The Wall Street Journal

OPINION

OCTOBER 30, 2009, 11:39 P.M. ET

Is the Stock Exchange Obsolete?

The CEO of the NYSE says the future of New York as a financial center will largely be determined by Washington.

By MARY ANASTASIA O'GRADY

In the late 18th century there was a buttonwood tree in lower Manhattan where brokers gathered to trade stocks. But by 1817, the tree had become obsolete as a trading hub. The traders migrated indoors and changed the name of their group to the New York Stock and Exchange Board. The exchange moved a couple of more times after that, and in 1903 the NYSE opened for business in the neoclassical masterpiece that still stands at the corner of Wall and Broad Streets.


Today a giant American flag stretches across the tall Corinthian columns of that elegant design—the very symbol of American economic freedom. Yet even as hordes of out-of-towners stroll by daily on tours of New York's financial landmarks, it sometimes seems that international finance is leaving the bricks and mortar behind.

With the advent of electronic markets, equities trading now largely happens in cyberspace. That fact raises the question of whether New York, with its high taxes and high-priced real estate, still makes sense as a financial center. Equally uncertain is whether the Big Board's legendary Wall Street address should be included in the profitable 21st century business model of the company, which is now known as NYSE-Euronext because of its acquisition of a European trading business in 2007. Is 11 Wall St. destined for the same fate as that buttonwood tree?

Recently I went to see Duncan Niederauer, the company's CEO, with these questions on my mind. Mr. Niederauer has only been at the helm of NYSE-Euronext since 2007. But he is no stranger to the equities markets, having spent 20 years in the equities division at Goldman Sachs.

The NYSE used to have a visitors gallery that allowed tourists to peer down on traders scurrying around the floor. But all that changed on Sept. 11, 2001. The exchange is no longer open to the public, and when I arrived at its doors I had to navigate a gauntlet of heavy metal barricades, stroll past a couple of machine-gun-toting guards, and clear a metal detector before I was escorted into the CEO's office. As it turns out, access for tourists is not the only thing that has changed in recent years. Things on the floor are a lot different, too.

I begin the interview with the broader question about New York as a financial center. Is it in decline?

That, the CEO tells me without hesitating, is largely up to our federal politicians.

"New York City's ability to compete is largely out of its immediate sphere of influence," he says. "A lot is going to have to do with what changes come out of Washington and what their regulatory and legislative response to the crisis is." Washington's response is "going to determine New York's ability to continue to compete in a world that we all know is in the process of a pretty transformational rebalancing."

The large German insurer Allianz recently announced that it would delist in New York. I wonder aloud if that isn't a bad sign. Mr. Niederauer is matter of fact, calling Allianz's decision "rational," and consistent with similar decisions made by other European companies.

"If you turn the clock back 20 or 30 years," he says, "it made a tremendous amount of sense for companies like Allianz to list in the United States because their local market was not deep, it was not liquid, it was not easily accessed by investors outside the immediate jurisdiction. So if those companies had multinational aspirations for either brand awareness, shareholder involvement or both, the only way to diversify the shareholder base was to list in the biggest capital market in the world, which was the United States. The NYSE won virtually every one of those listings."

Now, it's a different story. The "local market is a lot deeper, a lot more liquid, and it's much easier to invest cross-border than it was 20 years ago. All the big mutual funds here have no trouble and have plenty of flexibility in their charters to enable them to invest in the local markets." As a result, Mr. Niederauer says, Allianz's decision makes sense. But he quickly adds two important points.

First, the good news: There are nearly 70 Chinese companies now listed on the NYSE. "Those have all come in the last few years" and "for the same reasons that the Allianzes of the world came here 20 or 30 years ago." So far, the Chinese domestic market "is not developed, liquid or deep enough," which draws companies to the U.S.

The bad news, according to Mr. Niederauer, is that while Allianz had some legitimate reasons to delist, the 2002 Sarbanes-Oxley law may very well have been the nail in the coffin. The act—which increased the reporting burden on companies—is "one of the things that has made us less competitive," and "hurt the U.S. capital markets competitiveness."

How so? He says some companies "use it as a differentiator because they don't have a strong reputation and don't come from markets with solid regulatory oversight." But "I'm afraid in the case of companies like Allianz, it's a drag," because complying with Sarbanes-Oxley ends up costing companies a lot of money. It is worth noting, he adds, that though five Russian companies are listed in New York, not one has been added since 2004.

The CEO says small companies are especially suffering under Sarbanes-Oxley. When Congress passed the act, it was "meant to be fairly cost-effective for a small company with a fairly simple business model to comply."

But it hasn't turned out that way. "If we surveyed 100 small companies with market caps of less than half a billion dollars, let's say, I think they would all tell you, 'yes we know we were told it was only supposed to cost 75 or 100 thousand dollars a year to comply.' But most of them would say it costs about 10 times that. And that's an awful big burden for a small company to bear."

