Reinventing Nestlé

Similarly - and with a little help from George Clooney - Nestlé's bosses hoped to change modern coffee-drinking habits with Nespresso coffee pods. But in April this aim was shaken when a UK court ruled that an alternative coffee capsule that uses Nespresso machines did not break Nestlé's patents.

That was a classic victory of the 'little man' - in this case, Dualit, a company best-known for making retro toasters - against the big battalions. True, Nestlé's defeat will have little effect on the group's accounts. Most likely, Nespresso is wonderfully profitable - the the best guess among City analysts is that it generates about £2bn of annual revenue for Nestlé, which filters down to operating profits of around £450m. But that’s a small helping for the Nestlé food monster that generates annual sales of about £65bn and operating profits approaching £10bn. Besides, the UK court's decision has no effect on the Nespresso patents for the rest of Europe.

Yet, despite that, the Nespresso ruling could have a significance for Nestlé that goes beyond the sales numbers. It has the potential to undermine the way that the world's biggest foods processor goes about its business because, if ever there was a company that plays for the long haul, it is Nestlé.

The histories of both Nescafé and Nespresso illustrate this nicely. It took seven years of freezing coffee solutions in the 1930s before Nescafé was ready for the market. More recently, Nestlé started working on the Nespresso technology in 1970. It filed its first patents in 1976, but did not launch Nespresso pods until 1986. Then it was not until the mid-1990s that Nespresso broke into profit. "It took off very slowly. It was 20 years of conviction that got us there," said Paul Bulcke, Nestlé's chief executive, of Nespresso's development.

That partly explains why Nestlé's lawyers will appeal against the UK judgement. Generically, however, Mr Bulcke's words could be a description of how Nestlé goes about all of its business - it is driven by conviction. It is 'conviction' that has brought Nestlé a presence in 194 countries in the world (that's one more than there are member states of the United Nations) and 'conviction' that has brought it 29 brands with annual sales over Swf1bn (£700m), the best known of which to UK consumers - apart from those already mentioned - are Kit Kat, Perrier, Nesquik and Felix cat foods.

Fat profits

Now that conviction is shifting Nestlé away from being a foods processor. Read the company's annual report and you might be pushed to learn that it processes foods at all and have even less notion that it makes calorie-rich stuff such as Häagen-Dazs ice cream or sugar-coated Smarties. Nowadays, Nestlé talks about itself as a 'Nutrition, Health and Wellness' company. The question is whether this is just neat marketing that helps disguise Nestlé's culpability in a world of obesity or whether it is sincerely meant?

A bit of both, perhaps. But, more to the point, the shift of focus towards 'nutrition etc' epitomises the ability of Nestlé's bosses over the company's 120-year history to make big decisions even though they would be disruptive.

Back in the 1990s, Nestlé's chairman, Peter Brabeck-Lemathe - then its chief executive - was not alone among food company chiefs to see that their industry was one where brands were becoming commoditised, growth was becoming pedestrian and profit margins were getting squeezed. His response was to take Nestlé towards 'functional' foods - foods that have some sort of health benefit - whose sales were growing much faster than standard processed foods. The result has been products such as Boost, a nutritional drink, Power Bar, instant energy for sports players, and the Jenny Craig operation of low-calorie food and slimming centres.

Sure, there is a debate about the efficacy of nutritional foods. Marion Nestle (no connection with the company), a US academic who blogs at www.foodpolitics.com, calls the stuff "nutrifluff" and points to the simple but dull truth that "if you want to do something for your health, you don't eat as much and you don't eat processed foods". But arguably that's not the point. More relevant is that food politics will stick around for as long as obesity remains a global problem, so food companies have to tailor business plans that are both helpful and profitable.

And last year Nestlé made its most dramatic shift towards nutritional foods with the $12bn acquisition of Pfizer Nutrition from US pharma giant Pfizer. That was a fat price to pay - about 20 times cash profits - but Nestlé had to fight off two rivals - French foods processor Danone and US baby foods maker Mead Johnson - who also wanted Pfizer Nutrition's chief attraction: a big presence in the market for baby foods in China.

