Cadbury India: Hold

Recommendation:Hold

Aarati Krishnan

In a surprise announcement last week, Cadbury Schweppes Plc, parent company of Cadbury India, announced that it was "investigating" the possibility of increasing its shareholding in Cadbury India subject to legal and other approvals.

A decision has not yet been made, it said, but if it did go through with the plan, the acquisition of additional stake would be made at a price not exceeding Rs.500 per share.

Taking the Indian arm private

It is quite likely that the decision will go through. And if it does, it is quite likely that Cadbury Schweppes Plc will be looking to mop up the entire remaining public shareholding in Cadbury India, subsequently delisting it from the bourses.

Over the past few years, Cadbury Schweppes Plc has converted quite a few of its subsidiaries worldwide into wholly owned subsidiaries. Only last year, Cadbury Schweppes South Africa and Cadbury Foods Beijing were converted into wholly owned subsidiaries through an acquisition of the minority stake in these companies.

Stock Stuck On Stake Issue

Despite this possibility though, the Cadbury India stock has not seen a very sharp rally on the bourses, after a couple of days of initial enthusiasm. The stock hovers at Rs.432 levels, well below the indicated "maximum" price for the acquisition. One reason for this could be that the method by which the stake hike will be put through, is as yet unclear.

The parent could choose to partly enhance its stake through a buyback offer. If the buyback is routed through the open market, shareholders may as well give up any hope of ceding their shares at a substantial premium to the current market price.

If the stake hike is through an open offer, then there is a greater probability of shareholders earning a premium to the current market price. However, the upper price limit of Rs.500 set for such an offer appears to be a dampener.

Evaluating the pricing

How well does the indicated maximum price of Rs.500 for the stock capture the value of Cadbury India? From a historical perspective, shareholders in Cadbury India could well complain that the parent is taking advantage of the present beaten-down valuations to put through its stake hike.

This argument would indeed hold some water. Even if the parent does offer the maximum price of Rs.500 for the stake hike, the public shareholders of Cadbury India are not earning much of a premium for ceding complete control of the company's management to the parent.

In this context, it should be mentioned that Cadbury India makes a relatively modest contribution to Cadbury Schweppes Plc's revenues and profits. In 2000, Cadbury India contributed just 1.8 per cent of its parent's sales and 1.5 per cent to its profit before taxes.

Therefore, though the Indian markets undoubtedly hold good potential, the success or otherwise of the move to take Cadbury India private, is probably not a life or death issue for its parent.

Assuming that Cadbury India sustains its earnings growth of the first nine months through the fourth quarter, the price of Rs.500 discounts Cadbury India's 2001 per share earnings by around 29 times. In the bull markets of 1999, the price earnings multiple of the stock climbed to as high as 60 times its earnings. The PEM was hovering at around 54 times its latest earnings even in March 2000.

Valuation relative to peers

However, the tailspin on the bourses has since reduced Cadbury India's PEM to about half this level. The PEM of 29 times for the Cadbury India(at the maximum price proposed by the parent) just about matches the current PEM for its closest rival-Nestle India.

The other company which falls in Cadbury's peer group-Smithkline Beecham Consumer Healthcare, trades at a PEM of around 15 times its earnings on the bourses. However, Smithkline Beecham Consumer Healthcare is probably not a good benchmark for comparison with Cadbury India.

The company has an extremely limited product portfolio(restricted to malted foods and to a small extent, biscuits) and recent new product introductions by the parent have not been routed through the listed company, thus trimming its earnings potential.

On the other hand, Nestle India has a much more broadbased product portfolio than Cadbury India(consisting of milk products, dairy products, coffee and water apart from confectionery) and enjoys better access to its parent's portfolio of brands.

Historical earnings growth

However, when viewed in light of the historical growth rates in earnings, Cadbury India appears to posess a superior track record. Over the past three years to 2000, Cadbury India has definitely outpaced Nestle India, both in profit and sales growth.

Since 1998, Cadbury India has managed a compounded annual sales growth of around 18 per cent and an impressive profit growth of around 40 per cent. In contrast, Nestle India's sales have grown at a sedate 4 per cent while profits have grown at around 18 per cent. Nestle India's sedate growth is partly to the cyclicality of its coffee business.

If one goes entirely by the track record of the past three years, Cadbury would deserve a better PEM than Nestle. However, the question is one of whether Cadbnury will be in a position to sustain its impressive growth rates of past three years.

Future prospects

As with other FMCG companies, over the past year, Cadbury India too has been hit by the dwindling growth rates in demand for its products. From a robust 19 per cent growth in net sales in 1999, Cadbury India's sales growth dwindled to around 12 per cent in 2000 and further to 7 per cent in the first nine months of 2001. Growth in sustainable net profits too, has dropped from 26 per cent in 2000 to 17 per cent in 2001.

A declining trend in prices of cocoa, Cadbury's key input, has definitely helped to pep up Cadbury's profit margins over the past two years. However, with the cocoa market returning to a deficit situation in 2001-02, thios advanatge may not remain with Cadbury India for very long.

Clearly, in the near term, it may prove difficult to sustain the present growth in net profits unless sales growth picks up. For Cadbury India, which has a dominant share of the domestic market for chocolates and relies heavily on just this segment, this is directly correlated to how quickly the confectionery market recovers from its sluggish growth rates of the recent past. This hinges on a pick-up in economic and agricultural growth. Being impulse purchases, chocolates and confectionery products have been quite vulnerable to a cutback in consumer spending.

Unlike Nestle India, which has consciously diversified into food categories here it perceives higher potential(such as processed foods, water and dairy products), Cadbury is still heavily dependent on its two relatively small product baskets for growth(confectionery and malted food drinks). Cadbury has tried to tweak its existing product basket for higher growth rates, but a pick-up in demand for both of its product lines will be crucial to its future growth.

There is also the question of intensifying competition. As an early entranbt to the Indian market Cadbury has for years enjoyed a dominant position in the organised confectionery market. However, the entry of a host of new players such as Hindustan Lever, Nestle into the confectionery segment has resulted in an escalation in competitive activity on Cadbury's turf. The dismantling of restrictions on imports of food products and the entry of giants such as Mars into the Indian markets, are also bound to present a challenge to Cadbury's market share.

However, over the long term, there is one factor in the company's favour. Unlike several other FMCG products, confectionery products have penetrated a very small proportion of both urban and rural households. Therefore, despite the recent signs to the contrary, there does exist considerable potential for Cadbury to expand within its core product segments. Cadbury's extensions into low unit price packs and its recent launch of the Temptations range of premium chocolates are efforts aimed at expanding within its core product range.

Given that the decision on the stake hike and the mode of the hike is as yet unclear, existing investors in the stock may hold on to their shares in Cadbury India. However, making fresh purchases in the stock in the hope of making gains on arbitrage will be beset with a high degree of risk.