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Aarati Krishnan

Rising milk prices have taken a toll on margins.

ONE-OFF factors, such as the phase-out of tax holiday on exports and inadequate milk availability, may have had a hand in Nestle India's surprisingly bad numbers for the April-June 2004 quarter. However, the company is also facing a slew of new challenges in its businesses, which could have a bearing on its numbers.

Shareholders can, therefore, pare exposures in the Nestle India stock. At a price-earnings multiple of 23 times its trailing 12-month earnings, the stock trades at a significant premium to frontline FMCG companies. The stiff valuation levels also make the stock susceptible to negative earnings surprises.

Nestle India has closed the April-June 2004 quarter with a 32.6 per cent drop in its net profits, even as net sales remained unchanged.

Some troubles may not last...

Domestic sales, which crept up by 3.1 per cent this quarter, was impacted by inadequate availability of milk fat and "rationalisation of stocks". The chocolate market also went through a temporary hiatus due to the worm infestation controversy. These would no longer be an issue in the coming months. Chocolate marketers have improved their packaging and reduced prices to pep up volume growth, in the aftermath of the controversy and this may deliver results.

Competition for milk procurement has been quite high in the recent months and was aggravated by the faltering monsoon. The recent revival in the monsoon rains in the northern belt, may help alleviate the situation to some extent, by improving the availability of feed.

... . But new ones may surface

However, several challenges have also surfaced for Nestle's core businesses and these could continue to impact its performance. For one, the sharp decline in Nestle's export sales for the quarter is worrisome. Global coffee prices for the quarter ruled about 18 per cent higher than last year , as several other producing countries suffered a drop in output.

Yet, with a 6.5 per cent volume growth and a 21.6 per cent decline sales value, Nestle India's coffee export business does not appear to have capitalised on these opportunities. Nestle has attributed the drop to a shift in product mix towards bulk coffee packs. But whether this shift is here to stay, needs to be watched.

Second, Nestle's profit margins have contracted from 20.6 per cent to 15.4 per cent this quarter, on the back of rising milk prices. Milk prices have climbed sharply over the past six months, as intensifying competition for procurement impacted prices. The revival in monsoon could help alleviate the situation to some extent.

However, the contraction in margins is also a sign that the company is unable to pass on spikes in input costs through selling price increases.

Though businesses such as coffee, noodles and chocolates are not directly impacted by price wars, Nestle India's growing dependence on low-priced packs, at price points of Rs 5, