Description

All financial figures are quoted in US dollars, and converted from Swiss Francs to US at the rate of $.9754.

Ticker symbol: NSRGY on pink sheets

Recent price: $118 US

Number of shares outstanding: 1.548 billion.

Total liabilities - short term cash & securities: ($50 billion)

Trailing Enterprise Value (EV): $233 billion.

2007 EBITDA: $17.78 billion

2007 trailing EV/EBITDA: 13.X

2008 forecast EBITDA: $19.2 billion.

2008 exit rate forecast EV/EBITDA: 11.9X

Nestle is the world’s largest food and beverage company.

2007 revenue was $104.97 billion. Key divisions include freeze dried coffee company, ice tea and bottled water. The firm also produces baby foods and infant formula, dairy products, confectionary products, ice cream and pet foods (Purina).

The firm has a 75% ownership position in Alcon (current market value of $32 billion), and a 28% investment in L’Oreal, worth $20.7 billion. L'oreal sits on the balance sheet with a value of $7.9 billion

Business is broadly distributed throughout the globe, The firm is the largest international food company in Russia, where business is growing by more than 15% per year.

Nestle has a pharmaceutical products division. This primarily includes the pro rata generation of revenue and profit from Alcon. Revenue is also earned from two joint ventures with L’oreal, “Galderma” and “Laboratoire Inneov”. These companies produce corticosteroids and cosmetic nutritional supplements.

Geographically, Nestle generates 38% of business from Europe, 35% of business from emerging markets and just 27% from North America.

The firm has grown organically and through acquisition. In July 2007, the Novartis medical nutrition business was purchased for $2.5 billion. In late 2007, Nestle added Gerber, the maker of baby foods, for $5.5 billion.

Business has been good.

Revenues have improved by an average of 6.2% annually for the last decade. Over that same period, margins in this very tough business have improved by more than 36%.

70% of Nestle brands generate annual revenues in excess of $1 billion. I consider Nestle’s business to represent the global benchmark in its industry.

Management forecasts that business will get even better in 2008.

Nestle intends to improve sales by at least 5% in 2008 and increase operating margins.
The firm has a long history of beating conservative targets.

A potential divestiture may lie ahead.

Alcon represents roughly 14.2% of Nestlé’s current enterprise value. However, the firm makes up just 4.5% of Nestle trailing revenues and 8% of trailing EBITDA.

There has been recent speculation that ACL will be spun off completely from Nestle in the future. Alcon is considered a glamorous “growth” investment and sells for about 20X trailing EV/EBITDA. Management of Nestle is highly attuned to shareholder wishes. Accordingly, I believe that there is more than some truth to the rumour.

Alcon is accounted for proportionately on the income statement and balance sheets. Therefore, a removal of the equity stake will result in a reduction in revenues, EBITDA and liabilities.

Each Nestle ADR has roughly .146 shares of Alcon contained within the market cap. This represents a value of $19.7 per ADR.

All else being equal, a demerger would result in current ADR holders having their NSRGY stock fall to $98.30, and receive $19.70 of ACL stock.

Ex ACL, Nestle could have a 2008 exit EV of $193 billion and EBITDA of $17.3 billion, or a valuation of 11.2X EV/EBITDA.

Nestle has an inexpensive valuation, even without a divestiture.

With Alcon, Nestle shares are selling for about 11.8X my estimated 2008 EV/EBITDA, still far lower than peers Pepsi and Danone.

Pepsi sells for about 13.7X my 2008 estimated EV/EBITDA and generates about 60% of revenues from North America (ex Mexico). Danone sells for about 15.5X my estimated 2008 EV/EBITDA and has a revenue mix geographically similar to Nestle.

What could fair value for Nestle, ex Alcon, be in 24 months?

I estimate that Nestle will sell for 13X trailing 2009 exit rate EV/EBITDA, in line with present valuations. My assumption is that EBITDA will reach $19.1 billion in 2009, and that total liabilities-short term cash will be $35 billion. Based upon 1.55 billion ADR’s outstanding, this suggests a price of

$137.60

To that, I add in forecast dividends over the next 24 months of

$6

To this, I assume that Alcon continues to sell for 20X trailing EV/EBITDA. My forecast is that Alcon generates $2.8 billion of EBITDA in 2009. This produces a forecast value of $186 per Alcon share, or 37% above the current value. This works out to be approximately

$27.20 per Nestle ADR.