"Why aren't more smaller companies launching initial public offerings?" He quickly answers his own question: "The threshold is getting higher and higher because of all the costs associated with being a publicly listed company. A lot of that is the fear of what these things are going to cost, the creep of expense to comply with these various regulations." Even with Sarbanes-Oxley being relaxed a bit, Mr. Niederauer says the exchange still suffers from the perception of heavy regulation.

Listings, of course, are not NYSE-Euronext's only source of income. In the second quarter, revenues from listings accounted for only 17% of the total—about the same proportion as revenue from "market data" services. That's because Mr. Niederauer and John Thain, his predecessor, anticipated the fact that competitiveness in a global capital market would increasingly depend on deriving income from other products and places outside of the U.S.

In the same second quarter, derivatives trading amounted to 26% of revenue. That includes trading in American Stock Exchange options, which NYSE-Euronext acquired in 2008, and options traded through the exchange's electronic trading platform known as NYSE-Arca. Even more significantly, most of the derivatives income is generated at the LIFFE, an electronic trading platform with operations based in London.

All of this demonstrates that NYSE-Euronext executives have been able to read the electronic tape on the wall. But it's one thing to invest in Europe and cyberspace. It is quite another to argue that the historic venue in lower Manhattan retains its raison d'être.

The traditional NYSE model—using specialists to make markets—worked fine for decades because the Big Board had a near monopoly on U.S. equity trading. But now most trades are executed electronically and markets are open 24 hours around the globe. How can Mr. Niederauer still justify "the floor"? He argues that the New York floor offers customers something that computers are incapable of providing: "the human touch."

Though he doesn't want to "overplay the hand of the floor," he maintains that having people executing trades on high volatility days gives the NYSE-Euronext an edge. "I view it as having a real-time lever where we can apply as much human judgment in an individual situation or on an individual day as is required."

He says NYSE-Euronext's combination of cutting-edge technology and human judgment is "an invaluable combination that no one else can replicate. I can't do that without the floor." And because the NYSE-Euronext has expanded the products that can be traded there—adding options, Nasdaq stocks, derivatives, European stocks—some agency firms have actually added personnel recently and decided "to run their whole business from here."

Listening to the CEO promote his company, I begin to feel somewhat more optimistic than I did when I walked in. Maybe my all-time favorite New York institution—not counting the Cyclone roller coaster at Coney Island—can survive after all.

Then we circle back to the subject of regulation, and the dark clouds return. Mr. Niederauer says Washington is casting a shadow of uncertainty over the market. Exhibit A is the possibility that "the boardroom and corporate governance" could be "federalized." And he warns that "we don't need acts of Congress to talk to us about what board composition or decentralization should look like."

He is relieved that it appears Congress has shelved its plans to tax multinationals headquartered in the U.S. on their non-U.S. profits that are not repatriated. That, he says, would have been "a competitive disadvantage for U.S. companies," which could have had "knock-on effects in the U.S. capital markets." But he remains concerned about the "transaction tariff on all transactions in the regulated markets" that's currently being bandied about. "It would have disastrous consequences."

At bottom, Mr. Niederauer is worried about what government is doing to risk takers. "It was striking if not staggering that virtually no companies [backed by venture capital] came to market last year. I didn't want to hear that it was just because the market was bumpy and valuations weren't that good." He says that until late in the year that was not a valid excuse.

Though the initial offering "pipeline" is now stronger than it's been in two years, he worries about keeping the "virtuous circle" healthy. Remember how it's supposed to work: "the entrepreneur gets rewarded for taking personal risk, borrowing capital, taking an idea, starting a new business from scratch. That's America the last time I checked. When they get big enough, they've proved the idea works, they want to grow, they come to the equity market because it's an efficient way to raise more capital to grow and the next thing you know Microsoft starts in a recession and now employs 95,000 people around the world, 25 to 30 years later. That's America, that's what we're supposed to stand for, and if we're not careful that virtuous circle is going to go backward and it's going to be a vicious circle."

Small companies, he argues, are the key to the recovery. "They're the economic engine in this country, certainly after every recession. That's where most of the new job creation comes from. I think we're all a little nervous that if we start to convey that risk-taking is no longer okay, what impact does that have on entrepreneurial spirit and innovation?"

In 2008, the NYSE had one venture-capital backed company come to market all year. "That's not good," he says. Not good for the NYSE-Euronext, not good for New York, and not good for America.

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved

November 1, 2009


Can Citigroup Carry Its Own Weight?


By ANDREW MARTIN and GRETCHEN MORGENSON



















OVER the past 80 years, the United States government has engineered not one, not two, not three, but at least four rescues of the institution now known as Citigroup. In previous instances, the bank came back from the crisis and prospered.

Will Citigroup rise again from its recent near-death experience?

The answer to that question concerns not only the 276,000 employees who work at what was once the world’s largest bank, but the nation’s taxpayers as well. Even as Citigroup’s stock has soared from a low of $1.02 to its current $4.09 — and the company has eked out a $101 million profit in the third quarter along the way — it’s still unclear whether it can climb out of the hole that its former leaders dug before and during the mortgage mania. If Citigroup remains stuck, taxpayers will be on the hook for outsize losses.