Globally, baby-food sales - a $30bn-plus market - are growing by 10 per cent a year. But in the developing world they are motoring faster still, and no market offers more potential than China's. That's not just thanks to its size; the effect of the government's one-child policy is that most newly-affluent Chinese mums have just one little emperor to dote on, so obviously they want only the best baby glop. That means expensive - and high-margin - stuff, with a foreign brand name. Pfizer Nutrition makes 85 per cent of its sales in emerging markets and has a 7 per cent share of baby foods in China, where the $6bn-a-year market looks set to double by 2016.

The size of the Pfizer Nutrition deal shocked Nestlé followers, who originally guessed it would sell for half the final price. But Nestlé had to outbid determined rivals, so Mr Bulcke made the biggest deal of his tenure to date.

Nestlé's five-year record

Nestlé in numbers

Where the business comes from...(percentage of total)

...and the product breakdown (percentage of total)

Shape-shifting

Still, making big deals is part of Nestlé's willingness to take company-shifting decisions, if need be. Back in 1985, it made what was the bigger-ever acquisition outside the oil industry when it bought US foods maker Carnation for $3bn. And there have been other direction-changing deals. In the 1990s, Nestlé turned itself into the world's biggest supplier of bottled water via the acquisitions of Perrier (in 1992) and San Pellegrino (1997). In 2002, the $10bn purchase of Ralston Purina made Nestlé the world's second biggest pet foods maker (behind US company Mars). And the $8bn acquisition in 2007 of Gerber brought the group a near monopoly of baby foods in the US.

Deals such as these are vital if Nestlé is to keep its sales and profits moving ahead. Management has had various targets over the years, but focuses on the 'Nestlé Model', which is for 'organic' sales growth of between 5 per cent and 6 per cent a year. The group's bosses say they hit that target for the 17th consecutive year in 2012; and included in organic growth of 5.9 per cent was 'real internal growth' of 3.1 per cent.

Obviously, it does not help that Nestlé reports its performance in Swiss francs, a currency that tends to rise against the other major currencies, even though it makes less than 2 per cent of its Swf92bn sales in its native Switzerland. Nor does the regular turnover of acquisitions and disposals help make the long-term trend clear. For example, our table of Nestlé's five-year record, above, shows turnover shrinking 11 per cent between 2008 and 2012. But that reflects the effect of Nestlé selling its controlling interest in Alcon, a US maker of contact-lens solution for $11bn.

Because it's worth it?

That disposal - in 2010 - prompted much speculation that Nestlé was preparing for another sea-changing move - the acquisition of French cosmetics company L'Oréal, in which Nestlé has owned 30 per cent of the equity since 1974. Since then, speculation has gone into reverse and the assumption now is that Nestlé will sell its stake next year when restrictions on the disposal expire. If it does, then the most likely buyer is L'Oréal itself. Nestlé has always been a co-operative shareholder in L'Oréal, so to sell to a hostile bidder could damage its reputation.

True, Nestlé no longer has any interests outside foods. Yet it has been more widely diversified in the past and could diversify again. Especially as L'Oréal has so much in common with where Nestlé wants to be. Many of its products, whose best-known brands are Lancôme and Garnier, fulfil a similar function to Nespresso coffee pods - they are fast-moving consumer items masquerading as luxury goods. As such, they generate plump profit margins - 16 per cent in 2012 on sales of €22.5bn (£19bn). Besides, Nestlé and L'Oréal share so many customers; not just affluent westerners but, more importantly, the newly-affluent easterners for whom brand recognition means even more.

Nestlé's bosses will have to think hard on L’Oréal's best-known marketing slogan - 'Because I'm worth it' - and decide whether that really will apply to the two companies together. They have not been helped by the rise in L'Oréal's share price, which has doubled in the past year and, at €136, values the company at £70bn. True, Nestlé could win control with an outlay of about £21bn (bringing it another 30 per cent), but even that is a big move. Whatever they do, Nestlé's chiefs will have the group's long-term interests in mind. That's how it is with Nestlé - always planning for the long term. True, Dualit's victory in the Nespresso wars might spoil Nescafé's 75th birthday, but a more important anniversary is coming round soon - in 2016 it will be 150 years since Nestlé was founded. Chances are, at Nestlé's headquarters overlooking Lake Geneva, they are already planning for the next 150.

