"At the end of the day, 100 percent of the value of an equity depends on the future, not on the past."
That quote comes from Bill Miller's biography from 2002, The Man Who Beats the S&P, and sums up a key concern I have with the prospects of confectionary titan Wrigley (NYSE:WWY). The other part of my bearish equation has to do with the valuation, which is simply too high.
First off, there is little debate that Wrigley is a great company, with an enviable track record of solid sales and earnings growth. To stay true to my bearish tone, I'll refer you to recent articles by fellow Fools Steven Mallas and Nathan Parmelee, with Steven being the counterpart to this duel.
Slowing growth
My problem with Wrigley is that investors are incorrectly extrapolating its strong historical track record well into the future, and recent trends suggest that growth will be increasingly difficult to come by. This is especially worrisome because of the high valuation, meaning Wrigley has a higher probability of underperforming the growth expectations already baked into the stock price.
For slowing growth trends, look no further than Wrigley's just-announced second-quarter results. Fellow Fool Lawrence Rothman pointed out that North American sales growth came in at low single digits and that a substantially weak dollar boosted international growth, which enhances international revenue when translated to the currency here at home. Management also said it has a "long-term earnings growth objective of 9-11 percent."
I'll be the first to admit that one quarter is meaningless in determining Wrigley's fortunes, but 10% long-term earnings growth doesn't cut it for me, considering that the stock is trading at almost 26 times earnings expectations for this year.
I'll also be the first to admit that earnings aren't the best way to determine Wrigley's capital-generating potential. Free cash flow is a much better metric, and it has fallen for three straight years -- and I'm not counting the acquisitions, including the sizeable purchase of Kraft's (NYSE:KFT) confectionary assets two years ago.
How sweet it isn't
Based on my calculations, last year's free cash flow fell to about $1.50 per share, putting the trailing price-to-free cash flow multiple at a sky-high 40. As I mentioned above, Wrigley's future free cash flow is what matters, and the past is relevant only to the extent that it helps us figure out what the future might hold.
Judging by recent trends, it's only getting harder out there for Wrigley as it deals with slowing domestic growth and higher input costs that go into producing gum, such as sugar, sweeteners, and corn syrup. Also, over the past five years, net profit margins have steadily contracted, falling from almost 15% in 2002 to less than 12% over the past 12 months. This supports a longer-term slide in Wrigley's competitive position.
It could be that competition from the likes of Hershey (NYSE:HSY), Tootsie Roll (NYSE:TR), or giant Cadbury Schweppes (NYSE:CSG) is eating into Wrigley's double-digit margins, and the company does concede that the industry is "intensely competitive." So why does it trade at a premium multiple to the group?
Well, Wrigley does post some of the highest margins in the industry, and competitors are mired in even worse competitive positions. Hershey just reported a double-digit fall in earnings, while Cadbury is splitting its beverage and candy businesses and has been subject to rumors that Cott (NYSE:COT) or PepsiCo (NYSE:PEP) is interested in acquiring it.
But despite Wrigley's being a leader in the industry, it's facing ever-increasing competition, and 9% to 11% earnings growth isn't going to cut it given the lofty valuation, which I believe is based on the company's past growth. The reality is that it will be an uphill battle for Wrigley, and I can't get anywhere near the current stock price by forecasting low double-digit cash flow growth.
Wait! You're not done with this Duel. Go back and read the other arguments, then vote for a winner.
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Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.