Citigroup remains a sprawling, complex enterprise, with 200 million customer accounts and operations in more than 100 countries. And when people talk about institutions that have grown so large and entwined in the economy that regulators have deemed them too big to be allowed to fail, Citigroup is the premier example.

As a result, the government has handed Citigroup $45 billion under the Troubled Asset Relief Program over the last year. Through the Federal Deposit Insurance Corporation, a major bank regulator, the government has also agreed to back roughly $300 billion in soured assets that sit on Citigroup’s books. Even as other troubled institutions recently curtailed their use of another F.D.I.C. program that backs new debt issued by banks, Citigroup has continued to tap the arrangement.

Citigroup is also one of only two TARP recipients so desperate for capital that they’ve swapped government-issued shares into common stock, diluting existing shareholders. (GMAC, the troubled auto lender that may receive another government infusion, is the other.)

While Citigroup has written down tens of billions of dollars’ worth of mortgages on its books, there are looming problems in its huge credit card portfolio. Of the company’s $1.2 trillion in credit commitments outstanding in the second quarter, $873 billion were credit card lines. A measure of the bank’s efforts to wrestle that problem to the ground is the interest it charges customers: in October, Citigroup raised interest rates on some credit card holders to 29.99 percent.

Chris Whalen, editor of the Institutional Risk Analyst, calls Citigroup “the queen of the zombie dance,” referring to the group of financial institutions that the government has on life support.

“They are hoping that a combination of bank assistance and maximizing revenue and buying time will let them survive,” he said. “When I look at the whole picture, Citigroup is in the process of resolution. I continue to believe the equity is worth zero and that the company will have to go to bondholders for some kind of money to make the bank stable.”

VIKRAM S. PANDIT, Citigroup’s C.E.O., said in an interview that he was confident that Citigroup was on the right course, focusing on global banking and shedding segments of the company — like insurance and the brokerage business — that aren’t part of that mission. To date, he said Citigroup had sharply reduced its expenses, improved how it monitors risk, and established a management team that he said would return the bank to sustained profitability.

“Our distinctiveness is we connect the world better than anyone else,” he said, noting Citigroup’s global reach. “We have a great capability of building a business around that. And we are in the process of building a culture around that.”

Mr. Pandit said he was working with federal regulators on a schedule for paying back TARP funds, which he said was crucial to restoring Citigroup’s image among consumers. “It’s very hard to change perceptions in this marketplace,” he said. “We are not a troubled bank. We have a lot of assistance from the government. We can’t fight that.”

In trying to right itself, Citigroup plans to undo much of what it did during a period some insiders call the lost decade — with events that included merging with Travelers Group in 1998 and a huge, dizzying expansion of its asset base. To untangle the company, Mr. Pandit has split Citigroup in half. One part consists of operations that Citigroup executives consider central to the bank’s future; these include retail banking worldwide, investment banking and transaction services for institutional clients.

The other part contains businesses that Citigroup executives hope to exit or unload. This includes asset management and consumer lending, such as residential and commercial real estate, as well as auto loans and student loans. Citigroup is also selling some of the many companies it acquired in recent years. In the weak economy, however, buyers are few.

To be sure, Citigroup’s financial cushion has fattened significantly, thanks in large part to taxpayer relief — prompting some banking analysts to be relatively optimistic about the bank’s prospects.

One is Matt O’Connor, an analyst at Deutsche Bank. He says that Citigroup is still saddled with potential risks, but that it’s well positioned for an economic recovery, in that it can sell off assets more quickly, or for another downturn, since it has government protection and relatively little commercial real estate exposure.

“We find Citi shares could reach $10,” Mr. O’Connor wrote in a recent report to investors. “However this may be several years away and many uncertainties remain — both to Citi and banks over all.”

Yet compared with other big banks like JPMorgan Chase or the Goldman Sachs Group, Citigroup’s operations are not yet generating enough profits to cover potentially devastating write-downs to come. In the third quarter, none of the units upon which Citigroup has pinned its hopes showed a jump in revenue.

Analysts at Fitch Ratings project that Citigroup will continue to be plagued with hefty loan loss provisions and that its operations will remain weak into 2010. The primary reason for Citigroup’s woes, of course, is relatively straightforward. The bank simply placed too large a bet on risky consumer loans, especially mortgages. These were often repackaged into complex financial instruments that went sour when the economy collapsed. Citigroup ended up eating these losses.

Citigroup also sank deeper into the swamp of troubled loans than its peers, according to interviews with more than a dozen former employees and analysts, because of a number of other factors: a culture of deal-making that trumped efforts to help existing businesses grow on their own; constant churn among the executive ranks; the sapping of top talent; the blunting of dissent; and a drive to mimic competitors’ risk-taking while failing to assess when those gambles were becoming perilous.

