After strong gains the past 4 months, some headwinds for Nestle stock

The overall slowdown apart, margin pressure from rising input cost, market share loss in a few segments and expensive valuations are overhangs

Shares of Nestle India, have been in demand among investors, having risen by about 25 per cent in the past four months. In contrast, the Nifty 50 and Nifty FMCG indices has lost about two per cent each in the same period. Double-digit volume-led topline growth in the June 2019 quarter, even as most of its FMCG peers saw their volumes decline, and recent inclusion of the stock in the Nifty 50 index, turned investors bullish on the maker of Maggi noodles, Nescafe and Kit Kat chocolates.

The stock’s outperformance, however, has also led to pricey valuation or price-earnings ratio (P/E). At 58 times its CY20 estimated earnings, the Nestle stock not only trades at a staggering 28 per cent premium to its own long-term one-year forward P/E, but its valuation is 20 per cent higher that of Hindustan Unilever, India’s largest FMCG company, as well. Add to this a few changes in the fundamental environment, it is not surprising that the Street is turning a bit cautious on the stock.

Analysts at Edelweiss Securities downgraded the stock to ‘hold' on Monday. Besides the rich valuation, likely incremental pressure on gross margins amid high input cost and recent market share loss in infant food and ketchup segments are reasons cited by the broking firm for the downgrade. As per Bloomberg data, this is the second downgrade in two months; the earlier one to ‘hold’ was by ICICI Securities in August.

Prices of key raw materials are rising. This, along with expected higher advertising spends, could keep operating margins under check. During the January-June 2019 period or H1CY2019 (Nestle follows January-December as accounting year), prices of milk, wheat, sugar, palm oil, among others had drifted up by 5-12 per cent year-on-year and Nestle had upped its ad spends, albeit marginally. This resulted in a 77 basis point year-on-year contraction in EBITDA (earnings before interest, tax, depreciation and amortisation) margin to about 24 per cent. Though the company has hiked some prices, they are unlikely to be reflected fully in realisation in the ensuing quarter, say analysts.

Apart from profitability, there could be some moderation in topline growth as well. Besides the on-going consumption slowdown in the country, the higher base of CY2018 (quarterly basis) means that achieving high double-digit revenue growth may not be easy for Nestle in the next couple of quarters. No doubt, with over 11 per cent year-on-year revenue growth in June 2019 quarter, Nestle was one of the few outliers in the FMCG space. Moreover, after the over 30 per cent earnings growth in CY18, analysts are now pegging the firm's earnings to grow by about 15 per cent in the current year.

Market share loss in infant foods, ketchup and sauces is another concern. Analysts at Edelweiss Securities believe Nestle may not be able to recoup this loss easily, as its share has been gobbled up by global players. This makes the possibility of sustaining high valuations tougher. SBICAP Securities in its note last month had highlighted that the high valuation calls for sustained, healthy double-digit earnings growth. While revenue share of ketchup and sauces is tiny, infant nutrition has around 15 per cent revenue share, as per analyst’s estimates.

The recent support the stock got on technical grounds on being included in the Nifty 50 is also likely to be short-lived.

That said, there are few concerns about Nestle’s long-term growth prospects, which remains healthy. Capacity addition, new product launches (61 habe already been launched since 2016 with a healthy 70 per cent success rate, which is above 5-7 per cent for the industry), and expansion of direct distribution are among strong long-term growth levers for the company.

Overall, the management’s commentary following the September 2019 quarter results and lowering of valuations would be key for the stock in the near term.