Profit growth capped

The market gave a thumbs-down to Nestle India’s stock on Monday, after the company reported a disappointing performance for the June quarter (Q2 CY2011), especially on margins. The growth in top-line also slipped to the lowest level in five quarters. The stock fell by 2.47 per cent as compared to a 0.64 per cent rise in the Sensex on Monday.

In the future, sales growth would be more driven by capacity expansion (or volume). Stiff competition is likely to keep a check on this, as well as on product prices. Further, the only hope for improvement in overall profitability is expansion in operating profit margin, as the company’s depreciation and taxation will continue to tread higher. But it looks difficult, as a substantial correction in raw material prices is unlikely, say analysts. Though the prices of some raw materials have softened somewhat (wheat and sugar prices have turned benign), prices of milk and a few others remain high.

Says Varun Lohchab of Religare Institutional Research, “The risk-reward ratio remains unfavourable from the current levels over the next 12 months, given a slow profit after tax growth and return on equity due to high capex program and rich valuation.” The stock’s valuation even at 35 times on next year’s (CY2012) estimated earnings look stretched, believe analysts.
 

PROFITABILITY SLIPS
In Rs cr	CY’10	Q2’ CY’11
Net revenues	6,274	1,768
Y-o-Y chg %	22.0	20.0
Operating profit	1,267	344
Y-o-Y chg %	23.0	18.0
OPM (%)	20.2	19.4
Y-o-Y chg (bps)	23	-41
Net profit	819	214
Y-o-Y chg %	25.0	10.0
NPM (%)	13.0	12.0
Y-o-Y chg (bps)	34	-114
Source: Capitaline

PRESSURE ON PROFITABILITY
Volume growth, so far the company’s focus to maintain an increased market share, is estimated to have come down to 13-14 per cent from around 20 per cent in CY2010. Further, the company would have faced challenges in passing raw material escalations in the high competition category of noodles, estimates Himani Singh of Elara Securities. The trend, if it continues, is a concern.

However, analysts hope the overall sales growth momentum will be sustained, thanks to the ongoing capacity expansion and price hikes. Besides, the company’s focus on augmenting its premium product portfolio will support top-line growth, points out Latika Chopra of J P Morgan, in her post-result update.

Meanwhile, operational and overall profitability slipped in the June quarter due to higher costs. Operating profit margin (OPM), though marginally down by 41 bps year-on-year to 19.4 per cent, is down by 166 bps sequentially, as raw material prices of milk solids, green coffee and oils remained firm during the quarter.

Antonio Helio Waszyk, chairman and managing director of the company, says, “Improved product, channel mix and operational efficiencies partially helped offset the higher commodity prices.” But, the increased tax provision in the event of exemption limits on the Pantnagar factory coming down to 30 per cent (of profits) from 100 per cent led to a 114 bps drop in the net profit margin (NPM).

Improvement in operating profit margin (OPM) is a bigger success factor for the company’s overall profitability (NPM) outlook, as increasing competition (especially in noodles) and the tax provision will put a cap on growth rates.

HIGH VALUATIONS
Given the challenging business scenario and absence of any positive trigger, analysts are cautious on the stock. A meaningful ease in the prices of raw materials is essential for boosting the volume growth and improving margins, which in-turn should rub off positively on the stock. However, the possibility of such a scenario looks bleak for now.