A byproduct of these flaws is now smoldering on taxpayers’ doorstep, causing worries on Capitol Hill that the United States may never get back the bailout money it gave to Citigroup. Representative Lloyd Doggett, a Texas Democrat on the House Ways and Means Committee, recently registered unease about the government’s guarantee of $300 billion in Citigroup assets and how effectively the Treasury secretary, Timothy F. Geithner, was monitoring the bank.

“We cannot know the full scope of the taxpayers’ potential cost from these hasty guarantees,” Mr. Doggett said last week in an e-mail message. “Inexplicably, Secretary Geithner appears unwilling to commit to conduct an analysis, despite my specific request to him in March. A critical and transparent examination of the response to the financial crisis is essential not only to learn from past mistakes, but also to prevent further erosion of the public’s trust in government.”

The Treasury secretary declined to comment.

Neil M. Barofsky, special inspector general of TARP, has assembled a team to examine how Citigroup is using taxpayer funds. In a Sept. 21 letter to Mr. Doggett, he said: “The Citigroup guarantees raise important oversight concerns.”

Those concerns are shared by others, particularly financial analysts.

“Traditional banking is still in a recession, and the situation is very tenuous,” said Janet Tavakoli, founder of Tavakoli Structured Finance, a consulting firm. “If we do get our money back from Citi, some of it will be the money we printed to give to them.”

ALTHOUGH history does not repeat, now and then, as Mark Twain famously proclaimed, it rhymes. Nowhere in the financial world, perhaps, is that more true than for Citigroup.

During the 1920s, the institution then known as National City Bank opened stores around the country to encourage the burgeoning middle class to invest in stocks and bonds. With little money down — 10 percent of the cost of a trade was all an investor needed to buy shares — investors poured into the stock market. Charles E. Mitchell, C.E.O. of National City, hyped these sales throughout the period. His nickname was “Sunshine Charley.”

Then came the Great Crash of 1929. Vilified as a “bankster” in the aftermath of the crash, Mr. Mitchell testified to Congress that banks “were too ready to loan, too ready to meet the competition of neighbors, too willing to cut down their margins to a point of encouraging excessive bargaining.”

Before the crash, industry practice allowed National City not only to underwrite securities but also to employ a sales army to peddle them to depositors. After Congressional hearings determined that this conflict of interest was a major cause of the debacle, lawmakers passed the Glass-Steagall Act, separating activities of commercial banks (which offered plain old savings accounts and loans) from those of investment firms (which trafficked in more highflying endeavors like stock trading and underwriting).

Although thousands of smaller banks failed, government policies to prop up the banking sector helped National City and other major banks weather the Depression.

Fifty years later, what was then known as Citicorp found itself in trouble again as huge loans to developing countries in Latin America soured. The federal government weakened capital and accounting requirements to allow big American banks to survive the crisis. Still, in the early 1990s, the bank was in a precarious state because of its problems in Latin America, coupled with losses in commercial real estate and a weak economy.

Citicorp survived this crisis with an infusion of cash from a Saudi Arabian prince and a gift from Alan Greenspan, then the chairman of the Federal Reserve. Mr. Greenspan’s Fed kept interest rates unusually low, allowing Citicorp and other troubled banks to borrow money cheaply and lend at higher rates to their customers.

By 1998, Citicorp had more than regained its footing and was willing to take a more aggressive stance. At the direction of its chief executive, John S. Reed, Citicorp agreed to join forces with the Travelers Group, an amalgam of insurance, brokerage and investment banking services run by a brash dealmaker named Sanford I. Weill. The largest merger in history followed, creating a colossus named Citigroup with $700 billion in assets.

Because Travelers had an investment firm under its umbrella, the creation of Citigroup prompted Congress to eliminate what remained of the Depression-era separation between Main Street banking and Wall Street trading. Mr. Reed and Mr. Weill argued persuasively for the change, and, along with the rest of the financial industry, deployed an armada of lobbyists in Washington. In 1999, Congress overturned Glass-Steagall.

“By liberating our financial companies from an antiquated regulatory structure, this legislation will unleash the creativity of our industry and insure our global competitiveness,” Mr. Weill and Mr. Reed, Citigroup’s co-chairmen and co-chief executives, said in a statement after Congress repealed the law. “As a result, all Americans — investors, savers, insureds — will be better served.”

Former employees wax nostalgic about the early days of the merger.

“Across the board, it was clearly No. 1,” said one former top executive who requested anonymity to maintain relationships with former colleagues. “You had franchises that were the envy of the world. It was a remarkably powerful institution.”

Profits soared, and by 2003, Citigroup was generating nearly $18 billion a year in them. But even as the money flowed, the euphoria over earnings was tempered by personnel upheaval, recurrent scandals and the realities of managing such a behemoth.

