An Investment Analysis for Eskimo Pie

Question One: What do you think of the Nestle and Goldman Sachs’ valuations of Eskimo Pie Corporation. How would you go about valuing it as a stand-alone company? Be prepared to give reasons for your assumptions and comment on uncertainties and the sensitivity of the predictions to changes in those assumptions.

All of the competing valuation rationales, or indeed the resultant estimates, have to be weighed against a set of assumptions and alternate approaches or techniques. As a starting point, one may want to assume rational expectations based on a reasonably strong form of market efficiency. The former loosely refers to making full or proper use of whatever material information and forecasting techniques available or generally practiced. At the same time, the latter maintains that no insider type or closely held information can have material impacts on valuation. In fact, the two grand assumptions need not be intertwined or reduced to each other, however, defined at a micro level. Furthermore, they can never be trivially reduced to aggregated or macro-level market efficiency, which, in the end, hinges crucially upon information cost and data processing technology, among other things. On the other hand, assuming one without drawing upon the other might result in overlooking an important layer of contingency to be discussed shortly.

To begin with, the generic assumption of rational expectation can be made operational and meaningful in this particular valuation setup, which strikes a balance of a routinely analyzed core as opposed to an unconventional add-on. The latter pertains to the rather unusual notion of operational cash flows (which are licensing or royalty based), capex, or the structure of fixed cost outlays (which for some reason show an overlap with the licensee technology as if it were invested in and leased off). Moreover, it also has to do with the nature or structure of the leveraged buyout scheme building on a ‘special’ dividend. Yet, the conventional core has to do with the fact that market multiples, as a matter of peer or benchmark based valuation, could be deployed for consistency’s sake. Furthermore, they could serve as one way of lending some extra comparability and robustness to the valuation process or its underlying confidence interval. For instance, referring to the price-to-sales (P/S) and price-to-earnings (P/E) could be rationalized because most investors and analysts use these as a rule of thumb. Moreover, it might at times prove all that matters for comparable cost structures, margins, and performance ratios. However, these market multiples only make sense in a reasonably efficient market. Its assumption could be taken with skepticism whenever it is evident that the underlying values do not converge even within industries, let alone across remote sectors.

As it happens, the cost structure may oscillate even for the same company over time. Suffice it to see just how widely the costs of goods sold vary in terms of the resultant gross margin. For Eskimo Pie, this margin has been reasonably stable throughout the late 1980s. According to Exhibit 1 in the case study (Ruback, 2003), it accounts to approximately 30% as opposed to advertising and promotion expenses to gross profit, which ratio used to be about twice as high anywhere around the baseline year of 1987. Although one might presume improving cost efficiency or marketing efficacy, the less naïve would refer to a decelerating growth in the industry. For one thing, it is evident in the Reynolds’ business line breakdown (Table A), which shows a kind of mean-reverting pattern for Eskimo Pie’s sales or effective share in the portfolio or earnings contributions . The Exhibit 3 data present a similar trend looming large over the long haul, which tentatively points to Eskimo sales about to reach their all-time high penetration rate. However, that need not imply complete saturation bearing in mind an expanding variety; the odds can be raised by referring back to Exhibit 1’s structural implications, solvency, and liquidity. Although Eskimo boasts having secured some $13B in cash, its ratio vis-à-vis the net working capital has soared as high as $13,191/$11,735=1.24 up from about .6. In fact, the implied twofold warp in the effective current assets’ earning power together with idle cash coming to dominate the core asset structure could reveal some adverse trends and implications for valuation. Consequently, it may not be made apparent amidst capex contraction that might otherwise have counted toward improving (decreasing) investment cash outflows.

On second thought, as Exhibit 4 would suggest, the industry at large has seen a steady growth in both the sales and the advertising budgets. One way of reconciling the external environment and the internal developments would be to appreciate that, in effective terms, growth in the latter has outmatched the scale expansion. Although the ratios have been comparable between 1990 and 1987 at .0159 and .0253 respectively, that must have marked a sustained maturity in the light of the far lower .0034 value back in 1980.

The qualifications mentioned above apply to possible uses of P/S, yet not necessarily P/E. Although Eskimo Pie appears to have been turning into a ‘cash cow,’ it remains a question whether its profitability or investor ratios are strong enough for this ‘question mark’ type turnaround to prove of interest to a more optimistic and apt owner aiming at converting it into a would-be ‘star’ project. For instance, Nestle’s diversification strategy or longer-term vision may well tap into some heretofore-unfilled market niches, natural operating complementarity, or manufacturing overhead savings to inform synergy in ways that may build on ad-hoc asset specificity as a positive aspect, without necessarily allowing this lock-in to be overcome toward greater market liquidity as a standalone asset or prospective spin-off.

In addition, it is unlikely that the IPO host of candidate investors would look at P/S or P/E without backing the naïve analysis with more ‘fundamentally’ driven valuation. It may include dividend discounting, cash flow based valuation, Sharpe ratio, and related metrics. The latter captures the expected, excessive rate of return net of risk as presented in the historical variance or standard deviation. Although it would appear that all of the meaningful benchmarks or industry figures could be taken from Exhibits 8c and 9, the data might beg further questions rather than handle any. The analyst might end up wondering whichever yields or borrowing rates to deploy as the risk-free rate or the cost of debt (CoD), a component of the WACC discount. Furthermore, the choice of actual values might affect the differential or excess rate of expected return very materially while driving the cut-off criterion or direction of decision-making. Worse yet, neither an expected rate (historical average) nor the underlying variance or variability within one could possibly be inferred for Eskimo by the very definition of never having gone public before, which IPO possibility is only just being contemplated.

Incidentally, the related issues would plague direct or NPV-based valuation, if only because the small number of observations, which implies a short valuation horizon (three time periods as per Exhibit 6) and a high share of terminal value. Moreover, it embeds low efficiency into the estimates or an inherently high structural variance in the cash streams and the WACC discounting alike. Not least, although capex has gone down some 45 percent (and is now comparable to the depreciation in line with Exhibit 2), the actual structure of the overhead cannot readily be discerned from the operating cost forecast (Exhibit 6). Thus, it may have been targeted as a matter of ratio based projections rather than detailed as fundamentals. The fact that flexible budgeting has been employed to qualify the prior estimates by ex-post or actual sales can hardly secure long-term forecasting accuracy, validity, or robustness. Therefore, it is rather awkward to speculate on the EBITDA component of the after-tax cash flows. Anyhow, these could be strongly contingent on or trivially reduced to the licensees’ own sales forecasts.

Although it should be possible to obtain an NPV for Eskimo, with the peer stock price performance used as cost of equity (the applicable beta would be near unity by definition in light of similar benchmarks being invoked), the single most critical pillar missing is the actual structure of capital with leverage ill-defined or an LBO (leveraged buyout) yet to be considered to arrive at an ultimate financing mix.

As a tentative bottom line, one is left with two controlling scenarios, which could in fact qualify each other. As one option, it is possible to go with a fixed or stationary leverage based on Exhibit 1 balance sheet. It is anything but plausible given that the ratio of long-term debt to equity has changed drastically totaling .038 as of 1990 down from .078 as of 1987. Though material in its right, this magnitude of change reveals a less than significant after-tax cost of debt in the WACC structure, which may, however, be reversed in the event a $2M loan is taken out to mediate the LBO. The only favorable flipside of a singular capital structure such as this is the irrelevance of CoD or risk-free hurdle multiplicity.

To draw a tentative bottom line, multiples based valuation for Eskimo as a standalone project is the most feasible or low-cost second best available prior to tapping the extra dimensions. For instance, based on a P/S of 1.2x and a P/E at 25x, and with the adjusted rather than forecasted sales and earnings on hand at $56,655K and $2,893K respectively (Exhibit 6), a stock value or total ‘cap’ can be obtained anywhere in between $68M and $72M. This interval for the market value might refer to the hyper-optimistic upper bound (which may not be discriminating between the free cash flows to equity versus to total firm capital). Nevertheless, Nestle’s bid at as low as $61M clearly points to the possibility that selling it as a standalone via an IPO might be about as lucrative as it is less than realistic, bearing in mind that even the inherent synergies point to a less optimistic lower bound.

Question Two: Why would Nestlé want to acquire Eskimo Pie? Are there potential synergies? In your opinionis Eskimo Pie worth more to Nestlé than it is worth as a stand-alone company? Reservations and assumptions must be clear in your reasoning.

It is difficult to speculate about any prospective synergies for the lack of Nestle financials under study. Although these are up for grabs as a 10K prospectus, it should for now be safe to presume that the case-specific information is the only piece of data on hand, which does not deny any merit to further operations-specific conjectures based on the two companies’ profiles. Although Nestle is a widely diversified player, its portfolio has been maintained and rebalanced in a way that could accommodate its core lines of business while building on its core competencies and portfolio-relevant human capital as one way of spreading the learning cost over an optimum scale and scope.

Ex ante, Nestle might well be interested in augmenting its portfolio naturally focusing on vertical integration and goodwill. Moreover, it should bear in mind that acquiring a historical trendsetter could credibly reinforce its perceived reputation as a market leader. The latter status is the most important in a segment showing oligopsony, or a highly concentrated bargaining power of the buyers or licensees, with the ten largest, accounting for about two-thirds of the sales in Eskimo’s setup.

On second thought, Nestle already has a similar frozen novelties business on board. Therefore, the expansion could be more of a horizontal integration style. It is only with an eye on this kind of indeterminacy that the otherwise potentially sizable synergies might not turn out to be superior from the standpoint of alternate resource allocation. However, nothing in the market data (Exhibit 5) suggests that an anomaly of standalone valuation allegedly outmatching synergy-driven capitalization builds on heavy upside undervaluation.

Again, a somewhat myopic yet plausible first guess might lead one to see just that—a natural leeway for vertical integration of Eskimo into Nestle as opposed to an ill-crafted and totally ‘non-organic’ diversification as exhibited by Reynolds maintaining assets as diverse as metals and foods. Closer scrutiny as above reveals more complex tradeoffs. As it happens, it was quite natural from day one for Reynolds to have maintained a vertically integrated scheme between its Eskimo ice cream line and its aluminum foil business unit from the standpoint of packaging and emotive appeal. The horizontal integration for Nestle might not be that promising taking into consideration the saturation patterns mentioned earlier. Thus, an existing vertical integration drawing upon the actual synergies could clearly be favored as a certainty equivalent over would-be projects. Therefore, Reynolds is hesitant as to its portfolio re-balancing or financing priorities.

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When it comes to an IPO, the valuation range of 14 to 16 appears arbitrary amidst as loose a choice of valuation techniques. There is also too much at stake in terms of a $13B ‘special dividend’ payout for it to fully justify a possible yet uncertain issuance that can at best secure a few million dollars in extra working capital. Given that Eskimo as a ‘cash cow’ could at the very worst be used directly as a financing vehicle on the strength of its idle cash pile, either option appears inferior compared to staying put and cross-subsidizing between the business lines. That said, if one were to formally choose between the two particular second bests, a standalone IPO versus a direct vertical sale, Reynolds might want to consider the former option because, regardless of whatever underlying synergy kept in mind, Nestle’s best bid at some $61M barely amounts to the lower bound on the alternate, IPO based valuation range.