Putting a price on Nestlé

You can learn a lot by stepping back and viewing the big picture. So, with the help of the tables, left, let's look at Nestlé by comparing it with two other giants: an Anglo-Dutch one, Unilever, and Cincinnati-based Procter & Gamble. These three dominate the manufacture of 'fast-moving consumer goods', the stuff that fills supermarket trolleys the developed world over - and increasingly in the developing world - whether it's Nestlé's Shredded Wheat breakfast cereal, Unilever's Flora spreads or Procter & Gamble's Ariel detergents. And let’s make the comparison easier by putting the key data in sterling.

Of course, all three companies are huge, and Nestlé is the biggest, with latest full-year sales of £63bn and profits of over £9bn. If its shares were listed in London, Nestlé's £147bn market capitalisation would make it the most valuable company, just pipping Royal Dutch Shell. Take the Nestlé shares owned by UK investors alone and you have £10.8bn-worth of equity; enough, if it were a stand-alone company, to be the 38th biggest in the FTSE 100.

Most notable is how similar are the three companies' profit margins, all of which are fairly healthy. In a way, they have to be fulsome because all three companies have a monster's appetite for capital, which they process quite efficiently. Nestlé turns over its capital just once a year and claims a return of 16.4 per cent, while Procter trundles in at half that rate of capital turn and makes a lower - though acceptable - return. As for Unilever, don't believe the data. Its return on capital is not really nudging 26 per cent and, correspondingly, it does not turn over its capital almost twice a year. The equity component of a company's capital is often the most contrived figure in a balance sheet and somewhere along the line Unilever has made write-offs that mean capital employed is understated and returns are overstated.

Nestlé rules the food world.

More useful as an efficiency check is to focus on the rate at which the companies turn over their current assets - mostly stocks and debtors - and on their five-year growth rates. Growth isn't inspiring at either of the three companies, but what would you expect of three centenarian companies whose combined turnover - if they were a country - would make them bigger than Portugal?

But that prompts the bigger mystery - if growth prospects are so ordinary, why are their shares all rated so highly? Admittedly, our table shows PE ratios based on 2012's declared earnings; yet even on earnings forecast for 2013, the multiple is still 19 times in Nestlé's case.

The answer is that shares in these three come with two big bull factors, though one is likely to run out of steam soon. The factor that's slowing is the role of the three as quasi-government debt in times of uncertainty. In other words, when the outlook is as troubled as it has been much of the time since 2008, then holding shares in, say, Nestlé is not quite as reassuring as putting capital into US Treasury bonds, but it's getting there. That's because Nestlé - along with a dozen or so global greats - is almost certain to weather whatever storm blows up, raising its dividend in the process. Blue-chips’ shares really don't come a deeper shade of blue.

The second factor is that all three - and especially Nestlé - offer a back-door entry into the world's developing economies, where investor action is increasingly focused. Nestlé makes over 40 per cent of its sales (over £26bn in 2012) in Asia, Latin America and Africa, while Brazil and China are, respectively, its third- and fourth-biggest markets. Each generated over £3.5bn of sales in 2012, which is comfortably more than the £2bn that Nestlé made in the UK. And China is growing fast - in 2007 Nestlé made just £1.4bn sales in China.

Still, there is a price for everything and, at 20 times historic earnings and 19 times forecasts for 2013, Nestlé's shares are just too highly rated. Look at it this way: the shares' average rating for the past 30 years is 16 times historic earnings. Obviously, there is a lot of variation around that average - back in the 1980s, the shares often traded on a single-figure PE ratio and they peaked at over 30 times earnings in 1999 since when the trend has been more down than up.

To maximise the chances of success, an investor wants to buy at less than the average PE ratio - say, buy at 14 times earnings to build in a margin of safety. On current earnings - and, remember, we are using historic earnings multiples - that implies an acceptable entry price would be Swf47, 29 per cent below the current level. Don't despair, the share price was below Swf47 in August 2011 and stands a decent chance of being below it within the next couple of years or so. True, it would need a market shake-out to get the price there, but these things happen. Invest in Nestlé the way that its bosses run the company - be patient.

Slow-moving giants and fast-moving goods

The basic numbers

About the shares

The business performance