Mr. Weill’s longtime sidekick and heir apparent, Jamie Dimon, was ousted eight months after the merger. (He now runs JPMorgan, a bank that has weathered the financial downturn much better than most of its large rivals.) A steady exodus of top talent followed Mr. Dimon’s departure from Citigroup; it has only accelerated since the financial crisis began in 2007.

In the last decade, for instance, Citigroup has had four chief executives, six chief financial officers, seven heads of consumer banking and eight investment banking chiefs.

Bank of America, by contrast, has had two C.E.O.’s, four chief financial officers and one chief operating officer during the same period — though that relative stability didn’t spare the bank from mistakes and pain in the crisis.

After a series of financial scandals that tarnished the bank’s reputation, Mr. Weill announced his retirement as chief executive at the end of 2003, handing the reins to Charles O. Prince III, his longtime general counsel who had navigated the company through its various legal and regulatory crises but had never run a major financial institution. Mr. Prince did not return several phone calls seeking comment.

Deal-making largely continued unabated under Mr. Prince, while the bank’s myriad parts were never effectively knit together. During his three-and-a-half-year reign, Citigroup bought five large mortgage lenders or loan servicers and four credit card lenders or portfolios. This buying spree would almost certainly have been larger had the Federal Reserve Bank of New York not barred Citigroup from making acquisitions for 12 months between the spring of 2005 and 2006 — a ban that followed complaints by foreign regulators that Citigroup’s risk management practices were dangerously lax.

Even with occasional regulatory restraints, Citigroup’s assets ballooned from $1.49 trillion to $2.19 trillion from 2005 to 2007, an increase of 46.9 percent (and three times the size of Citigroup’s balance sheet when the merger that created it occurred).

But amid that impressive growth, dubious mortgage loans and questionable trading in mortgage and other debt-related securities began to undermine Citigroup’s finances. One ugly class of securities continues to haunt the bank: collateralized debt obligations, or C.D.O.’s.

From 2004 to the beginning of 2008, Citigroup underwrote $70 billion in C.D.O.’s but had to keep $57 billion of that amount on its own books when it couldn’t find buyers, according to a class-action lawsuit filed in federal court in Manhattan, on behalf of disgruntled Citigroup investors. The suit contends that by late 2006, Citigroup’s C.D.O. operations “had devolved into a Ponzi scheme where unsold portions of older C.D.O. securitizations were recycled as the asset base for new C.D.O. securitizations.”

Furthermore, the lawsuit says, Citigroup executives engaged in various accounting gimmicks to conceal the bank’s ownership of assets that eventually soured. Citigroup denies the allegations and says it will vigorously fight the suit.

Still, the unfortunate truth about the bank during the last several years, according to analysts and former insiders, is that it was managed horribly. “They just blew it,” said one former Citigroup executive, who like many others interviewed for this article requested anonymity because of pending lawsuits and a desire to preserve relationships with former colleagues. “It’s really hard to drive the car if you don’t have the headlights on.”

If Citigroup was driving blind, regulators seem to have been unaware. Officials at the Office of Comptroller of the Currency and the New York Fed — overseen at the time by Mr. Geithner, who has since become the Treasury secretary — stood by as Citigroup amassed a portfolio that would ultimately generate losses of more than $35 billion.

CITIGROUP’S financial architecture remains rickety. One reason is that it relies much more heavily than most other large domestic banks on uninsured deposits in overseas locales, where customers are quick to pull their money at the first sign of trouble. Also, some of the accounting machinery it put in place to temporarily move assets off of its balance sheet (and make the bank look financially healthier) has backfired.

Mr. Pandit maintained that Citigroup’s strategy would take some time and depended in part on how the economy fared. Should the economy continue to improve, for instance, he said the bank would snare handsome returns when it sells off assets. Other assets, like some mortgages, for example, will simply be paid off over time, he said.

“We have time,” he said. “If markets do turn around, these are going to be very valuable businesses. This is going to take awhile.” Yet analysts say that for Citigroup to survive, it must quickly sell the businesses it wants to exit. And that is especially hard to do given that it is shopping its wares at a time when few people appear to want them, particularly Citigroup’s middle-tier operations in far-flung regions around the globe.

That means the plan to offload the orphan businesses is likely to take much longer than Citigroup’s management had hoped. In January 2009, two years was an estimate for this wind-down, but that is looking more improbable by the day, according to analysts and others familiar with the bank’s operations.

Mr. Whalen, the bank analyst, thinks that squaring away Citigroup’s problems will take more than low interest rates and taxpayer assistance.

“Citigroup will need future capital injections,” he said. “Eventually what happens with Citigroup is the government is going to turn to the bondholders and say we can’t put any more money into this. You own the company now.”

