Nestle Is Vulnerable to Shareholder Activism

Source: Nestle annual report

If you're a Nestle shareholder, things haven't been too sweet for you of late. A strong Swiss franc, which is the currency in which the Vevey, Switzerland-based company reports its financial statements, has weighed on performance, while lackluster growth in key markets has been disappointing. And with the Swiss franc expected to remain strong for the foreseeable future, there may not be any relief in sight for Nestle. Could this be an opportune time for activist investors to pile in?

With Nestle's market cap of $250 billion, it would be tough for a single activist investor to obtain a large enough stake to effect change. According to Activist Insight's annual review for 2013, however, it might not be as far fetched as you may think.

Activist investor activity across large-cap stocks is on the rise, with companies like Apple and Procter & Gamble, commanding market caps of $568 billion and $216.9 billion, respectively, no longer out of reach. In 2013, for example, activism in companies with a market cap in excess of $10 billion nearly doubled in comparison to 2012 levels. In fact, the Activist Insight report suggests that with assets under management at investment firms ballooning, a target's size is"no longer a deterrent."

The thing about Nestle is that it has always been a steady performer for investors, delivering on its promises for organic sales growth, paying uninterrupted dividends since 1960, and not ruffling the feathers of activist investors who instead targeted companies like PepsiCo. But the tide for Nestle began turning in the wrong direction about a year ago, when organic sales started to falter and the company suggested it was considering lowering its dividend payout ratio "in the coming years" to 50% from the 67% level where it has resided over the trailing-12 months. 

The road has been rocky ever since despite the fact that in 2013 the company slashed the compensation of chief executive Paul Bulcke by 7% below 2012 levels. Nestle execs also hinted toward a share buyback -- something that the company hasn't performed in years -- with the proceeds from the February sale of a chunk of its stake in L'Oreal.

What's the trouble?
The trouble really began in 2013, which the company in its annual report characterized as having been "challenging." Nestle missed on its trademark long-term organic sales target of between 5% and 6% growth, and its stock price languished in comparison to rivals like Mondelez International. That trouble has persisted into 2014 as well.  

In its first quarter, Nestle suffered from a 5.1% drop in sales. Performance in Europe weighed on results, with a modest 0.3% increase. Meanwhile, a 4.6% sales increase in the Americas and a 7.3% jump in the Asia, Oceania, and Africa regions couldn't offset a negative foreign exchange impact of 8.6%.

Most disappointing was that Nestle produced organic sales growth (excluding the impact from foreign exchange and acquisitions) of 4.2%, below its ideal range. For the full year, however, Nestle expects to deliver on this metric with organic sales growth of 5% as well as margin improvement. 

Nestle isn't stopping there. It is on a streamlining mission to grow by acquisition in the areas where it can generate the most cash and to shed underperforming assets. CEO Bulcke made his intentions clear at a recent investor conference. He was cited in The Wall Street Journal as saying:

We will divest certain businesses or subcategories of certain businesses. We will not allow problems to drag on. 

Nestle already unloaded some of those problems, including PowerBar, which it sold to Post Holdings in February. And if the company can return to delivering on its sales promises in a consistent manner, perhaps it returning shareholder value will become a higher priority, which could rejuvenate the stock price.

On the expansion side, Nestle is also targeting high-end chocolate, where rivals Mondelez and Hershey already have market share.  

I think there will be some sort of premium chocolate initiative on a global basis for the company over coming months and quarters. And to be honest, about time too. -- Jon Cox, Kepler Cheuvreux analyst cited in Reuters. 

Meanwhile, Nestle might affectionately be known as a confectionery company, but it is more than that. It is a foods company by definition but it also plays elsewhere, including in the health and wellness industry, where it seeks to be a leader among its peers. To that end, Nestle in recent days revealed it will acquire select skin-care products from Canada's  Valeant Pharmaceuticals in a $1.4 billion cash transaction. But no share buyback has been announced.

Aesthetic dermatology products are a highly cash generative business and seem to serve a similar purpose to Botox. The addition of the Valeant assets coupled with Nestle's skin care joint venture with L'Oreal gives the company exposure to "more than half of the fast-growing medical aesthetics market around the world," according to Nestle.

Foolish conclusion
The fact that Nestle has had a tough go of it in the last set of quarters is rough but it could trigger the kind of change that shareholders have been missing. It's a mixed bag at the moment. The company is pursuing streamlining efforts but is scaling back its earnings payout ratio and the share buybacks have yet to materialize.

Whether or not activist investors will take an interest in Nestle remains to be seen, but the point really is that Nestle hasn't really been in a position to be in the discussion until recently. If activists enter the picture, it could lead to greater shareholder value for investors whether by share repurchases or a higher percentage of earning dedicated to dividends.  

Not everything is in Nestle's control. For instance, there's not too much it can do to rectify the foreign exchange impact. But investors still have a lot to watch for. They should observe the way that Nestle uses the cash that it will generate from its recent expansion efforts and any future asset sales to see if shareholder value becomes an increasing priority for the company.