Cadbury's Indigestion From Some Bad Chocolate

Since hitting an intermediate bottom last June, shares in the world’s largest confectionery maker, Cadbury Schweppes (CSG), which includes some of the world’s leading chocolate brands in its product portfolio, have bounced back smartly to realize a 10% gain over two short months.

While buying into a safe consumer non-cyclical like Cadbury’s is a sensible move if you’re expecting a recession induced market downturn, the company recently ran afoul of the sort of PR disaster that would be the stuff of nightmares for any food corporation exec, and of some concern for shareholders.

Last June, the company had to announce an embarrassing recall of over one million chocolate bars in the U.K. following the discovery of illness-causing quantities of salmonella in a number of its chocolate lines. The U.K. is one of the biggest chocolate markets in the world and where Cadbury derives 15% of its sales.

While the source of the contamination was subsequently isolated to a single U.K. plant, and a quick internal assessment was put out suggesting that the overall the cost of the problem could be limited to just 20 million pounds (US $37.6 million), there’s no guarantee that the final bill for this mess couldn’t go much higher.

It’s not clear whether the company’s internal loss estimate includes any allowance for damages related to potential consumer litigation. Government health authorities in the U.K. have concluded that “consumption of products made by CS [Cadbury Schweppes] was the most credible explanation of the [salmonella] outbreak” in the U.K.

Moreover, it was also revealed that the company had first detected salmonella contamination in its products as early as January but had chosen not to disclose this fact to the U.K.’s Food Standard Agency (FSA). And other revelations showed that the company had known of trace salmonella problems as far back as 2002.

Cadbury’s U.K. retail chocolate sales did in fact plunge 14% in July, but this was largely attributed to the record heat wave experienced by the U.K. and much of Europe this summer. A clearer picture should emerge once the back-to-school selling season starts next month, with all eyes looking for clues as to how market shares may shift before the crucial Christmas season.

With all these uncertainties still on the table, I wouldn’t be surprised if the shares give back a bit of the quick gains made over the past couple of months. At current levels, the shares trade at a 2007 forward P/E multiple of 15.6x – just slightly less than the 15.9x forward P/E for Nestle, a company which lacks the potential product liability risk at this juncture.

CSG 1-year chart:

By Eugene Bukoveczky, Contributor - Investopedia Advisor

At the time of release Eugene Bukoveczky did not own any shares in any of the companies mentioned in this article.