A Bubbly 2007 for Cadbury Schweppes?

The beverage and confectionary giant faced a lousy 2006 due to recalls and rising prices, but smart management moves have sweetened the picture

Few would dispute that 2006 has been an annus horribilis for candy and beverage giant Cadbury Schweppes. In June, the world's largest confectionary maker was forced to recall more than a million chocolate bars in Britain after traces of salmonella were found in some products.

The same month, infotech glitches caused production problems at the British arm, leading to a £12 million ($23.7 million) profit hit. (see BusinessWeek.com, 6/8/06, "Too Much Candy: IT Glitch Costs Cadbury"). By October, Cadbury Schweppes (CSG) had abandoned its annual profit target and said margins would be flat in 2006, citing higher costs for energy, sweeteners, and other raw materials. The unhappy string of events has prompted a 4.5% decline in the company's London-traded shares so far this year.

But now, as rumors circle that Cadbury Schweppes could be a takeover target, things are starting to look a little sweeter for the London-based maker of the famed Cadbury's Crème Egg and beverage icons such as Dr Pepper, 7Up, and Sunkist. Buoyed by strong drink sales in the U.S. and continued focus on cost cutting, the company looks to have stabilized its operating margins, which came in at 14.5% last year, and could even see an uptick in 2007, analysts say.

World of Gum

Cadbury also is taking up new battles. It will soon challenge archrival Wrigley's (WWY) in the British chewing gum market by introducing Trident there for the first time. The famous sugar-free gum has proved a runaway success worldwide for Cadbury, with sales of $850 million last year, up more than 20%. "All indications are that they've turned a corner and will be putting their problems behind them," says Andrew Saunders, a food analyst with Numis Securities in London.

On Dec. 12, Cadbury Schweppes is set to provide a "trading statement" that should give investors a taste of how the company has recovered from this summer's salmonella crisis. But according to Julian Hardwick, a food analyst at ABN Amro in London, the British launch of Trident alone "is a sign the worst is over," because the company might have delayed the rollout if conditions weren't right.

Cadbury hasn't said how much it will spend on the launch, but Hardwick reckons the company will have to shell out at least £20 million (about $39.4 million). With brands such as Trident, Dentyne, and Stimorol, Cadbury already has a 26% share of the global chewing gum market, the fastest growing confectionary segment.

Gradual Growth

The company still has its work cut out for it. It faces continued financial pressure as the prices of energy and raw materials rise. Lobbying groups concerned about child obesity and the impact of junk food in schools also are at its throat. And the British chocolate recall cost Cadbury £20 million ($39.4 million) and shook consumer confidence in a country where it gets about 15% of its £6.5 billion ($12.8 billion) in sales. To win back customers, Cadbury will have to spend heavily on promotion and advertising next year, analysts say.

American-born Chief Executive Officer Todd Stitzer seems to have matters well in hand, although he has admitted that this year has been "challenging." His "Fuel for Growth" initiative, introduced in 2003, is on track to cut the company's head count by 10% by the end of next year. Combined with additional cost-saving measures, the effort is slated to save £360 million (about $711 million) by the end of 2007.

That should set the stage for margin improvement, though industry experts caution that gains will fall short of Cadbury's original 2003 goal of improving operating margins by 0.5 to 0.75 of a percentage point annually. The company in October said it's now seeking "growth in operating margins over time" instead of a set goal.

In any event, its margins aren't bad compared to peers: Rival Nestlé, for instance, booked 2005 operating margins of 12%, more than two points lower than Cadbury's.

Beverage Boost

Harvard-educated Stitzer, who became CEO in 2003 after two decades with the company, also is firing up the company's response to growing health concerns. He has invested much of the proceeds from disposals of non-core assets into development of drinks such as 7Up Plus with added calcium, and a no-added-sugar chocolate sold under the Highlights brand. The company has increased its stable of low-fat, low-calorie offerings by 50% in the past three years, it said in October.

The boom in demand for low sugar and diet drinks has helped keep the U.S. beverage arm, where sales of brands such as Snapple and Clamato grew at a 10% clip in the first half, in robust health. The U.S. beverage business provides more than 50% of Cadbury Schweppes' cash flow, with margins exceeding 20%.

Cadbury Schweppes' difficult year has recently fed speculation that the company could be the target of a takeover bid. Cadbury trades at 16 times estimated 2007 earnings, lower than rival PepsiCo's (PEP) 18.53 price-earnings ratio, but "not so low that it's screaming out as a buyout target," says ABN Amro's Hardwick.

Thinking Local

Buyout firms or industrial acquirers likely would have to ante up a hefty sum to woo shareholders. On Dec. 4, for instance, Britain's Premier Foods bought fellow British food maker RHM, which carried a price-earnings ratio of 8, and had to pay a 30% premium.

Indeed, analysts say Cadbury might more likely be an acquirer, as it seeks to boost sales and expand its presence abroad. About half of the world's confectionary market remains in the hands of local or regional companies, and Cadbury has made no secret of its interest in acquiring brands in emerging markets.

While the company won't rule out more big takeovers such as its $4.2 billion purchase of Adams (which brought in the Trident and Dentyne brands, among others) in December, 2002, its priority is on "regional bolt-ons," Stitzer said at an investor seminar on Oct. 30. Last February, for example, Cadbury bought the gum unit of Dan Products for £33 million to expand in South Africa, making it the No. 1 gum maker there. Going forward, that strategy could be Cadbury's recipe for success.