Hold Nestle; Target Price: Rs5,450; Microsec

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Rating: Hold; Target Price: Rs5,450; CMP: Rs5,948; Downside: 8.4%

Valuations stretched; maintain Hold

We maintain Hold rating on Nestle and believe the 26% rally in the stock price in the last 6 months leaves little headroom for further outperformance with valuations stretched at 39.7x/33.6x CY15E/CY16E PE. While we remain optimistic on the company’s long term prospects with its presence in low penetration categories, higher than expected commodity cost inflation could impact near term margins while subdued external environment could mute volume growth. Q3CY14 results were ahead of estimates with revenue/ebidta/pat growth of 8.9%/8.6%/12.1% respectively.  

$ Q3CY14 result above expectations: The company posted 8.9% YoY growth in sales to Rs25,578mn (1.6% above expectation) on the back of healthy 9.9% YoY growth in domestic business which was led by price hikes and product mix change. Exports declined 3.9% YoY due to lower coffee exports. Operating profit was up 8.6% YoY at Rs5347mn as operating margins were flat at 20.9%. Interest expenses were negligible due to repayment of ECB loan in the last quarter. Adj PAT was up 12%YoY to Rs3272mn (3.6% above estimates).

$ Revenue growth gaining momentum: Products like Maggi Oats Noodles, Maggi Vegetable Atta Noodles, fortified seasoning Maggi Masala-ae-Magic, as well as strong brands Kit Kat, Nescafe, Milkmaid and Everyday performed well during the quarter. Management continues to rationalize its product portfolio to eliminate low margin SKUs which are not in line with its vision of Nutrition, Health and Wellness or growth strategy. We expect the domestic business to gain momentum and further improve with buoyancy from the external environment in the next 6-9 months.        

$ Margins to expand over 2 years: Gross margins of the company declined by 114bps YoY on the back of input cost pressure and significantly higher cost of milk and its derivatives in India which was even higher than those in international markets. With focus on various efficiency and cost containment programs the company was able to maintain operating margins at 20.9% as admin & other expenditure was up mere 5.1% while employee cost was up 6.4%YoY. We expect operating margins to expand from a low of 20.7% in CY14E to 21.5% in CY16E with gross margin expanding to 54.2% from 53.4% over the same period.         

$ Valuation & risks: We have reduced our operating profit by 6.3%/5% for CY14/CY15 factoring in lower revenue growth along with lower gross margins due to high commodity prices. Earnings have been reduced by ~3.4% for both years. Nestle is trading at 46.4x/39.7x CY14E/CY15E PE respectively. We maintain Hold rating on the stock and value it at Rs5450 (32x Sept’16 PE) giving a 10% discount to its 5-year mean +1 SD valuation. Key upside could be sharp volume growth recovery along with softening commodity cost while downside risk could be sustained pressure on revenue growth.

Thanks & Regards