Online Extra: Nestle: Getting Fat and Happy

The purchase of pet-food maker Ralston should help spur sales, while cost-cutting pads profits

Friskies cat food doesn't sound sexy. Kit Kat chocolate bars lack the innovation of an Internet router or a mobile phone. And yet, these days, the owner of Friskies, Kit Kat, and 8,000 food brands looks like a much more tempting investment than your typical tech company. At least, that's what investors have apparently decided about Nestle, the world's largest food company with $47 billion in annual sales, 224,000 employees, and 500 factories in 80 countries.

Nestle's stock has doubled in the past three years and soared by about 30% in 2000 alone. This year, it's down some 6% with the rest of the market, but analysts see reasons for optimism. "It's my favorite stock in the sector because there are real signs of growth and margins are accelerating," says Sylvan Massot, a food analyst at Morgan Stanley Dean Witter in London. Over the past three years, Nestle's sales have accelerated from less that 3% annually to more than 4%, and gross margins have jumped from under 10% to about 12%.

Just as important, Nestle looks like a good bet to shrug off the global economic slowdown. First-quarter sales rose 9.6%, and the company expects a further increase in earnings and sales this year. Its results are being boosted by strong performance in emerging markets, including Russia and China. In the former, Nestle says, its sales volume has grown 40% over the past year.

CUTTING COSTS. The Swiss giant's problem long has been that it was unwieldy and too dependent on low-growth, low-margin raw materials or basic foodstuffs. Over the past few years, its solution has been to sell off divisions such as Findus frozen foods and Hills Brother coffee. In their place, the company has concentrated on more promising products such as mineral water and pet food.

This past January, Nestle spent $11 billion to buy Ralston, the leading pet-food maker in North America, a move that was applauded by analysts. "Most basic foodstuffs only grow about as fast as the economy expands 2% to 3%," says Frederic Bersier, a food analyst at Lombard Ogier & Cie in Zurich. "But pet foods are growing at more than double that rate."

Nestle's other focus has been on cutting costs. Last year alone, it closed 38 factories. There's also a new emphasis on energy conservation and better manufacturing techniques. All told, the company has slashed $1.6 billion in expenses since 1997, with hardly any layoffs or labor strife. An additional $1 billion is scheduled to come out in the next three years, cuts that can be achieved almost painlessly by streamlining far-flung country operations.

"E-EVOLUTION." At the same time, Nestle plans to invest as much as $1.8 billion over the next three years to become one of the world's Web-smart elite. It plans to overhaul everything from buying raw materials such as cocoa beans to producing, marketing, and selling its Kit-Kat chocolate bars and Nescafe instant coffee. Peter Brabeck-Letmathe, Nestle's CEO, calls the process "an e-revolution."

The company has inked a $200 million deal with SAP to link its five different e-mail systems and permit it to know, for the first time, how much it buys from around the world. It will then will be able to buy more efficiently across borders, negotiate better contracts with suppliers, and, most importantly, centralize production.

Other European food companies are moving along a similar path. But France's Danone, a major producer of dairy products and mineral water, has a price-earnings ratio about 20% higher than Nestle's. "Danone is fantastically focused, but fully valued," says Julian Hardwick, a food analyst at ABN Amro in London. Nestle's other large European competitor is Unilever, an Anglo-Dutch conglomerate whose global scope and size rival the Swiss giant's. But it's undergoing a radical transformation, with massive layoffs and brand pruning. "Unilever is being more aggressive, but it has further to go," says Darrell Durrie, a food analyst at Fortis Bank in Amsterdam.

A BILLION NEW BUYERS. In facing off with Kraft and other U.S. competitors, moreover, Nestle hopes that its strategy for the developing world will help it grow faster. Food demand in Europe and the U.S. will expand by only 2% a year for the forseeable future, but demand for prepared foods will rise much faster in countries such as Pakistan, Thailand, Mexico, and Argentina. Once annual incomes reach $1,500 a person, CEO Brabeck-Letmathe says, Nestle customers are born. Over the next decade, that could mean 1 billion new customers for the company.

Of course, exposure to the developing world brings both political and economic dangers. Nestle's aggressive marketing of infant baby formula around the globe has generated a withering storm of bad publicity. According to critics, the consumption of formula milk by babies in the Third World has led to thousands of infant deaths because milk is often prepared using unsterilized water. And when the Asian financial crisis struck, Nestle's sales were hit hard. "The emerging markets can be a roller coaster, but long-term they should deliver growth," says John Keele, a food analyst at BNP Paribas in London.

Back in the developed world, Nestle intends to keep concentrating on innovation and higher value added products. In particular, it has its eye on more "health" and "nutrition" products. A coup could be gaining control of the French cosmetics company L'Oreal. Nestle owns 49% of Gesparal, an investment vehicle 51% owned by the French Bettencourt family, which is headed by the elderly Lillian Bettencourt. Gesparal in turn owns 53.7% of L'Oreal, with the rest quoted on the Paris Bourse. Bettencourt says she won't sell out during her lifetime.

But afterwards? Given L'Oreal's success, Nestle would love to have greater control, since cosmetics are more photogenic than pet food -- and a faster-growing market as well.

By William Echikson in Brussels

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