Copyright 2009 The New York Times Company

Nestlé

The unrepentant chocolatier


Oct 29th 2009 LAUSANNE AND VEVEY
From The Economist print edition

The world’s biggest food company is betting on an emerging class of health and nutrition products to spur its growth. But risks abound









Illustration by Robin Chevalier







IT IS a curious blend of kitchen and laboratory. From one room wafts the bittersweet smell of chocolate being gently heated and stirred by chocolatiers. Around the corner it is all science. A double row of cubicles contains human guinea pigs who sniff and taste from little tubs, scoring each on criteria such as sweetness or bitterness to produce complex flavour charts. Down the corridor, women in comfortable chairs talk about how chocolate makes them feel. Cameras and microphones record their most minute gestures for the scrutiny of psychologists and anthropologists.

This is the science behind Nestlé’s 110-year-old chocolate factory next door, which each morning exhales the aroma of roasting almonds and cocoa beans over Broc, a chocolate-box-perfect Swiss village where even the weeds in an overgrown lot seem orderly. It is in these laboratories, where a pinch of art is mixed with SFr25m ($23.6m) of technology, that new chocolate recipes are devised. At another Nestlé research centre in Lausanne, meanwhile, researchers have been working out how chocolate affects metabolism and the behaviour of gut microbes—in other words, analysing chocolate as a pharmaceutical product, rather than a treat.

Investment in this kind of research may seem indulgent, particularly in a recession. But it exemplifies Nestlé’s strategy for future growth. Although the company is best known for chocolate, ice-cream and sugary snacks, Peter Brabeck-Letmathe, the firm’s chairman, and Paul Bulcke, its chief executive, hope to transform the food company into the world’s leading health, nutrition and “wellness” firm. It is tempting to dismiss this as a mere marketing stunt—an effort to make people feel better about eating things they really shouldn’t. Yet there is a sound commercial logic behind Nestlé’s shift towards health and nutrition.

Sales of foodstuffs that have been intentionally modified and improved by manufacturers to provide claimed health benefits—known as “functional foods”—are, in many cases, growing far more quickly than foods sales as a whole. Sales of functional foods in western Europe grew by 10.2% a year between 2004 and 2007, whereas sales of packaged food grew by 6.3% a year over that period (see chart 1), according to Euromonitor, a market-research firm. Some categories are growing even faster. In America, sales of functional foods that promote “gut health”, for example, grew by an average of 15.8% a year between 2002 and 2007, according to a recent PricewaterhouseCoopers report, compared with overall food-sales growth of 2.9% a year, according to Datamonitor (see chart 2). The PricewaterhouseCoopers report predicts that the global market for functional foods will grow in value from $78 billion in 2007 to $128 billion in 2013.

Looking further ahead, Nestlé sees great potential in the idea of “personalised” nutrition. Just as drugs companies have long talked of devising drugs that take account of genetic variations between people, the firm wants to do the same with food. That is why it is investing in the nascent fields of metabolomics and proteomics with the aim of providing foods, diets, devices and even services for particular subgroups of the population. It forecasts that by 2017, global sales of nutrition for “specific need states” could reach $100 billion. Existing examples include Musashi whey-protein supplements and PowerBar snacks for athletes; Sondalis and Nutren Glytrol liquid diets for diabetics; and Optifast powders and shakes for dieters.




















Switching to a new diet

This shift in emphasis towards health and nutrition will, Nestlé hopes, transform it from a purveyor of low-margin, commoditised foodstuffs into a provider of high-margin products and services. (It already owns Jenny Craig, a chain of American weight-loss centres, which it is now expanding globally.) The firm needs new sources of growth. Sales of bottled water, which are about 10% of its business, are falling in rich countries because of the recession. They may yet bounce back, but analysts fret that bottled water, which is now firmly in the sights of environmental groups, may go the way of the fur trade.

Nestlé also seems to be losing market share in other products, though company officials dispute the assertion. Pablo Zuanic, an analyst at JPMorgan, reckons that in the second quarter of 2009, 44% of Nestlé’s product lines lost market share in America, and none of its products gained market share there, according to surveys of retail-data by ACNielsen, a market-research firm. Scepticism about Nestlé’s prospects can also been seen in its share price: its shares trade at a lower multiple of earnings than those of its main European competitors. One reason is that investors are concerned that it may invest some or all of the SFr30 billion it is likely to receive next year from selling its share in Alcon, an eye-care firm, in businesses that are less profitable than the ones it already has.

Investors are also worried that Nestlé has become too large and unwieldy. The firm has 30 product lines that each generate more than SFr1 billion in annual sales, from Nescafé coffee and Nesquik milk to Purina pet food and Pure Life, a bottled water that is sometimes made from stuff that comes out of taps, rather than out of the ground. Consumers have been trading down to cheaper, unbranded foods in recent years, a trend that accelerated in the recession, potentially undermining the value of owning big brands.

So the company has seized upon evidence that incorporating healthier ingredients into its products could help it get its sales moving in rich countries again, and win over hearts and minds in emerging markets, too. These ingredients include live bacteria in yogurt, extra calcium of a form that is more easily absorbed by children’s bodies, and sterols (a kind of plant fat) that reduce blood cholesterol.

