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Nestlé gives an inch on share buybacks but Loeb wants more

Jun 28 2017 10:00
Claire Boston and Scott Deveau, Bloomberg

New York - Nestlé made its first concession to activist investor Dan Loeb, announcing on Tuesday a $21bn share buyback plan to boost its stock price. Don’t expect Loeb’s Third Point to stop there.

Behind Loeb’s campaign is a push for Europe’s largest company to follow many of its blue-chip peers in sacrificing its top-notch credit ratings to capitalize on rock-bottom interest rates.

Two days after the hedge fund manager announced his stake in Nestlé, the company announced the share repurchase plans, which would boost its leverage to 1.5 times a measure of earnings by 2020 from a ratio of about 1 time.

That’s unlikely to please Loeb, who is urging the packaged food giant to increase leverage to at least 2 times to “produce enormous capacity for share buybacks,” according to a letter to investors in his hedge fund Third Point.

While Nestlé’s willingness to push up its leverage slowly is a reversal of CEO Mark Schneider’s previous policy on buybacks, it would put the company more in line with other corporate titans that have let credit ratings slip in an effort to boost a measure of profitability.

Schneider said in February in his first public appearance as CEO that buying back stock is a lower priority than reinvesting in Nestlé’s business and paying dividends.

Nestlé shares rose as much as 1.7% in early Zurich trading on Wednesday.

“Third Point needs the success more than Nestlé, as they haven’t landed a real coup in a while,” said Christian Zogg, head of equity and fixed income at LLB Asset Management in Vaduz, Liechtenstein, which holds Nestlé shares.

“From the outside, the impression is often that these giant tankers are moving slowly or not at all, but in fact there are permanent portfolio adjustments.”

Loeb’s bet

Loeb is betting that pushing Nestle’s debt levels to at least two times earnings before interest, tax, depreciation and amortization wouldn’t have a dramatic impact on its credit rating and put its leverage ratio in line with its competitors.

While the shares have rallied to a record high this year, his pitch to borrow to buy back stock is underpinned by a belief that Nestle can accelerate sales growth and boost earnings in coming years. 

READ: Nestlé targeted in activist's biggest-ever bet

Negative interest rates in Switzerland also make repurchasing stock attractive. Cheap borrowing costs mean the company can buy back shares, reduce dividend payments, and thereby boost cash flow.

A representative for Vevey, Switzerland-based Nestle declined to comment. A spokesperson for Third Point in New York wasn’t immediately available for comment.

The company generates enough cash that it won’t need to sell assets or issue bonds to support the repurchases and will probably keep its near-perfect credit rating, said Bloomberg Intelligence analyst Duncan Fox. Methodology that Moody’s Investors Service uses to assign grades shows a leverage ratio of 1.5 times Ebitda could be consistent with Nestle’s current AA-tier grade.

“They’re going to be generating a huge amount of free cash on an annual basis,” Fox said in an interview. “They could have done this at any time, and I expect Mark Schneider was thinking of doing it.”

Declining ratings

Ratings across investment-grade issuers have declined in part because nearly a decade of ultra-low interest rates worldwide has already allowed legions of companies to pile on debt in an effort to increase their stock prices.

Less than 11% of corporate investment-grade debt outstanding carries top AAA or AA grades, according to Bloomberg Barclays index data. A decade ago, more than 35% did. The share of notes that are rated in the lowest tier, BBB, has jumped to more than 43%, from about 25% a decade ago.

Nestlé has long had the highest ratings among its peers. Loeb wrote in his investor letter that such creditworthiness “serves no real business purpose” for a company like Nestle, which has strong cash flow and is in an industry that fares better in economic downturns.

Unilever is rated two steps below Nestlé, while Danone and Kerry are ranked in the triple-B range, the lowest tier of investment-grade.

Cheap financing

Debt financing remains cheap enough that companies don’t face steep increases in their borrowing costs if their ratings slip, said Philip Zahn, an analyst at Fitch Ratings.

The average non-financial company worldwide pays about 4.62% annually to borrow in the debt markets, compared with 9.84% for equity, according to data compiled by Aswath Damodaran, a finance professor at the Stern School of Business at New York University.

“It doesn’t really cost you very much to move down the ratings scale given the current interest rate environment,” Zahn said “That can and undoubtedly will change in time.”

Ratings companies have dinged issuers for buyback programmes in the past. Moody’s has a negative outlook on Microsoft’s top credit rating and said it could downgrade the company if it “continues with aggressive shareholder returns.”

Fitch Ratings cut the credit grades on Jack Daniel’s producer Brown-Forman and Chili’s Grill & Bar operator Brinker International last year, citing their stock repurchases. 

So far, Nestlé’s bondholders are shrugging off the risk. The company’s $550m of 1.875% bonds due in 2021 gained 0.07 cent to 99.92c on the dollar on Monday and didn’t change hands on Tuesday, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

CEO Schneider seems more focused on boosting profit than rejiggering Nestlé’s balance sheet and risking a ratings downgrade, CreditSights analysts Simon Atkinson and Maryum Ali said. “We wouldn’t be lightening up on a Nestlé bond holding just yet,” they wrote in a note to clients on Monday.

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