While I realize that Wall Street typically prices stocks on the basis of what investors believe a company will look like in the future, I'm still surprised by the relative valuations that come out of the process. Take the case of Mondelez (Nasdaq:MDLZ). This company is focused on multiple growth areas in the packaged food space (and has a large developing market exposure) and does indeed post better growth than many of its peers, but the overall combination of growth and margins wouldn't normally seem to argue for valuation on par with Kellogg (NYSE:K) or Nestle (Nasdaq:NSRGY). Consequently, although I do expect Mondelez to do well relative to its sector in terms of reported growth, I continue to believe that valuation is already too steep.
Growth Comes Back In The First Quarter
Mondelez hasn't established a very good track record since its split from Kraft (Nasdaq:KRFT), but this quarter may mark the start of better numbers. Reported revenue rose almost 2%, with organic revenue growth of nearly 4% on better than 2% volume growth. Those numbers are better than the prior quarter and also higher than sell-side estimates, but it's worth mentioning that this quarter's results were still below where most analysts had their numbers a few months ago.
Margins continue to be a significant talking point, and not in a particularly good way. Gross margin was stable, but operating income fell 12% and reported operating margin missed the average estimate by about two points. Half of that miss can be tied to “one time” items (a year-ago gain on sale in Russia and devaluation in Venezuela), but that still leaves a sizable miss tied to ongoing investments in marketing. What's more, given that the devaluation of the bolivar didn't exactly go unnoticed, I have to ask why analysts didn't factor this into their numbers (and if they did, that makes the miss all the larger).
Keeping Pace, Relatively Speaking
Although bullish sell-side analysts seem to be making much of Mondelez's “return to growth”, I'm not quite sure the performance is worth quite this level of celebration. True, the 3.8% organic growth rate was better than the 2.2% growth rate at Kellogg, but it was less than the 4.3% growth of Nestle.
Along those lines, Kellogg appeared to outdo Mondelez in the snacks category (though they're certainly not identical businesses), while Nestle outperformed in confectionary. In beverages, it looks like Mondelez outdid Nestle in powdered drinks, but Nestle seemed to do better in coffee – likely due in no small part to the Nespresso business (the single-cup automated system that is Nestle's answer to Green Mountain Coffee's (Nasdaq:GMCR) Keurig and Starbucks' (Nasdaq:SBUX) Verismo). While Mondelez did highlight Tassimo as “top-performing brand”, retail sales data suggests it hasn't been a breakaway success.
It's probably also worth throwing PepsiCo (NYSE:PEP) into the mix here as well. PepsiCo reported 6% organic revenue growth for its Americas Foods business this quarter, with solid growth in developing markets (organic volume up 15% in the Asia, Middle East, Africa region) and some volume growth in Europe as well.
Would A Combination Build Value?
With the involvement of the same activist investor in both Mondelez and PepsiCo, speculation has ramped up that PepsiCo could make a bid for Mondelez. Normally I'm skeptical of these developments, as there are probably at least 20 rumors for every real deal and most of the deals that do occur actually destroy shareholder value at the acquiring company.
I feel differently about this rumor, though. Adding Mondelez would definitely round out PepsiCo's snack food offerings – adding the global leader in cookies (biscuits), chocolate, candy, and powdered drinks to a company that rules the roost in chips. What's more, I think there would be very significant potential leverage when it came to manufacturing, distribution, and marketing – it is very expensive to run a global food business, and running more products through existing channels could offer powerful margin leverage to the combined entity.
The Bottom Line
How you feel about the likelihood of a deal with PepsiCo likely has a lot to do with the value you do, or don't, see in Mondelez today. On its own merits, I think Mondelez is significantly overvalued – even with a long-term free cash flow growth rate 50% higher than those of Nestle and Kellogg (and 20% higher than richly-valued Hershey (NYSE:HSY), the shares don't appear worth more than $25 after subtracting the debt.
Factor in PepsiCo, though, and things change significantly. Because of the potential operating leverage and synergies, I think PepsiCo could go into the $30s on Mondelez and still come out ahead over the long-term. As I give a deal about a one-third chance of happening, I'd be willing to pay something in the neighborhood of $27 for Mondelez today. With the price near $31, I believe that investors are overvaluing the growth and margin potential of this food company, and would likely be better off with Kellogg or Nestle at similar multiples.
At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.
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