Nestle's Response to Activist Investors Underwhelms

Nestle has announced some tweaks to internal capital allocation as well as a CHF 20 billion buyback program. In our opinion, this is an underwhelming package designed to stave off activist interest in the company following Third Point Capital’s recent investment and demands for strategic change. Management said it intends to funnel more capital to higher-growth opportunities and cited bottled water, pet care, infant formula, and coffee as categories of focus. The company will look for opportunities for “targeted efficiency programs” that will not impede growth. Externally, it said, capital will be allocated to acquisitions that offer growth opportunities in its focus product categories and geographies.

Nestle’s share-repurchase program is shortsighted, in our opinion, and is not likely to create long-term value for shareholders. We regard Nestle as being slightly overvalued, which implies that we would expect long-term returns below the cost of equity on shares bought at the current market level.

The buyback program aside, we see very little of significance in this strategic update, and we think it will do little to maximize value for long-term shareholders. We will continue to take a more conservative approach to forecasting the cash flows of Nestle relative to companies more committed to driving growth by streamlining operations. Unilever UL/UN is one such company, as its response to a takeover approach was more holistic and aggressive, which gives us more conviction that its financial targets will be achieved.

Nestle’s announced changes should be seen as a positive, but we think they fall well short of getting to the root of the company’s issues. Stagnant growth is the obvious problem, and management appears to be focused on that. Nestle--which generated CHF 90 billion in sales last year, more than any other consumer product company--has not achieved its self-described “Nestle model” organic growth rate of 5%-6% since 2012. This can be partly attributed to the fairly low inflationary environment in recent years, and with pricing pressures appearing to creep back into Europe, we estimate this could add 100 basis points to the 3.2% organic growth rate achieved last year. However, it also reflects structural changes in the industry, in particular the growth of unbranded competition in the hard-discounter channel and the potential disintermediation of mainstream grocers by e-commerce. The renewed focus on investing in growth opportunities cannot hurt, but we think a more holistic approach that reinvigorates the entire operating model is required in order to provide the financial flexibility required to kick-start Nestle’s growth.

Benefits derived from scale, including supply chain entrenchment and cost advantages, are still the most commonly occurring moat sources in consumer staples. Scale contributes to large cash flows that allow manufacturers to react quickly to any changes in the competitive environment, ensuring that they retain shelf space. Rather than being the drivers of category growth that they once were, however, large-cap consumer companies are playing whack-a-mole with waves of new entrants, whose emergence is facilitated by the growing demand for craft, artisanal, and niche products. Despite the vast customer acquisition budgets of the large-cap manufacturers (Nestle spent CHF 1.7 billion, or 1.9% of sales, on research and development last year, and CHF 18.4 billion, or 24% of sales, on marketing and administrative expenses, both of which are around standard for the industry), returns on investment are falling as a result of this increased competitive pressure. Nestle’s return on invested capital has declined steadily from 31% in 2007 (excluding Alcon) to 20% last year.

We believe that by reversing this decline in returns on new invested capital through changes to its internal capital allocation, Nestle can reignite its organic growth rate. Here, we evaluate the strategic options the company faces, some of which are our own suggestions and some of which are those of Third Point Capital.

Wholesale portfolio reconfiguration. We think Nestle is simply too big. We believe the firm should trim its portfolio footprint to those categories in which it is a leader or a strong number two, as it is in these categories where its strongest competitive advantages lie. This would go much further than the sale of the U.S. confectionery business currently being considered. It would probably involve an exit in some markets in bottled water, prepared dishes, and confectionery, leaving it with a strong presence in other beverages, infant formula and dairy, nutrition and healthcare, and pet food--a portfolio with plenty of scale to sustain its wide economic moat. Procter & Gamble PG recently went through a portfolio pruning process that allowed it to focus on its strongest businesses, and it still operates a strong and well-entrenched business.

Reallocation of R&D spending. In our view, the efficacy of the research and development budget is one of Nestle's biggest problems. The return on R&D spending, measured by impact of organic growth to the top line in Swiss francs divided by R&D expense, has steadily declined by more than half since 2011, implying that R&D is becoming less effective. We believe that as Nestle has grown and become more reliant on blockbuster innovation to drive growth, it has become more difficult for small projects with high net present value to receive the investment they require to get to market. Yet the emergence of new entrants, which by definition more often operate within a niche than with a large portfolio of products, supports our contention that industry growth is highest in niche categories. Therefore, we think Nestle--and large-cap manufacturers in general--must either increase R&D spending as a percentage of sales for the benefit of the entire portfolio, or reallocate the spending to those projects that yield the highest incremental returns. This would not have a detrimental impact on margins if accompanied by efforts to streamline the business elsewhere.

Sell the stake in L'Oreal. This is one of the propositions from Third Point, but we think the value creation from the transaction would be very limited. We value Nestle's 23.2% stake in L'Oreal separately from our discounted cash flow model, based on our fair value estimate of the stand-alone business. As we currently regard L'Oreal as overvalued, a sale of the asset would by definition create value for Nestle shareholders. However, at the current market value, the disposal of the stake would increase our valuation of Nestle by less than 2%, and with such a thin margin--and the risk of a large disposal weighing on the market price of L'Oreal--we do not think this would be a worthwhile exercise. Having said that, we think Nestle should use the L'Oreal investment as a source of funds if an opportunity emerges for a transformative deal that would help reposition the portfolio toward higher-growth and higher-return categories. Our opinion that L'Oreal is currently overvalued implies that we would expect below-cost-of-equity returns on the investment in the long term.