Higher input costs could keep Nestle’s profit margins under pressure in the short-term, but leadership across segments would act as a cushion.
Consequently, its December 2009 quarter profits were below par considering Nestlé’s consistent track record, and it dipped for the first time in the last fourteen quarters.
While Nestle’s profits were below expectations, it seems that markets were already anticipating a subdued performance, given that its stock has underperformed the broader indices since early February 2010.
Going ahead, margins could remain under some pressure for the next 1-2 quarters with commodity prices still ruling higher, and may prove to be an overhang on the stock.
Positively, revenues grew at 24 per cent in the December quarter, outperforming most estimates as majority of its product portfolio is delivering strong growth. Since domestic sales are showing good traction, and expect revenue growth to remain healthy in the future.
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Robust domestic sales
With the urban population pegged at a strong 30 crore and growing, so will Nestle’s product portfolio in these markets. With products like Nescafe (coffee), Cerelac (milk, infant & baby food), Kit-Kat, Polo, Munch and Eclairs (chocolates and confectionary) and Maggi (culinary and prepared dishes), Nestle enjoys leadership position in most of these categories chalking robust growth rates in the past. On an average, sales grew at 21 per cent in the last three years on the back of domestic sales, which accounts for 93 per cent.
In the milk products and nutrition segment, which contributes about 45 per cent of its sales, Nestle’s infant foods occupy around 80 per cent market share giving the company strong pricing power and superior profit margins. With products like Cerelac, Nestum and Lactogen, this segment grew by about 18 per cent year-on-year in the December quarter.
Although this segment is estimated to grow by around 10-12 per cent going ahead, expect it to continue to deliver robust margins as the case in the past. In beverages (coffee), however, which has grown in single-digits, expect revenue growth to be modest.
In the fast growing culinary business, its Maggi brand has been doing well. Maggi holds around 75 per cent market share in the instant noodles market. Along with Ketchups and soups, the business segment has been able to deliver around 25 per cent category growth in the past three years, with volumes raking up as high as 25-30 per cent. Launch of new variants in Maggi (Pazzta, Masala-ae-Magic) along with higher sales of milk-based products helped Nestle chip in 24 per cent revenue growth in the December quarter.
| MILKING PROFITS | |||||
| in Rs crore | CY09 | Q4 CY09 | % Chg | CY10E | CY11E |
| Net sales | 5,129.0 | 1,352 | 24.0 | 6,068 | 7,176 |
| EBITDA | 1,070.0 | 233.0 | 9.9 | 1,261.0 | 1,462 |
| EBITDA (%) * | 20.9 | 17.3 | -220 bps | 20.8 | 20.4 |
| Net profit | 733.0 | 113.0 | -6.7 | 867.0 | 1,062 |
| EPS (Rs) | 76.4 | 90.3 | 110.6 | ||
| P/E (x) | 34.4 | 29.1 | 23.8 | ||
| E: Estimates bps = Basis points * Adjusted for rise in provisions for acturial retirement benefits Source: Company, Analyst reports | |||||
Exports, which contribute around 7-10 per cent of total sales, have been subdued for quite some time even as Nestle has been trying to diversify its product portfolio. In the recent quarters, decline in coffee exports to Russia have pulled down growth rates. In CY2009, exports, which fell by 2.9 per cent, were however positively benefited from a weak rupee for most part of the year.
Input costs pressures
Rising input costs (particularly milk and sugar) and higher employee costs played spoilsport for Nestle in the last quarter of 2009. Prices of key inputs such as milk solids (up 15 per cent), wheat (up 30 per cent) and sugar (up 100 per cent) touched record levels in 2009.
Consequently, in December 2009 quarter, cost of goods sold as a percentage of net sales stood at 48.24 per cent as against 47.19 per cent in the year ago quarter. Due to this, its bottom-line took a knock in the quarter. Nestle provided for actuarial losses, which saw employee costs jump 65 per cent to Rs 137 crore.
Increasing competition from the likes of GlaxoSmithKline Consumer (Hindustan Unilever in the wings) and launch of new products in the noodles segment, meant that ad-spends and promotional spends were higher.
Consequently, operating margins were lower by 480 basis points (14.7 per cent); adjusted for the actuarial losses, margins were lower by 220 basis points at 17.3 per cent – almost half due to higher input costs.
Going ahead, while easing sugar prices are marginally positive, agri commodity inflation remains a key concern. Likewise, the currently high milk prices (milk and its concentrates constitute around 40 per cent of Nestle’s raw material costs) could keep margins under pressure over the next 1-2 quarters.
Reports suggest that Nestle has effected price hikes in select Kit-Kat SKUs, Cerelac, Nestle Dahi and Nestle Everyday Dairy Whitener, which should provide some cushion to margins. Going ahead, analysts expect margins to inch up to around 20-21 per cent from second half of CY2010.
What’s also comforting is that Nestle is benefiting from tax savings, as it has been able to derive higher production volumes from plants in tax exempt locations like Pantnagar. Nestle recently secured approvals from the Himachal Pradesh government to set up an Rs 250-crore food processing unit. This should help on the tax front, and simultaneously meet the increasing domestic demand across categories in the long run.
Conclusion
Driven by domestic sales, Nestle’s net sales is expected to grow at an average of around 18-20 per cent in the next two years. Even though Nestle’s portfolio is urban centric, low-priced SKUs will help the company clock good growth rates in the rural markets as well.
Expectation of a good rabi crop should lower inflation for wheat and sugar and aid margins in the medium-term. But, higher ad spends could be an overhang. Nevertheless, the fast growing high-margin prepared dishes and cooking aids segment and, Nestle’s relatively higher pricing power across segments would cushion margin pressures. Hence, expect Nestle’s earnings to grow by 20-21 per cent on average in the next two years.
At Rs 2,704.15, the stock is trading at 29.9 times its estimated CY2010 earnings, which is at the higher band of its one-year forward PE (based on three-year average) of 19-33. Hence, it will be appropriate to consider the stock at dips for the long-term.