I would advise steering clear of companies with big debt burdens, punchy valuations and exposure to consumers. Enter Cadbury, the world’s second-largest chocolate and chewing-gum producer (behind Mars/Wrigley), which looks vulnerable for the following reasons.
Cadbury (LSE:CBRY), tipped as a BUY by The Daily Telegraph
Firstly, I suspect investors are being lulled into a false sense of security by its perceived defensive qualities. At its trading update last week, the company reported it was still on track to hit its targets. But this doesn’t mean it will be immune in a recession. Branded food is a late-cycle play. Consumers tend to cut back on big-ticket items first, before down-trading to cheaper supermarket own-label products as unemployment bites and disposable incomes shrink. Once the brand owners see this, their priorities shift from maintaining profit margins to protecting market share, triggering heavy discounting.
Next, with raw material costs (such as cocoa) set to rise another 6%-8% in 2009, Cadbury is raising prices. This may seem to make sense, but I reckon it will soon put consumers off buying, and possibly damage Cadbury’s “value for money” image. The cracks are already showing, with shoppers shunning some of its more costly names, such as its organic Green & Black’s chocolate. The likes of Tesco and Wal-Mart are also piling on the pressure by launching good quality sweets and innovating with organic and sugar-free chocolate. A similar battle occurred in the early 1990s, when food brands had to slash prices to defend volumes. If history repeats itself, Cadbury’s rich underlying operating profit (EBIT) margins of 12% will not be sustainable. Another worry is that the board is still guiding the City towards margins of ‘mid-teens’ by 2011 – potentially setting themselves up for a major fall. For Cadbury to achieve a 15% return on sales during an economic slump looks like a pipedream.
Finally, the stock is too expensive, trading on nearly 18 times prospective earnings. This premium rating is due to the firm being touted as a potential bid target, having demerged its drinks business earlier this year. But with finance director Ken Hanna’s recent departure, I reckon any such deal is unlikely, largely because of the racy valuation. To me the firm is worth around ten times 2008 EBIT, equating to an enterprise value of £6.7bn. After deducting £1.7bn of net debt, I’d estimate a fair value of about 370p per share, 25% below current levels. Worse still (although not disclosed), I suspect that after the pummeling on the global indices, a £300m hole (or 22p a share loss) has just been blown through the group’s pension scheme.
So while Cadbury should benefit from price hikes and sterling’s weakness in the second half, unless a takeover bid materialises, the stock could quickly turn sour in 2009.
Recommendation: SELL at 505p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments.