Cadbury Schweppes: What Now?

Acquisitions to satisfy changing consumer tastes and a merger may be in the cards for the candymaker, which for now can't unload its beverage division

The last year has been a roller-coaster ride for shareholders in Cadbury Schweppes (CSG), the world's largest candymaker and a leading maker of beverages. After announcing in March that it planned to sell off its U.S. drinks business, which includes big brands such as Dr. Pepper, 7Up, Snapple, Mott's, Canada Dry, and Hawaiian Punch, Cadbury was forced to postpone the deal when the credit markets imploded in July.

Cadbury's stock had climbed 33% since the start of the year, to a May high of 723.75 pence in London, on the possibility of a $15 billion private equity deal for the drinks unit. Then, when the buyout fell through (, 7/27/07), shares plunged 30% to a low of 514 pence in August.

Finally, on Oct. 11, the maker of Dairy Milk chocolate, Creme Eggs, and Trident chewing gum threw in the towel. Instead of selling its U.S. drinks unit, Cadbury will spin it out to shareholders, creating a new, as-yet-unnamed beverages giant with annual sales of more than $5 billion. As a standalone entity, the company may be more easily sold at some point in the future if market conditions improve.

Cadbury Needs Drinks

Where does that leave the rest of Cadbury? It's a mixed picture, analysts say. The company's shares have recovered to 614 pence, but Cadbury won't realize the big cash windfall it would have gotten from selling off drinks. The rationale for the sale—advanced by shareholder activists—was that Cadbury was worth less than the sum of its parts and should be broken up to maximize shareholder value (, 3/13/07).

Another reason for splitting up the company was to allow greater focus, respectively, on candy and drinks, which don't share much in common. The problem is, this isn't the best of times in the confectionary industry. Cadbury without beverages will face a tough market on its own.

The problem, analysts say, is that growing interest in healthy eating in North America and Western Europe is taking a bite out of the candy business (, 10/12/07). Research firm Mintel International reckons confectionary sales in the U.S. fell 14% between 2001 and 2006, while the British market is expected to grow a mere 1% in real terms between 2007 and 2012, to $2.6 billion.

That's bad news for a company looking to cash in on sweet tooths. "The whole confectionary sector [in Western Europe and North America] is going through a hard time," says Irina Kazanthuk, an analyst for Euromonitor International in London. "No one is expecting an explosion in market performance any time soon."

Chewing on Acquisitions

There are places where candy consumption is growing faster than average, including Eastern Europe and Asia Pacific, which are posting 4% to 5% annual growth. Unfortunately for Cadbury, these are parts of the world where it has relatively limited presence. It's a second-tier player in most developing markets behind competitors Nestlé (NESN.DE) and Kraft Foods (KFT), and has yet to capitalize on its high-profile brands as newly affluent consumers gain access to candy bars and chewing gum.

One solution is to scoop up local players in emerging markets. Cadbury already has shelled out $564 million for a Turkish chewing gum business and a Japanese candy company, and has its eyes on other acquisitions, particularly in India and China.

Euromonitor's Kazanthuk cautions that the company also must make non-chocolate acquisitions—especially in chewing gum and fruit candies—to tailor its business to the tastes of emerging countries.

The changes in customer tastes and the growing importance of emerging economies have made Cadbury's situation tougher. To be sure, the company's revenues grew a strong 10% year-over-year in the third quarter, to $7.66 billion, but analysts think the company will have trouble matching that pace going forward. "Cadbury will struggle to continue to grow at the 10% rate in the fourth quarter," says Credit Suisse Group (CS) analyst Charlie Mills, who has an underperform rating on the company. "There's an issue over increasing margins. The company has to convince the market it can do that."

Profiting from a Merger?

Lifting profits will also be tough. Cadbury Chief Executive Todd Stitzer conceded when reporting third-quarter results that commodity prices are on track to rise 5% to 6% in 2008—increases that will inevitably hurt the company's bottom line. Last year, for instance, higher costs for energy, sweeteners, and other raw materials lopped 1.4 points off Cadbury's operating margins. And in the first half of this year, margins were just 8.1%—highlighting how difficult it will be for Stitzer to reach his stated goal of "mid-teen" margins by 2011.

There's always the possibility that Cadbury might end up merging with another candymaker. But the list of potential candidates is limited by regulatory concerns. Competition authorities would likely balk at a deal with Mars or Nestlé, which compete in many of the same markets as Cadbury. Wrigley (WWY) and Kraft would similarly shy away from buying the candymaker, as both are currently focused on sorting out their own business problems.

The merger that makes the most sense would be with Hershey (HSY), which announced a 66% year-on-year drop in third-quarter profits to $62.8 million on Oct. 18. Rumors abound over whether the two underperforming candy companies could pull off a deal. Industry analysts say any linkup, however, is unlikely until the Hershey Trust, which holds a controlling stake in the company, agrees to give up some of its control.

Without such a megamerger, Cadbury will have to hit its projected 4% to 6% annual revenue growth target increases through organic growth and acquisitions of small companies. All in all, not an easy task. Cadbury Schweppes may have made billions from selling chocolate to the masses, but now it faces a major toothache over how to keep its own business moving forward.

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