Continued pressure on Nestle India margins may hurt investor returns

Nestle
Rich valuations typically indicate strong investor sentiment in favour of a stock, but it also means that there is little room for such companies to disappoint the Street. That seems to be the story of Nestle India, the maker of popular consumer products like Maggi, Kit Kat, Munch and Nescafe. Despite the company outperforming peers in terms of volume and sales growth in the September 2019 quarter, amid a weak consumption environment, the stock of Nestle shed 2.54 per cent to Rs 14,107.50 a share on Monday. Continued input cost pressure, which hurt its overall earnings growth in the September quarter (Q3, as the company follows a January-December accounting calendar), weighed on investor sentiment in a flat market — Sensex was up 21 points, or 0.05 per cent, over its previous close. Nestle declared its quarterly result after market hours on Friday.

While the company’s operating revenue grew 9.4 per cent on a year-on-year basis to Rs 3,216 crore, in line with the Bloomberg consensus estimate, the reported profit before tax (PBT), at Rs 699.9 crore, was way lower than analysts’ expectation of Rs 760 crore. In fact, the 4.2 per cent year-on-year PBT growth was the lowest for Nestle in 10 quarters. Net profit grew by 33.5 per cent year-on-year, driven by lower tax rates. The effective tax rate of Nestle in the quarter was about 15 per cent, against around 34 per cent in the past, so it is not comparable with the year-ago numbers.

Nestle’s topline growth was entirely driven by domestic sales (93-94 per cent of overall sales), which rose by 10.5 per cent year-on-year to Rs 3,039 crore. Exports were down 7 per cent amid lower coffee sales to Turkey. Domestic sales growth was led by volumes and a favourable product mix. Lower dependence on rural areas, which are facing relatively more demand headwinds than urban, helped Nestle fare better than some of its peers. The company earns 75 per cent of its revenues from big cities and towns. While Nestle’s key brands performed strongly in the quarter, according to the company’s press release, its focus on premium portfolio also helped.

Expect a healthy traction in revenues going ahead too, say analysts. “A focus on innovation, launches, market share and premiumisation is likely to boost volume-led growth,” say Edelweiss Research analysts who have a ‘hold’ rating on the stock.

The worry, however, is the elevated input cost. According to Nestle, higher commodity prices, particularly milk and its derivatives, spoilt the show in Q3. Cost of raw materials as a percentage of net sales shot up by 214 basis point year-on-year. Thus, Nestle’s earnings before interest, tax, depreciation and amortisation (Ebitda) margin contracted by 131 basis points year-on-year to 23.4 per cent in Q3, the fourth consecutive quarter of margin compression for the consumer product major.

Even in the near term, Nestle expects the cost of milk and related inputs to remain high. Analysts at ICICI Securities have, therefore, cut their earnings estimates for Nestle by 3-4 per cent over 2018-2020 amid higher-than-expected inflation in input costs. However, as observed in Q3, cost efficiency measures resulting in better operating leverage and faster growth of high-margin premium products could help partly confine the input cost pressure at the Ebitda level.

Overall, while the company’s long-term growth and earnings potential remain intact, investors are recommended to wait for a decent correction before entering the stock, given near-term margin challenges and the pricey valuation. The stock currently trades at 60 times its 2019 estimated earnings, a 15-25 per cent premium to peers like Hindustan Unilever and Britannia.


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