A study by Harvard Business School found that between 2004 and 2007, sales of Nestlé’s products containing such “functional” ingredients increased by 23.7% a year, compared with growth of 6.2% a year for its ordinary foods. Sales of Nestlé’s functional foods grew by 20% in 2008. And on October 22nd the company announced that in the difficult year to September 2009, in which the underlying growth rate (stripping out price changes and currency movements) across its food and beverage product lines was 0.7%, functional foods still managed to eke out growth of 4%.

Other companies are benefiting from the same trend. Results released on September 23rd by Danone, a French diary and yogurt company, showed that its bestselling yogurts are those with live bacteria that are said to strengthen immunity or ease constipation. Even drugs companies are eyeing this new market. In March the chairman of Sanofi-Aventis, a French drug firm, mused about acquiring food and nutrition firms as a way to pursue growth.

Few companies, however, are spending the sort of money that Nestlé is to develop foods that are tailored to improve health. Even so, Mr Brabeck-Letmathe’s grand plan to reinvent his company must navigate several dangers. Does it make sense to invest in costly, long-term research for a market that may not materialise? Another risk is that a sceptical public will not be convinced by Nestlé’s grand health claims, prompting a backlash from the public or activists. There is also a danger that the new strategy might damage the firm’s blockbuster legacy brands, such as Nescafé, which have taken decades to build.

Profit or peril?

Start with the cost of research. If Nestlé were content to battle it out with Kraft, the world’s second-largest food firm, in the business of just selling food, then its outlay on research and development (R&D) would be difficult to justify. But Mr Brabeck-Letmathe saw a decade ago that the food industry was becoming a commoditised grind with diminishing margins and little scope for disruptive innovation. So he began pushing Nestlé to develop functional foods with higher profit margins, and he increased spending accordingly. In 2008 Nestlé spent just under SFr2 billion on R&D, a sum that has more than doubled since 1998. At about 2% of sales, this is considerably more than rivals are spending: in 2007 Danone spent about 1% of its sales on R&D, and Kraft spent about 1.2%.

Richard Laube, the head of Nestlé’s nutrition business and a former pharmaceuticals executive, describes a “pipeline” of some 75 research projects. Borrowing terminology from the drugs industry seems appropriate, given the time required to develop these new products. Unlike the quick development cycles usually seen in fast-moving consumer goods, which typically take one to two years, products in Nestlé’s nutrition pipeline may take four to six years to develop.

Mr Laube acknowledges that the pursuit of functional foods means that R&D expenditure must go up, not least because regulators on both sides of the Atlantic are taking a tougher line towards them. In October, America’s Food and Drug Administration warned that it was reviewing health claims made by food companies; it plans to announce stricter guidelines soon. The European Commission has forged ahead with strict rules on nutrition claims, and is in the process of tightening up the claims allowed on health grounds too. Companies wishing to make claims related to disease (“reduces blood pressure”, “cuts risk of heart attacks”, and so on) will have to provide solid scientific evidence to back them up. That takes time and money.

But it will be worthwhile if consumers prove willing, as they seem to be, to pay more for products with health benefits. Another benefit to such long-term research, observes Mr Laube, is that it tends to produce the sorts of innovations that pay dividends for longer than the minor, fleeting improvements made to consumer goods. He points to the formulas for whey protein, used in Nestlé’s PowerBar range, and for hypoallergenic baby food. In both cases consumers continue to pay premium prices for these products a decade after their initial introduction.

Nestlé is used to playing a long game. Take Nespresso, an almost instant espresso that is made by machine from a little capsule of coffee. Nestlé started working on the technology in 1970 and filed its first patent in 1976. It was another decade before it was ready to start selling Nespresso pods and machines. Thereafter the business lost money for a decade. But now it is one of Nestlé’s fastest-growing products. Sales have been increasing by 30% a year (even though Nespresso is a premium brand) and are expected to reach nearly SFr3 billion this year. Consumers are, presumably, making coffee at home and trading down from more expensive coffees sold by the likes of Starbucks. “It took off very, very slowly,” says Mr Bulcke. “It was 20 years of conviction that got us there.”

The tighter regulatory outlook for functional foods could, in fact, benefit Nestlé because few of its rivals have the deep pockets necessary to invest in such research. The Swiss firm could end up in a strong position—provided, that is, it can develop functional foods with genuine benefits that consumers are willing to pay for. “The more science wins, the stronger Nestlé’s position,” reckons Peter Killing of IMD, a Swiss business school.

Another risk to Nestlé’s strategy is that of overreach, arising from two particular vulnerabilities. One is the legacy of the firm’s past scandals involving the sale of milk powder in poor countries, which led to painful boycotts. The other involves the food industry’s experience of a backlash against genetically modified (GM) crops.

