| Rising Raw Material Headwinds | Neutral Price: Rs4,864.50 28 February 2014 Price Target: Rs4,700.00 PT End Date: Dec14 | |
RM price trends. Over past two months, coffee, milk and palm oil (in rupee) prices have risen 20%, 7% and 10%, respectively. The sharp increase in coffee prices is being led by adverse weather conditions in Brazil, impacting coffee production and resulting in global production shortfalls. Milk prices have been firm on account of higher procurement costs.
Figure 1: Robusta coffee prices (USD/ton) | Figure 2: Arabica coffee prices (USD/lb) |
Figure 3: Milk price index
Source: GoI
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Figure 4: Palm oil price (INR/ton)
Source: Bloomberg
|
Earnings Sensitivity. Milk/milk powder, coffee and palm oil account for ~35%, 10% and 10% of Nestle India’s COGS. We estimate that a 1% increase in costs for these commodities could negatively impact Nestle India's earnings by ~0.2-0.5%, assuming the inflation is not passed on to consumers.
Figure 5: Nestle India - COGS breakdown (CY12)
Source: Company
Pricing and inventory covers. Nestle could resort to price hikes to mitigate the impact of cost inflation, although demand weakness in recent quarters may necessitate more calibrated price hike decisions. Also, given the inventory cover that the company may hold, the timing and extent of the impact could be delayed and lower.
Our view. Nestle India's top-line growth has been challenged in the last two years by weak macro, the company's efforts to exit low return SKU/channels and aggressive pricing making it less competitive. Although the company fared relatively better on the margin front thanks to better product mix/pricing, incremental input cost inflation may pose downside risk to margins. Nestle has witnessed significant earnings downgrades over the past two years. Valuations at 36x and 31x CY14E and CY15 P/E are not comforting either.
Investment Thesis
We have a Neutral rating on Nestle. We remain positive on the company's long-term potential given low penetration levels and domination of unorganized players in the Indian processed foods industry. However, slowing macro, aggressive pricing strategy and the company’s conscious efforts to exit less profitable products/channels has led to a sharp deceleration in volume growth in the last two years. Current valuations at 36x CY14E P/E are not comforting either. A recovery in volume growth and the sustainability of margins at ~20%+ levels would be key for stock performance, in our view.
Valuation
Our Dec’14 PT of Rs4,700 is based on a forward P/E multiple of 30x, which is at a ~10% discount to its past five-year average considering slower volume growth trends currently being registered by the company
Risks to Rating and Price Target
Key upside risks:
Any sharper-than-expected volume growth on the back of strong consumer spending and/or substantial market share gains would be a key upside risk to our sales and earnings estimates. Sharp declines in commodity costs
would also pose upside risk to our margin assumptions and earnings estimates.
Key downside risks:
Any adverse impact of inflation on consumer demand would significantly impact our sales and earnings growth assumptions. Sharp inflation in milk/sugar/green coffee/wheat/vegetable oils prices would significantly impact our margin assumptions and earnings growth estimates. Nestle enjoys leadership positions in most of the categories it operates in. However, any significant rise in competitive activity by existing players and/or the entry of new players could lead to higher A&P spends and impact our margins/earnings assumptions.
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