A chocolate firm worth sinking your teeth into

What with obesity concerns and salmonella scandals, things aren't looking good for chocolate companies. But if firms can adapt to the new market, investors should see healthy profits.

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Like the England football team, Cadbury Schweppes has been in the news recently for the wrong reasons. The maker of Dairy Milk was forced to withdraw a million chocolate bars suspected of being contaminated by the salmonella bug, a move that might end up costing it £25m.

In doing so, Cadbury found itself in the same situation that Coca-Cola and Perrier have been in before, when pollutants were also found in their products. The good news is that the long term damage to Coca-Cola and Perrier turned out to be minimal and the stockmarket seems to have taken this into account in Cadbury's case, marking the shares down only slightly. But what about the rest of the sector?

Chocolate companies and falling demand

The story is mixed. Although the British are the biggest chocolate consumers in Europe getting through an average of 10kg each per year they were already beginning to lose their sweet tooth well before this incident. Mintel reports that between 2001 and 2005 the value of the chocolate market dropped by 7% and the firm estimates that over the next five years sales will continue to decline.

 

Why is that? First, the biggest consumers of chocolate are the young. So with an ageing society and fewer families, consumption is naturally falling. Second, with traffic light' food ingredient guidelines on the menu and health and obesity issues at the forefront of today's attitudes to food, chocolate is being pushed to one side. According to the British Medical Association, 20% of adults, 22% of boys and 28% of girls are now clinically obese, and chocolate products which can be high in hydrogenated fats, blamed for a number of medical conditions such as heart problems are among the easiest foods to cut out of the diet.

New ideas for a changed chocolate market

  To address these changing attitudes, the chocolate firms have had to adapt, bringing in smaller chocolate bars and changing to healthier ingredients. They have shifted to premium products to maintain profits, with dark, organic and fair-trade products in particular replicating the success of premium products in other consumer areas. Take Cadbury Schweppes, which is the UK's leading chocolate-maker with a 35% share of the market (Masterfoods has 30% and Nestl 15%). The firm has expanded overseas and now makes most of its profits from the American soft-drinks market, making the UK confectionery market relatively insignificant for them. But it has not given up on finding new profits in the chocolate market last year, it bought fair-trade and organic chocolate brand Green & Black's, which has been performing well, although it's still relatively small in scale. Other big firms are also trying new ideas. Masterfoods, owner of the Galaxy and Bounty brands, has opted for mini bars and re-sealable packs. Nestl, after suffering problems boosting sales of long-established brands such as Kit Kat, has gone for movie tie-ups and has removed additives from its perennially popular Smarties. But given the direction in which the market is moving, chocolatiers with high-quality brands are likely to be the best bet. We suggest some tasty targets below.

 

Three ways to play chocolate

The obvious chocolate play, Cadbury Schweppes (CBRY), is the orange cream of the sector. Chocolate is a minor part of its overall business and its valuation is also unattractive for a mature company, with the shares trading on 15 times earnings.

More appetising is Lindt & Sprngli (LISN). The Swiss luxury chocolate-maker has several attractions at the moment. Firstly, the shares have declined recently, making them look more attractive. Then there is the firm's positioning at the luxury end of the market. Rising costs a problem across the food industry hurt Lindt less in view of their higher-margin products, because increases can be passed onto customers more easily. Although not cheap (it trades on a p/e ratio of 24 times this year's earnings), this is much less of a concern for a high-quality firm with deluxe brands. But chocolate retailer Thorntons (THT) might be the tastiest choice of all. The firm's current strategy is rather muddled it sells through its own shops, over the internet and through supermarkets. But investors hope that new group chairman, John von Spreckelsen, the man who fixed ailing retailer Somerfield, will be able to turn things around. Shares have recovered since his appointment in early June, but are still just 15 times the firm's depressed earnings and currently yield over 5%. Short-term buyers should be wary, but this looks like a long-term story with plenty of potential.

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