By Aude Lagorce

Of MarketWatch

LONDON--European food giants have been sitting pretty for a while, but the need to bulk up to drive savings means a pickup in merger and acquisition activity is now firmly on the agenda.

Throughout the recent economic downturn, Swiss food behemoth Nestle SA (NESN.VX) and French yogurt champion Danone SA (BN.FR) adopted the same mantra: small is beautiful. At every shareholder meeting they reassured investors they would only consider targeted acquisitions and steer clear of mega deals.

But the rules of the game are changing: competition is intensifying as players fight for market share. The price increases of earlier in the decade are out of the question as long as demand remains subdued. Yet cost savings must be achieved if a collapse in margins is to be avoided. These elements combined indicate the big players may turn out to be less disciplined than their official line would suggest.

"The need to do something relatively larger is growing," said Rahul Sharma, director in the consumer practice of specialist investment fund Martin Currie.

"What these companies want most is assets with strong brands in Asia or other emerging markets. But because of current competition and because it's impossible to get pricing, they may eventually need to do something in mature markets just to get cost savings," he said.

The good news is that financing such deals should not be an issue.

Citigroup analysts point out that the balance sheets of food giants are under-utilized, as there has been no large-scale deals in Europe since Danone's purchase of Dutch rival Numico in 2007.

"The consumer environment remains tough and interest rates are low, and together with the ability to take on large amounts of debt, these represent almost ideal conditions for M&A activity," the broker said in a note to clients.

The risk, in such a scenario, is that companies might make indiscriminate purchases.

"Finding the right acquisition target is as important these days as finding the financing," said Ildiko Szalai, a food analyst at research firm Euromonitor.

In a heavily fragmented food sector, there is no dearth of targets, but many European firms would make for tricky purchases because of complex shareholding structures.

Still, there are a handful of attractive independent players. One of the most notable is Swiss luxury chocolate maker Lindt & Sprungli (LISN.EB), an appetizing prospect for Nestle in the wake of U.S.-based Kraft Foods Inc.'s (KFT) purchase of British confectioner Cadbury at the start of the year.

Bank of America Merrill Lynch estimates a tie-up with Lindt-- which has a market capitalization of $5.5 billion--would give Nestle a 12% global share in confectionary compared to 15% for Kraft-Cadbury.

And chocolate is a safe haven in uncertain economic times.

"Premium chocolate is a growth market and it fits the impulse-purchase category. It may not match Nestle's recent refocus on healthy categories, but since they recently bought Kraft's frozen pizza business, anything is possible," Sharma said.

Bank of America analysts agreed, highlighting that although Nestle has recently said it wants to grow the chocolate category in emerging markets, "the opportunity to purchase Lindt may prove too tempting in the end."

The cash is certainly not a problem. Nestle in January replenished its war chest with the $28 billion sale of its stake in eye-care group Alcon Inc. (ACL).

Another asset that could change hands in coming months is private-equity owned United Biscuits. The world's fourth-largest biscuit group, home to the McVities brand, is also a sizeable manufacturer of sweets and snacks. Its weakness? It derives nearly 85% of sales from Western Europe, making it only marginally attractive to firms looking for emerging-market growth.

"United Biscuits will help its buyer add scale. But it wouldn't add a lot of geographical value. If Campbell Soup (CPB) bought United Biscuits, the deal would give them scale, but they'd still end up with a business heavily reliant on developed markets," said Euromonitor's Szalai.

Biscuits and chocolate certainly make for appetite-wetting targets, but there is a flurry of attractive firms in healthier segments.

One of them, Yakult Honsha Co. (2267.TO), a pioneer in pro-biotic yogurts, would make a good match for Danone, which already has a 20% stake in the group and three seats on the board, several analysts said. Listed in Tokyo, Yakult has a market capitalization of roughly $5 billion and generated sales of $3 billion in fiscal 2010.

"In the food segment, and dairy in particular, companies that bring you functional expertise are very much in favor. I could definitely see something happen there," said Sharma, who mentioned Ireland's Kerry Group (KRZ.DB) and the U.K.'s Tate & Lyle (TATE.LN) as other firms with such competencies.

And for those looking to spice things up a bit, there's always H.J. Heinz Co. (HNZ). The ketchup specialist has very strong brand recognition, including in emerging markets, a sought-after quality.

But Sharma cautioned that Heinz is struggling to expand rapidly into new markets.

"As a standalone company they are faced with the fact that it's extremely costly for them to roll out their products into new markets where they want to be, in Asia for instance," he said.

For a bigger firm like Nestle, the geographical expansion would come at a minimum cost considering the sales force and distribution network already in place in the region.

"All Nestle has to decide is how much of a premium the Heinz brand warrants in comparison to local players," Sharma said.

Of course, there is always the possibility of a mega deal, such as a move on General Mills Inc. (GIS) from Nestle. The two firms already participate in a 50-50 joint venture, Cereal Partners Worldwide.

While a deal would increase Nestle's sales in the food service arena and give it the U.S. license to the fast-growing Yoplait fresh dairy brand, it would also dilute its growth and increase its exposure to the American market at a time when growth there is hard to generate, Citigroup cautioned.

By Aude Lagorce, 415-439-6400; AskNewswires@dowjones.com