Can Nestlé Resist This Morsel?

It's thinking hard before placing Hershey in its U.S. shopping bag

Nestlé (NSRGY ) is indisputably a global powerhouse, with such well-known brands as Nestlé Crunch in candy, Nescafé in coffee, and Friskies in pet food. But for most of its 136 years, the Swiss giant has been humbled in the U.S., struggling to catch up with rivals such as Kraft Foods Inc. (KFT ) and General Mills Inc. (GIS ). "We were not a success in the U.S. in either growth or profitability," concedes Joe M. Weller, who for the past seven years has been CEO of Glendale (Calif.)-based Nestlé USA.

Now, Weller, 57, and his bosses in Nestlé's headquarters in Vevey, Switzerland, hope to buy the growth that has eluded them so far. They've fattened up with three major deals in the past 18 months. First, they paid $10.3 billion in cash for pet-food powerhouse Ralston Purina Co. Nestlé next forked over $2.6 billion in stock for a controlling stake in Dreyer's Grand Ice Cream Inc., which owns or licenses the Dreyer's, Edy's, Starbucks, and Godiva brands. Then, on Aug. 6, Nestlé USA announced a $2.6 billion cash deal for Englewood (Col.)-based Chef America Inc., which makes Hot Pockets, a top-selling frozen cheese-and-meat-filled pastry snack.

All this should help Weller meet his goal of being No. 1 or No. 2 in each food category. But looming ahead is a far more important decision for Nestlé: whether to step up and make a bid for Hershey Foods Corp. (HSY ), the candy-store king of the American chocolate industry that may soon go on the market.

Adding Hershey's 44% share of the U.S. chocolate candy market to Nestlé's own 11% share would make the combo the American market leader by a wide margin. Nestlé could easily meet Hershey's expected price tag of $11 billion or more and also has the muscle to outlast bidders such as Kraft Foods, which many analysts believe could also make a run at Hershey. But Nestlé may decide the cost isn't worth it. Because its plate is full with the recent acquisitions, buying Hershey could mar Nestlé's top-notch credit rating and dilute earnings. Moreover, Nestlé could be forced to clear antitrust hurdles for gathering so large a share of the market, says John M. McMillin, an analyst at Prudential Securities Inc.

Weller admits that Nestlé's current No. 3 ranking in the U.S. candy market, behind Mars Inc. and Hershey, is problematic. "We need to strengthen that business," he says. Buying Hershey could help Nestlé meet its target of 4% annual internal sales growth by bulking up in the slow-growth candy industry, which analysts say is expanding at only 2.5% annually. Nestlé does not break out results for its U.S. chocolate sales. But Hershey's earnings, before one-time items, rose 14.5% last year, to $378 million, and sales rose 8%, to $4.6 billion. "Hershey's may be too good a morsel for Nestlé to pass up," says Donald Stuart, a partner with Cannondale Associates, a consulting firm based in Westport, Conn. Nestlé's worldwide earnings grew nearly 13%, to $4 billion, due in part to extensive restructuring and cost-cutting. Nestlé's global sales in all categories--some of them much faster-growing than candy--rose 1% in 2001, to $50.4 billion. About a quarter of those sales came from the U.S. market.

Weller declines to comment about a Hershey bid. But investors so far have supported Nestlé's dealmaking. They pushed Nestlé's stock price up 7%, to $227, on the Zurich Exchange in the week following the Chef America announcement, for instance. And with $10 billion in cash at the end of 2001 and $5.1 billion in cash flow last year, Nestlé can easily finance another acquisition.

Still, Wall Street might blanch at the short-term effects of a Hershey's acquisition. Analysts say that as the company's net debt load--its gross debt minus cash--rises from $2 billion to an estimated $13 billion after its recent acquisitions, investors will increase pressure to turn all the new brands into profitable category leaders. Andy Smith, an analyst at Schroder Salomon Smith Barney, estimates that if Nestlé pays $12.5 billion for Hershey, it would end up diluting earnings by about 4% in the first year.

Nestlé, of course, has long considered its strategic moves for the long term and might be willing to weather a brief drop in earnings. But Standard & Poor's Corp. analyst Christian Wenk says that in order to keep its AAA bond rating, Nestlé will have to increase its cash flow from operations from 46% of debt to 90% by 2004. That may mean selling more nonessential assets. Nestlé already raised $2.3 billion in March by spinning off 24% of its Alcon Inc. (ACL ) eye-care unit in an initial public offering. And Weller says he will wring out $260 million in annual savings from the Ralston Purina deal.

If the U.S. economy heads back into recession and consumers get skittish, the whole restructuring process will become a lot stickier for Nestlé. Several of the products it just picked up in its shopping spree, including Dreyer's and Purina ProPlan, carry higher-than-average retail prices for their categories. That makes them tough to pitch in a weak economy, when cash-strapped consumers are likely to be lured away by low-price "house" and generic brands.

There's plenty of work to be done even if Nestlé doesn't go after Hershey. Many food analysts were amazed at the price Nestlé paid for Chef America--almost four times Chef America's expected $720 million revenues in 2002. The brand generates 10% annual sales growth and profit margins of more than 20%, and when added to Nestlé's Lean Cuisine and Stouffer's brands, it gives Nestlé the lead in every frozen-meal category except pizza. "It's a marriage made in heaven," Weller says. But to get the most mileage from the company, Nestlé will likely have to take it beyond its niche market of U.S. convenience-food fanatics. And foreign markets are not as enamored of frozen foods as are U.S. consumers. Says Gary Stibel, principal of New England Consulting Group, based in Westport, Conn.: "Nestlé will have to prove it didn't just pay a huge premium for a brand that's landlocked."

Nestlé won't comment on any export strategy for its recently acquired brands. For now, the company's focus is on the U.S.--where it is deciding if it wants something sweet after three solid meals.

By Arlene Weintraub in Los Angeles, with Christine Tierney in Frankfurt

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