The likes of Tesco and Wal-Mart are already licking their lips, launching good-quality chocolate bars and also innovating with organic and sugar-free candies.
A similar battle occurred in the early 1990s recession, when brand owners were forced to slash prices to preserve market share. If history repeats itself, then Cadbury’s rich underlying operating profit (EBIT) margins of 13.2% will not be sustainable. What’s also worrying is that the board is still guiding the City towards margins of “mid-teens” by 2011 – thus potentially setting themselves up for a major fall. For Cadbury to achieve a 15% return on sales during an economic downturn will be a huge challenge.
The next issue is the group’s plan to demerge its drinks business by the middle of 2008. Given the dire state of the financial markets, I cannot see how this deal will enhance value. It might even damage shareholders, since having two boards and two stockmarket listings will load up central costs, and may even detract from operational performance.
Lastly, the stock is expensive. To me the confectionary and drinks units should be rated on 2008 enterprise value to EBIT multiples of 12 and ten times respectively – giving corresponding valuations of £7.5bn and £5.6bn for the standalone units. After deducting £3.2bn of corporate net debt, I reckon the stock is worth (on a sum-of-the-parts basis) about 470p per share, or 18% below current levels. With the price looking vulnerable and lobbyists becoming ever more vocal on obesity issues, I would advise investors to sell.
Recommendation: TAKE PROFITS at 579p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments