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After the Warren Buffett-backed takeover of Heinz, Big Food merits a fresh look. Makers of meals, sauces and spreads may offer better value than is immediately obvious.
The value of shares depends on future cash flows. In many sectors, high profit margins are a fleeting thing – just ask yellow-pages publishers, or record-store clerks. But food-makers' strong finances may have a very long shelf life. This is the sort of "moat"-like protection that Mr. Buffett famously prizes.
The sector's giants are built around strong brands, relentlessly promoted and rejuvenated. Technological disruption is minimal. Developing markets offer promise. Profitability is strong, and holds remarkably steady. Operating margins at Heinz have only wavered 2.2 percentage points in 10 years, around a 15.5-per-cent average.
Willis Welby, a research boutique, argues that investors overlook this margin stability. They assign too-low multiples of earnings and put unfairly pessimistic projections of declining margins in their discounted cash flow models.
The Willis analysts work backward from current share prices. Using a discount rate of 8 per cent and assuming that revenues increase in the long term at a 5-per-cent rate, they generate implied long-term margins, which they compare to analysts' medium-term forecasts.
The results are striking. Even expensive-looking shares can offer good value. The $28-billion (U.S.) Heinz takeout, frequently described as expensive, looks fairly priced. And several big companies look downright cheap, notably Campbell Soup, ConAgra Foods, Danone, General Mills and Unilever.
Of course, long-term cheapness doesn't automatically make a company a takeover target. Any buyer would need patience – and confidence that the products will keep on selling, no matter how fashions and diets change.
Moreover, some of the cheap quintet are probably off-limits for a bid. Unilever is too big and Danone is too French. At Campbell, big family shareholders would need to be onside. Even ConAgra, at $14-billion, and General Mills at $29-billion, would make big mouthfuls. But Nestlé, which partners with General Mills to sell breakfast cereals outside North America, could certainly afford it.
But suppose this contrarian view on valuation is right. Even without future M&A, equity investors could pay a rich-looking price and still avoid indigestion.