Nestle India: Hold

Recommendation:Hold

Aarati Krishnan

THE NESTLE India stock has been bubbling with activity in an otherwise listless equity market.

Till date, the stock has surged 77 per cent from its low of Rs 304 in May 2000 and now commands a valuation 39 times the expected earnings for 2000. This is steep by FMCG standards.

The recent surge in the stock is partly driven by the announcement by the parent, Nestle SA, that it would use the creeping acquisition route to mop up another five per cent in Nestle India through open-market purchases. But improving the stock's valuation can also be traced to good financial performance in a market starved of healthy earnings numbers.

On a comeback trail

The resumption of its coffee exports to Russia and a favourable input price environment pepped up Nestle India's net profit growth to 28 per cent in the first nine months of 2000. Sales growth in this period was 10.4 per cent, with domestic sales rising 9.8 per cent and export sales 13.8 per cent. In reality, the growth in sustainable net profits was higher than reported as the company took an additional one-time charge of Rs 14.70 crore in the first nine months of 2000 for provisions against contingencies.

Unusually, low input prices may have contributed considerably to margin expansion. Continuing surpluses in global production have pushed both coffee and cocoa prices (the two key inputs for Nestle India, apart from milk) to historic lows in 2000. While coffee prices are hovering close to their seven-year lows, cocoa prices recently bounced off their lowest levels in three decades.

With global agencies forecasting high carry-in stocks for the next season, the soft input price advantage could be with Nestle for the time being. Does this mean Nestle India will sustain its healthy earnings performance over the next couple of years? This will depend on its ability to revive sales growth in its domestic product categories.

Greener pastures at home?

Nestle's 10.4 per cent sales growth in the first nine months of 2000 is partly magnified by the low base of comparison. The cessation of coffee exports to Russia due to the economic crisis there, led to a 38 per cent drop in export sales (and a 5 per cent drop in net sales) for Nestle India in 1999.

Instant coffee exports to Russia resumed this year, but the business remains poor because realisations have fallen in line with green coffee prices. Since realisations in the export market are unlikely to look up in the next year, Nestle will continue to look to its domestic product portfolio to sustain earnings growth.

In recent times, as with other FMCG companies, Nestle India's topline growth in the domestic market was unimpressive, at around 8 per cent in 1999 and 9.8 per cent in the first nine months of 2000. In the domestic market, Nestle India has traditionally derived its revenues from five product baskets -- coffee (Nescafe Select, Sunrise); milk products (Milkmaid condensed milk and ready mixes, Coffeemate coffee creamer, Everyday Dairy Whitener); weaning foods for infants (Cerelac, Nestum, Lactogen); chocolates/confectionery and malted beverages (Milo, KitKat, Charge, Munch, Polo); and food products (Maggi noodles, soups).

Cash cows slow down

Of these, weaning foods and milk products are the cash cows, with dominant market shares in both businesses. But as these are mature products, they appear likely to deliver steady, and not scorching, growth rates. Sales growth in these businesses was less than five per cent in 1999-2000.

In chocolates and instant coffee, the growth prospects appear brighter, but Nestle faces intense competition from the players with the dominant market shares. While Unilever and Tata Coffee are significant threats in the coffee market, the market leader Cadbury India has been a potent threat in the chocolate confectionery market.

Nestle's Kitkat has actually ceded market share to Cadbury's Perk in the past year. The market for specialised food products such as soups and noodles holds healthy growth potential. But the market is relatively small and players such as International Bestfoods, Unilever and Dabur are vying with a host of imported brands and regional players for a share of the pie.

Stretching existing businesses

Over the past year, Nestle has devoted considerable attention to the expansion of its domestic businesses. It has drawn brands such as Coffeemate coffee creamer, Frappe cold coffee and Nescafe Gold from the Swiss parent's portfolio to expand its milk products and beverages range. Incidentally, the inputs from the parent do not come free. Nestle India paid its parent a Rs 53.69-crore royalty in 1999 (net profits for the year were Rs 98.47 crore). Royalty payments accounted for 3.5-4 per cent of sales over the past three years.

Nestle has used the soft input prices to reduce prices of its coffee and chocolate brands. Products such as KitKat and Munch in low-unit price packs have been used to encourage trial and bolster flagging volumes. But these moves will take time to pay off.

However, the revival in the 2000 third quarter domestic sales is heartening. For the quarter ended September 2000, Nestle reported an 18 per cent growth in domestic sales (export sales declined 8 per cent due to lower realisations). Considering that Nestle has reduced both coffee and chocolate prices over the past year and held other product prices, this indicates volume growth of a higher order.

A plan to expand the network of Nescafe vending machines and establish coffee bars to encourage out-of-home consumption of coffee is also on the cards.

Testing the waters

Over the past year, the company has also announced forays into three new areas -- liquid milk, bottled water and biscuits. The foray into biscuits is through the joint venture Excelsia Foods, so the contribution to Nestle's revenues may at best be in the form of dividends for now.

Liquid milk and bottled water are businesses that hold immense growth potential. Larger players can expand through higher penetration levels and at the expense of the unorganised segment. However, both these segments are quite crowded with feature listed and unlisted players which have considerable financial muscle.

In the liquid milk segment, Nestle will be up against the formidable Amul, apart from a host of private dairies with established clientele.

In the bottled water market, the market leader, Bisleri (of Parle Products), has had to contend with competition from scores of me-too brands, apart from Pepsi's Aquafina, Coca-Cola's Kinley. Going forward, competition is only likely to increase, with Britannia planning to launch more bottled water brands from its foreign collaborator Danone's portfolio (Evian, one of the largest bottled water brands, is already on shop shelves).

Striving for niches

Nestle India has already launched two bottled water brands in the domestic market -- the internationally renowned Perrier, followed recently by its sparkling mineral water brand, San Pellegrino (reputed to be sourced from the Swiss Alps).

However, both products are for upmarket consumers. The premium pricing suggests that the products will remain niche products with relatively small target markets. Pure Life, the mass market bottled water brand to be launched shortly, will determine the success or failure of Nestle's bottled water foray.

Nestle India has also shied away from the mass market for liquid milk in plastic pouches, and instead restricted itself to ultra heat treated (UHT) milk in Tetrapacks. The product is priced at a substantial premium to the other local brands.

Investment outlook: Nestle's new product forays are into extremely competitive markets and investments in the new businesses are likely to be high over the next few years. In this respect, the advantage of soft input prices, high cash flows available from the stable businesses (such as weaning cereals and coffee) and the financial might of the parent, Nestle SA, will stand Nestle India in good stead.

The royalty to the parent should ensure that Nestle India continues to enjoy ungrudging access to the parent's product portfolio. In many respects, in India Nestle is pitted against its key adversaries worldwide -- Groupe Danone and Unilever. In the foods business at the global level, both companies are considerably smaller than Nestle SA.

But marketing prowess, rather than size is likely to determine the success of Nestle India's new product forays in the next couple of years. Since the high growth rates of this are partly on account of the low base of last year, the growth rates are likely to reach more moderate levels next year. The stock continues to be a good investment option for investors with a three-year horizon. But since the recent uptrend is partly on account of factors unrelated to the fundamentals, there could be some downside to the stock in the near-term.