Muted volume growth continues to mar Nestle's prospects

Firm missed analysts? expectations on all major parameters, posted single-digit growth in net sales, op profit and net profit

Nestle India’s steep price hikes in response to rising costs in the past few months and soft demand has resulted in muted volume growth in September 2012 quarter as well. While sales growth (year-on-year) came in single-digits for the first time in many quarters, net profit grew by a mere 2 per cent. While the stock has lagged its peer (BSE FMCG index) by a wide margin in the last one year, post results (on Monday evening) it has fallen 1.5 per cent to Rs 4,744 against a 1 per cent fall in the Sensex. What's more, analysts do not expect any improvement in the trend for the coming few quarters, until volume growth picks up or there are no further price hikes (unlikely). In this regard, they expect pressure to remain on the stock, which is trading at rich valuations.

Q3: Growth in single-digits

Nestle India missed analysts’ expectations on all major parameters and reported single-digit growth in net sales, operating profit and net profit. Sales growth, affected by volumes and single-digit growth (7.6 per cent) in domestic business (95 per cent of total revenues), has been lowest in past 18 quarters (read: historical low) and was below analysts expectations of 13.3 per cent growth. Says Antonio Hello Waszyk, chairman and managing director (CMD), “Domestic sales growth has been adversely affected by portfolio/channel optimisation and pricing for value in certain products.”

Anand Shah, analyst, Elara Capital estimates a sharper volume decline of 3-4 per cent in the current quarter versus 1 per cent in the first half of CY2012 led by channel/portfolio optimisation as well as consistent price hikes.

While raw material prices remained stable or benign in the September 2012 quarter, increase in headcount or employee base (with increased capacities) and other expenditure (which includes advertising and promotions to support new campaign for Maggi, innovations like MilkMaid Creations, Munch Rollz and re-launch of Nescafe Classic) led to flat operating profit margin of 20.9 per cent (though mostly on expected lines).

Despite a 48 per cent jump in other income and reversal of exchange differences (expensed in earlier periods) adjusted under interest costs, net profit margin dropped 73 basis points (bps) to 12.6 per cent as depreciation costs galloped to form 3.5 per cent of sales (up 146 basis points) thanks to near completion of the Rs 2,500 crore manufacturing expansion.

Concerns and Challenges

Volume growth continues to be an issue for the company. Says Waszyk, “2012 is proving to be a challenging year. While some actions like portfolio rationalisation, channel prioritisation, focussed innovations and Nestle Continuous Excellence implementation have started to yield results, other corrective actions on demand generation in specific categories will take some time.”

Margin expansion also looks unlikely as outlook for prices of wheat, milk, sugar and coffee is up, which will put upward pressure on input costs. On other hand, Abneesh Roy, analyst, Edelweiss Securities, said in his preview note that competitive intensity remains high in coffee, noodles and chocolate (major contributors to revenue).

In this backdrop of growth challenges and margin expansion concerns, stock valuation of 41 times CY2012 estimated earnings are difficult to justify. Gautam Duggad, analyst, Motilal Oswal Securities is neutral on the stock as he feels valuation appears expensive given the context of sub-par volume growth.

Says Shah of Elara Securities, in his post result note, “We highlight, management’s strong focus on margins (driven by pricing) vs. volumes is clearly hurting the latter (volumes) in near-medium term and could potentially drive consumer’s away from Nestle portfolio, in our view. We find Nestlé’s premium valuations demanding given that earnings growth is volatile in view of volume uncertainty and high depreciation/interest costs, both payouts and return ratios have dropped significantly and likely consensus earnings downgrades and consequently P/E de-rating.”