Nestle: Robust prospects, but high valuations

The company’s business fundamentals remain strong, but analysts believe current stock valuations factor in most upsides in the near to medium term.

Nestle India surprised the markets by posting higher-than-expected net profit for the quarter ended December 2010, which the company announced on Friday after market closing. However, while the stock jumped 5 per cent in the opening trade on Monday, it ended the day at the level of Friday’s closing, even as the BSE Sensex closed 1.25 per cent higher.

The fading of the enthusiasm could be on two counts. While one could be that the stock has significantly outperformed its peers (by 11 per cent) and the broader market (by 9 per cent) in the last 12 months, it also reflects markets’ concerns pertaining to competition and input costs, which could keep the company’s profitability under check in the near term.
 

STABLE GROWTH
In Rs crore	CY10	CY11E	CY12E
Sales	6,162	7,388	8,719
% chg y-o-y	20.1	19.9	18.0
Ebitda (%)	19.9	20.6	21.0
Net profit	812	989	1,184
% chg YoY	22.1	21.8	19.7
PE (x)	41.7	35.1	29.2
E:Estimated                                                                Source: Bloomberg

Also, higher capital expenditure, of Rs 1,700 crore over three years (Rs 900 crore in the next few months), is likely to strain its cash flows in the near term as well as its dividend payout (the amount of dividend paid to net profit), which fell to 57 per cent (the lowest in over a decade), compared to 84 per cent in 2009 calendar year. While the company’s zero-debt position augurs well for its debt raising plans and annual cash profits of Rs 1,000 crore provide comfort in the long-run, the expansion plans could see interest and depreciation costs rise in the interim. For the debt funding, the company has already received RBI approval to raise external commercial borrowings (ECB) up to $450 million.

Meanwhile, current PE valuations of over 41 times CY2010 EPS (35 times CY2011 estimated earnings) appear rich (its 10-year average PE is 30.5), leaving limited upside in the near to medium term. Analysts, however, suggest that the company’s future prospects and fundamentals remain good and, hence, long-term investors may consider the stock on 10-15 per cent correction from current levels of Rs 3,461.

Q4 higher than expectations
Nestle posted robust results for the October-December quarter. While sales grew 23 per cent year on year (YoY), to Rs 1,675 crore, net profit surged 80 per cent, to Rs 203 crore. Strong demand in the domestic market (volumes up 17 per cent YoY), coupled with 10 per cent impact of price rise, fuelled sales, which were up 27 per cent. Exports, however, declined 17 per cent as the company addressed higher domestic demand (higher margins market) and also due to rupee appreciation.

Reported Ebitda margins expanded by a whopping 550 basis points (bps) YoY to 19.3 per cent, due to lower employee costs and other expenditure. However, margins in the December 2009 quarter had taken a hit due to one-time costs towards actuarial loss and higher branding expenses. Nevertheless, even if one were to adjust for the one-offs and the low base, analysts suggest that margins were up 210 basis points on a YoY basis. On a sequential basis, Ebitda margins slipped marginally. Overall, while the performance was good and ahead of Street’s expectations, the boost to net profit was also aided due to a low base effect effect in the quarter a year ago, when the company’s performance was affected due to higher costs.

Outlook
On the margin front, while a decline in raw material consumption (as a percentage of sales) helped in the December 2010 quarter, analysts believe firm input costs and higher branding expenses could keep a check on the company’s operating profit margins.

“Margins are likely to be under pressure going forward, given input cost pressures, heightened brand building due to the rising competition in processed foods and brand investments especially in chocolates and beverages and escalating power, fuel and distribution costs,” wrote Citi’s analysts in a recent report.

The good news is that the company continues to witness traction in the domestic business. The December quarter was the 16th consecutive quarter of double-digit volume growth. This looks sustainable, given the growing demand across the company’s key product categories, led by urbanisation and changing habits of consumers. Analysts, too, are expecting the company’s top line to grow at about 18-20 per cent annually, over 2010-2012 period. The timely expansion of its manufacturing capacities at its various plants in Karnataka and also in two greenfield projects, should help on this front and capture a slice of the growing market.