Consolidation loses hold

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there's increasing talk about when and where the next round of consolidation will be among food marketers. A better question may be who's going to be selling brands-in other words who might be deconsolidating.

At Credit Suisse First Boston we have been skeptical of major moves toward consolidation because many recent deals haven't produced the promised results. We believe a primary reason many of the acquisitions of 2000 haven't worked out is because the increase in breadth of portfolios that resulted from those company purchases has ledto increased complexity and a loss of focus at many companies, more than offsetting the predicted positives of greater scale and cost savings.

In addition, many food companies-think names such as Kellogg, Hershey, Campbell, Hormel and McCormick-have insider-ownership positions that render takeover unlikely.

It is precisely because of this increased complexity and lack of focus that deconsolidation is actually more likely than more consolidation. We have already seen significant portfolio reshaping take place with the sale of agribusiness assets at ConAgra and the sale of the Heinz tuna and pet-food businesses to Del Monte. So what other companies might now be planning to sell off brands?

* Kraft Foods is one company talking about focusing the portfolio. We believe Altoids and Life Savers are on the block or will be, and that Wrigley would be the likely buyer. It also seems likely that Kraft's license to use the Breyers brand on yogurt will soon be for sale-if it's not already being hawked. Stove Top, Minute Rice and Shake `n Bake also could go, with perhaps ConAgra the likely buyer. Milk-Bone is a sale candidate, with Del Monte Foods the most obvious buyer.

* Campbell Soup Co. has Godiva and V8, brands that would be better suited to other companies' portfolios.

* Dean Foods might consider spinning off or selling branded operations (Silk, Horizon Organic) as the need for ramped up marketing spending dissipates. It also could sell its Specialty Foods Group, which includes pickles, olives and cheese sauces.

* Sara Lee is talking about "de-emphasizing" apparel.

Many of the companies that have been the most successful in the food industry long-term are focused operations (Wm. Wrigley Jr. Co., Hershey Foods Corp., McCormick & Co., Hormel Foods). There may be useful lessons to be drawn from this history.

new news

Big and consolidating retailers certainly need suppliers that can serve them on a broad geographic scale and keep pace with evolving technology. Just as important, retailers need manufacturers that can drive store traffic. The most effective marketing to achieve this aim is to have resonant new news-new products, product enhancements and so on-and that is more likely to come from marketers that are focused than marketers with scale.

Another driver here is the ability to fetch good prices for food brands. Prices or multiples for publicly traded food companies are higher today than in 2000, when merger mania took place, so this could be a good time to sell or spin off assets if willing buyers can be found. It is interesting that valuations are higher today, considering that prospects for growth across the industry are much lower. Most food companies in 2000 were talking about double-digit earnings growth; now it's in the mid-to-high single digits.

There are many more ways deals fail than succeed. There would be many hurdles to food industry deconsolidation, and one is tax consequences. Many brands that no longer are optimal in a given company's portfolio were started or acquired long ago and have a low tax basis. Unless something creative can be used-such as the way Procter & Gamble Co. spun off and sold Jif and Crisco to Smucker-asset sellers will have to consider whether after-tax proceeds of a sale can generate the same or greater returns than the asset being considered for sale.

From the purchaser's perspective, prices or valuations are higher than in 2000, which obviously is negative. Growth rates are generally considered to be slower and returns more risky or volatile-which is in contrast to higher valuations. One potentially offsetting factor here is lower cost of capital with lower interest rates.

commoditization

There are many challenges facing the food industry, including a power shift toward retailers, store brands, market fragmentation (for example, ethnicnd more recently, obesity.

The biggest underlying problem, however, is commoditization. Brands are getting less of a premium because the products are declining in magnitude of differentiation. This isn't easy to combat. The cost of new product generation, slotting fees and marketing to cut through the clutter all conspire to make growth more expensive.

While these trends are not new, they are manifesting themselves in new ways. Net pricing (after promotion spending) declined in the most recent quarters for General Mills, H.J. Heinz Co., Campbell and Kraft. Operating leverage has also turned negative (profits growing slower than sales) across the industry at companies such as ConAgra and Wrigley. This is especially painful at a time when commodity prices are rising. Earnings expectations on average for package-food companies in 2005 are now 6% lower than they were a year ago. Many food stocks and their earnings are about where they were five or six years ago, even excluding restructuring charges.

Due to the factors discussed above, many shareholders will likely view significant acquisitions with a healthy degree of skepticism. The share prices of bidders will likely be vulnerable. On the other hand, the share prices of sellers may appreciate. ConAgra's share price rose appreciably over the past year-even though its dispositions diluted earnings-because investors think the quality of the overall portfolio has improved.

ABOUT THE AUTHOR

David Nelson, managing director at Credit Suisse First Boston, is one of Wall Street's top analysts covering food and agribusiness companies. He is a rated Institutional Investor All-American for food stock coverage and the co-coordinator of the No. 1 rated CSFB Global Consumer team.

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