“Breastfeeding is best! We will salute and say this every day, but the world won’t believe us,” laments Mr Laube, describing the lingering suspicions harboured by some about the company’s behaviour in the developing world. The firm’s founder developed its trademark milk substitute not to replace mother’s milk, which health experts agree is the best food for babies, but to feed only those newborns who cannot be breast-fed safely. This is not company propaganda: the World Health Organisation confirms that “there will always be a small number of infants who have to be fed on breast-milk substitutes.” But the firm was caught in Africa and elsewhere promoting its milk powders so aggressively that they did, in fact, replace mother’s milk inappropriately—hurting the health of babies and, when the powder was mixed with unsafe water or in too weak a dose, leading to malnourishment or death. The firm insists it has mended its ways.

Nestlé’s deep reach in the developing world goes back decades and gives it a head start over most of its rich-world competitors when it comes to exploiting growth. Its early embrace of globalisation had less to do with planning than with the coincidence of being based in a small country and selling a highly tradable commodity. As early as 1919 Nestlé’s condensed-milk business had exhausted the supply of milk from local farmers, forcing it to open factories in Australia, England, Germany and Norway. Soon afterwards it bought the leading 27 condensed-milk factories in America, prompting this newspaper to note that year that Nestlé “is no longer a Swiss milk company; it is a very powerful international investment trust.”

Today less than 2% of Nestlé’s sales are in its home market, compared with 60% of Kraft’s. Enforced globalisation taught Nestlé far earlier than its rivals just how markedly tastes differ across the world. Its trademark line of Nescafé instant coffees, for instance, comes in a bewildering array of more than 500 flavours. The legacy of its powdered-milk scandals, however, is that Nestlé actions in poor countries are scrutinised like those of few others. That means any grand new effort to rebrand the firm’s offerings as “healthy” will face scepticism, in emerging markets in particular.

Nestlé’s strategy this time round is to work more closely with health authorities across the world. Its aim is to localise “wellness” in much the way it has adapted its coffees to various markets. It is, for instance, greatly expanding its efforts to add essential micronutrients—ranging from iodine and iron to vitamin A and zinc—to its basic foodstuffs.

Some 2 billion people suffer from deficiencies of such vitamins and minerals, with impacts ranging from blindness to premature death. The firm had dismissed infant cereal as a niche product, but now its researchers are using that product as a “carrier” for probiotics and vitamins for children. It is also developing cheap, single-serving packets of nutrient-rich food for the very poor, another market it had previously stayed out of. Mr Laube says the defensiveness of the past is gone: “Now we have a noble cause.”










Ilustration by Robin Chevalier





That may help in the poor world, but could Europe’s hysteria over Frankenfoods (as the British media dubbed GM foods) also stand in the way of Nestlé’s wellness products, if they are perceived to involve too much scientific meddling? The firm is treading carefully. Peter van Bladeren, head of Nestlé’s main research centre in Lausanne, insists its functional foods will “only improve nature” by adding healthy ingredients: “no weird stuff”. Unlike GM crops, which mainly benefit farmers, functional foods are intended to provide benefits to consumers. And the need to produce solid evidence of benefit to satisfy regulators should reassure shoppers, says Eric Scher of Sanford Bernstein, a research firm.

Stretching the brand

Finally, there is a risk that Nestlé’s new strategy could damage the firm’s blockbuster brands, which have taken decades to establish. This could happen in several ways. If some of the firm’s functional foods fail to pass muster with the regulators or, worse, turn out to cause harm rather than do good, then consumers could turn against all its products, even those that make no health claims at all. That could hurt, because most of its revenues will still come from selling treats like chocolate, ice-cream, coffee and flavoured milk.

That points to another potential snag. If a company known for selling indulgence wants to reinvent itself to symbolise wellness, does that not send mixed messages to the consumer? Mr Bulcke insists that there is no contradiction, and that taste will always trump nutritional benefits in the development of new products. Carmakers, after all, see no problem with marketing new cars on the basis that they produce fewer greenhouse-gas emissions without compromising on performance.

Mr Brabeck-Letmathe is convinced that all of Nestlé’s brands can be made to fit into the wellness strategy. “You don’t have to stretch,” he insists, “if the discipline of every product is to be healthier.” Every product must undergo what he calls a “sixty-forty-plus” analysis: at least 60% of those tasting it must prefer it to a rival product or the one it is replacing, and it must also be more nutritious. The company has, for instance, produced a new way of churning its ice-cream that produces much smaller ice crystals than the usual method. As a result it can still taste creamy even though it has half the fat.

Critics question, however, whether, in aggregate, Nestlé can deliver on its ambitious health and wellness promises. “The goals of food companies and the goals of public health are fundamentally different,” says Marion Nestle (no relation), a nutrition expert at New York University who is a noted critic of big food firms. “There is very little evidence that eating these things makes people healthier. If you want to do something for your health, you don’t eat as much, and you don’t eat processed food.”

That might indeed be healthier—but for many, perhaps, less pleasurable too. Mr Brabeck-Letmathe, a former ice-cream salesman from Austria, is unrepentant. Every single morning, he says, he enjoys dark chocolate and coffee made by Nestlé: “We don’t have to be ashamed.”

Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.