March 27, 2007

New Chocolate War Set to Pit Demerged Cadbury Against Nestle, Mars, Wrigley

By Jon Ashworth

With its heat and humidity, India may not seem an obvious market for a maker of chocolate bars. But Todd Spitzer, chief executive of Cadbury Schweppes, maker of Dairy Milk, sees things differently. For the world's largest confectionery maker, India is emerging as a key battleground in what promises to be one of the most exciting showdowns in the consumer goods market: a new chocolate war, pitting a soon-to-be-demerged Cadbury against some of the world's largest food companies for domination of a multi-billion pound market.

Cadbury already accounts for seven out of 10 chocolate products sold in India, yet only a third of India's 1.1bn population buys chocolate. There are 700m potential consumers to be got at and Cadbury has its eye on events such as Diwali, the festival of light, when millions of Indians set off fireworks and exchange presents of sweets and chocolate.

The London-based company is having change forced upon it. The arrival as a 3 percent shareholder of Nelson Peltz, the US activist investor, has precipitated a move in which Cadbury's remaining drinks business, including Canada Dry, Dr Pepper and 7Up, is being spun-off. Its Beverages division, now exclusively North American, has been Cadbury's cash cow, contributing an underlying profit of £584m ($1,143m, E860m) in 2006 out of operating profits of £909m in 2006. It could be worth more than £7bn to a private equity buyer.

The slimmed down Cadbury will focus on confectionery -- which breaks down into chocolate, gum and candy, fronted by names like Dairy Milk, Trident gum and Halls cough drops. Thanks especially to strong candy and chewing gum businesses, Cadbury has a 9.9 percent share of the overall confectionery market, ahead of Mars' 9 percent, Nestle's 7.8 percent and Wrigley's 5.8 percent (see chart).

But the British group's great challenge, post-demerger, is to push through a rapid and sustained increase in market share in its weaker markets, launch a flurry of new products and defeat the competition. It will also have to increase its margins: Cadbury's confectionery business shows a margin of 11.2 percent, well behind Hershey, on more than 20 percent and Wrigley, in gum, on 18.5 percent. If Cadbury can pull this off within the next three years, it will achieve its long-cherished goal of becoming a truly global player. If not, with private equity hovering and competitors eyeing the business, the company will be taken out in mid-stride.

Chocolate is the most important confectionery battleground, with global sales of £38bn a year. The global gum market is worth £10bn a year; candy, including boiled sweets and cough drops, is worth £23bn a year yet is scattered among dozens of players.

Five companies speak for just over 50 percent of worldwide chocolate sales. Mars, maker of M&Ms, Twix and Mars bars, has 14.8 percent of the market. Nestle, with KitKat, Yorkie and Milky Bar, has 12.6 percent. The US-based Hershey has 8.2 percent, Kraft (soon to demerge from Altria) has 7.7 percent and Cadbury has 7.5 percent.

Europe, the US and Australia account for three quarters of the world's chocolate sales. Cadbury and its rivals are trying to stimulate growth in these markets while looking to emerging markets for future gains. Cadbury's chocolate sales are anchored in eight "heritage" markets in which it commands an average 38 percent market share: the UK, Ireland, South Africa, Australia, New Zealand, India, Canada and Poland. Most of the rest of Cadbury's chocolate sales come from France, Spain, Russia and China, but market shares are less than 10 percent.

Cadbury is using four growth platforms to drive sales in its heritage markets. The first involves higher-priced variations on its flagship Dairy Milk. The second relies on the so-called health benefits of products such as Green & Black's, the organic, cocoa-rich chocolate brand it bought in 2005. Despite talk of compulsory health warnings on chocolate, City analysts -- citing the example of the tobacco industry, where UK cigarette sales continued rising for 10 years after smoking was first linked to cancer -- do not foresee any material impact on sales from the current obesity row.

Gifting accounts for a third of the global chocolate market and is growing in the developing world at 13 percent per annum, driven by holiday festivals such as Bayram in Turkey. Finally, cheap products will help Cadbury increase penetration and per capita consumption in its main markets while opening inroads in India and other developing countries. In Europe and other developed markets, per capita annual chocolate consumption is 4.9kg; in India it is just 0.03kg.

Similar battles are being fought over gum and candy. Cadbury's successfully broke into gum with the purchase of Adams in 2002, a business it has radically improved. Today, Adams has a 26 percent market share; its brands include Dentyne and Trident. Wrigley, the market leader, is down to 36 percent, led by brands such as Juicy Fruit and Wrigley's Spearmint.

Cadbury claims greater strength and depth in gum than either chocolate or candy, with number one shares in 18 countries including Mexico, Brazil and France, and number two positions in Japan and the US.

The gum category is growing by 8 percent per annum, compared with 4 percent-5 percent per annum for chocolate and candy. Most gum is now sugar-free and manufacturers make a big play on its breath-freshening, teeth-whitening capabilities. This "wellbeing" part of the gum market is worth £2.5bn a year and is growing at 15 percent a year.

Candy, worth £23bn globally, has grown at just 4 percent per annum since 2001, much lower than gum and chocolate, and is highly fragmented. The top five players account for just 20 percent of sales; Cadbury is the market leader with 7.2 percent. The candy market ranges from medicated cough drops to mass-produced boiled sweets.

Investec Securities highlights Cadbury's potential to start exploiting cross-category synergies between chocolate, sugar and gum. Borrowing telecoms parlance, Cadbury can lay claim to a variety of "triple play", "double play" and "single play" positions in countries where it has a leading market position. In the UK, for example, Cadbury is strong in chocolate and candy but has only just started competing in gum; Trident made its UK debut in January.

Most of Cadbury's initiatives in chocolate rely simply on tweaking the existing product lines, and analysts would like the innovation seen in gum brought to bear. But time is not on Cadbury's side. Peltz's intervention could galvanise prospective buyers for the business, whether private equity or competitors. There is value waiting to be unlocked. Using Investec's calculations, Cadbury's chocolate/candy business has an enterprise value of £5bn-£6.2bn as part of Cadbury Schweppes; faced with a bid premium, this could rise to £6.6bn-£7.2bn.

For Cadbury Schweppes as a whole, including Americas Beverages, net enterprise value rises from £13.3bn-£16.4bn at present to £16.4bn-£18.5bn under a sum-of-the-parts calculation based on potential take-out multiples. This implies an equity value of 643p-743p per share after deducting estimated net debt of £2.9bn. The shares were trading this week at 620p.

Many are sceptical that Cadbury will become a takeover target. The family-owned Mars would face steep competition hurdles; Nestle is focusing on nutrition and health products; Kraft is considered more likely to sell its Jacob Suchard chocolate division, maker of Milka, Toblerone and Cote d'Or, than to use it as a platform for a large acquisition. Hershey, which is controlled by a trust, is distracted after seeing its profits slip 10 percent in 2006 -- its first decline in three years.

In these breakneck times, however, with potential new takeover targets emerging each week, it would be foolish for Cadbury to assume it will be allowed to slowly press on with its confectionery growth plans. Unless it scores a series of spectacular victories in the new confectionery wars, and fast, another great British name could fall into foreign hands.