Cost, competition cap upside

While new product launches and capacity expansion are likely to drive growth, current valuations fail to capture the risks from intensifying competition

At 38 times the estimated earnings for 2011-12 (versus the three-year average of 28 times), the Nestle stock is trading at a premium of around 40 per cent over its peers. Given the intensifying competition and rising input costs pressures, these valuations seem unjustified.

Analysts believe the stock should trade at a 25-30 per cent premium over its peers (30 times FY12 earnings), due to its leadership position in high-growth food categories. Its key product categories include milk and nutrition (44 per cent of revenues), packaged foods (Maggi, 28 per cent), chocolates/confectionery and beverages (14 per cent each).

While the company is likely to post healthy volume growth of 19-20 per cent in the next two years, maintaining this growth momentum will be a major challenge. The intensifying competition in the noodles category (35 per cent of operating profits) will put its leadership position under threat, as well as hit pricing power. Its profitability is also likely to be under pressure, thanks to rising input prices.
 

PREMIUM VALUATIONS
In Rs  crore	CY10	CY11E	CY12E
Sales	6,255	7,422	8,823
Y-o-Y change (%)	21.9	18.7	18.9
Ebitda (%)	20.2	20.9	21.6
Y-o-Y change (bps)	-30	70	70
Net profit	819	1,001	1,235
Y-o-Y change (%)	25	22.3	23.4
P/E (x)	43.5	35.6	28.9
E: Estimated                    Source: Standard Chartered Research

Say Goldman Sachs analysts Puneet Jain and Aditya Soman, “While Nestle appears well positioned to leverage its dominant position in the packaged foods (Maggi) segment, we believe several headwinds such as input cost inflation and increased competition have surfaced, which could affect its earnings growth momentum in the medium term.” Further, higher capex will strain its return ratios in the near term.

Nestle aims to double capacities at all its units, enabling it to capture larger market share. It has lined up Rs 1,800-2,000 crore capex in the next two years for this. Nestle had an annual capex average of 5.2 per cent of sales in the past five years, set to move up to seven to eight per cent of estimated sales for the 2011 calendar year (CY). In comparison, the estimated capex of ITC, its diversified fast moving consumer goods (FMCG) peer, is pegged at four to six per cent of sales for 2011-12. The company recently started production at its new Maggi plant in Nanjangud, Karnataka. Another Maggi unit is being set up at Tahliwal, Himachal Pradesh. It is also setting up a research and development centre at Manesar, Haryana, to be operational in 2012. A slew of new products in the food and coffee segment would also fuel growth.

PRESSURES
With FMCG giants such as Hindustan Unilever (HUL), ITC and GSK Consumer stepping up product launches in the noodles segment, Nestle India will need to protect its market share in this space. The category could see some margin pressures, as a price war in this segment cannot be ruled out. Says Pinc Research analyst Naveen Trivedi, “We expect Nestle would focus on retaining the volume market share for Maggi noodles, which would result in lower profitability.” Milk and nutrition products could also face the heat of higher competition. Also, Nestle needs to arrest its falling market share in the coffee segment (to HUL).

Robust volume growth has enabled the company to deliver about 20 per cent top line growth on a consistent basis. The debt-free position, combined with high cash at its disposal (Rs 1,014 crore as on December 2010) enables it to fund its capex plans. It has also planned $450 million worth of external commercial borrowings. These plans would dilute its return ratios in the near term. The asset turnover ratio (sales/total assets), for instance, is likely to fall from CY10 levels of around seven times to six times in CY11 and five times in CY12, estimate analysts.

Nestle’s dividend payout ratio stood at 56 per cent in CY10 (the last three year’s average of 77 per cent). Given the huge investments the company has lined up, the reduction in dividend payout ratio is not surprising.

Input costs which form 47-48 per cent of its sales were a key pressure point in CY10 for the company. While most of its raw material costs like milk, sugar, coffee, wheat, etc, are near all-time highs, a decent monsoon could see some easing of supply and prices in the near term, believe analysts. Though the company has been able to pass on these high costs to end users due to its dominant position, intensifying competition will restrict its ability to do so.