= $170.80 of total value per ADR.

In comparison to the present share price, this represents a potential fair value return of 44.7%.

Should Nestle maintain its holdings in Alcon for at least two more years, and continues to sell for 13X trailing EV/EBITDA, fair value in 2009 could be $152 per share. With dividends, the possible return is still 33.9%.

Nestle is underfollowed by Wall Street, underowned by global institutions & underheld by US retail investors.

Oddly enough, for such a large firm, Yahoo reports just 3 US brokerage firms which issue coverage. Therefore, it is certainly not widely held by individual investors in the US. S&P doesn't follow it either.

Institutional ownership accounts for less than 27% of the outstanding issue. 44% of these institutions are deemed to be “low turnover” funds.

The largest mutual fund position is held by Oakmark Equity and Income fund (OAKBX). This is a 5 star rated fund in the moderate allocation category. The fund has actually pulled a net positive return out of the market YTD and is gathering assets thus far in 2008.

The Vanguard Wellington fund (VWELX) is the second largest mutual fund holder of NSRGY in the US. They are also rated 5 stars in the US in the moderate allocation category. Once again, this fund looks to be gathering net new assets so far in 2008.

A share split should improve liquidity and encourage more retail holdings.

In the short term, Nestle will be splitting the shares on a 10-1 basis. This could encourage a broader base of retail investment ownership in the future. After a recent 17% dividend hike, Nestlé’s current yield is now about 2.5%.

Nestle is my top pick in large cap food and beverage companies for 2008.

Food and beverage companies in North America struggle to avoid becoming little more than “off balance sheet” subsidiaries of Wal-Mart; whereby Wal-Mart demands and obtains lower prices from manufacturers at the expense of operating margins. Nestle, with sought after brands, and a clear emphasis on Europe and emerging markets, is less affected by this pricing pressure.

The cost of raw materials, packaging and energy increased for Nestle by more than 23% in 2007. However, the firm was able to increase prices ahead of the inflationary curve. A 16.7% increase in the Euro vs the US dollar in 2007, and similar outperformance of non US currencies has partially mitigated commodity price inflation for inputs, which are generally priced in US dollars.  Management expects to continue to improve pricing ahead of inflationary trends, in the year ahead.

Non diversified food businesses primarily based in the US may not be so lucky, and could conceivably dismay investors in 2008. Many firms will wrestle with commodity price inflation on their cost structure, potentially to the detriment of common shareholders.

I am purchasing shares of Nestle now, in anticipation of positive earnings revisions throughout 2008.

Value investors looking to diversify their portfolio outside of North America might do well to consider Nestle. Integration of the newly acquired Gerber foods and Novartis business could add nicely to margins in 2008. I believe that earnings forecasts look to be revised higher as early as the coming quarter of this year.   The stock deserves to move from a historic discount vs global peers, to a modest premium.

From an investment management perspective, the largest holders of Nestle stock appear to be gathering new money, and the company is underheld by institutions globally. If market conditions remain difficult, given the asset growth by the institutional holders, Nestle could be far less volatile than other food/beverage stocks in the near term.

A possible demerger with Alcon would be a real plus. Should a spin-off be announced this year, Nestle shareholders could see as much as $18.5 of incremental value unlocked over the next 24 months proforma.

A 24 month forecast total return of 33.9%-44.7%, if achieved, would represent a significant return, in a challenging environment, for a true blue chip. 

Catalyst

Positive earnings revisions throughout 2008, based upon currency and pricing initiatives. A 10 for 1 share split will enhance liquidity for smaller buyers. A potential spinoff of Alcon can enhance value. Increased investment from new institutions is probable. Investment accumulation is possible from top rated institutional and mutual fund holders that presently hold NSRGY and continue to gather assets YTD.