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Aarati Krishnan

SHAREHOLDERS can book profits in the Nestle India stock at current price levels of Rs 575. At its current price-earnings multiple of around 25 times its trailing 12-month earnings, the stock is expensive when viewed in the light of its sedate growth prospects. The firm trends in prices of the key commodities that Nestle India uses as inputs could also temper profit growth, going forward.

Over the past few months, it is the steady mop-up of shares from the open market by the parent that has sustained valuations for the stock. Nestle India's sales growth in the first half of 2003 was at 9.8 per cent, higher than the 6.5 per cent recorded in the financial year 2002.

The sales growth in 2003 would have been higher, but for the transporter's strike in the second quarter that impacted domestic sales. But this apparently healthy sales growth has been propelled more by increases in selling prices, than by robust volume offtake. Between 2002 and 2003, there has been a sharp spike in coffee prices, which propped up Nestle's export realisations. A hike in selling prices of a few products also propelled domestic sales growth.

But higher commodity prices of inputs such as cocoa, coffee and milk have also led to an upward spiral in costs. As a result of this, profit growth has not kept pace with sales growth. This is evident from the fact that the growth in Nestle India's operating profits, which was a healthy 23 per cent in 2002, dwindled to 10 per cent in the March 2003 quarter and further to 7 per cent in the June 2003 quarter.

The contraction in operating profit margins could continue, as prices of key inputs remain firm. Milk and cocoa prices continue to rule considerably higher than last year's levels, while coffee has softened marginally.

Another factor that could impact Nestle India's profit margins, going forward, is its increasing reliance on the low unit pack strategy. As a part of this strategy, Nestle India has launched variants of key brands (Chocostik, Maggi, Classic, Munch) at convenient price points of Rs 2, Rs 5 and Rs 10.

While this could help perk up volume offtake, it also has the side-effect of depriving the company of some of the pricing power it enjoys.

Having sought out new consumers by offering low-priced versions of its brands, it may be difficult for Nestle India to hike selling prices on products positioned at the Rs 2, Rs 5 or Rs 10 price points.

Historically, Nestle's net profit growth has diverged significantly from operating profit growth as a result of provisioning and treasury income.

Therefore, post-tax profits could continue to grow, despite the pressure on operating margins.

But as this is not a predictable or a sustainable source of earnings growth, shareholders should err on the side of caution and book profits on the stock.

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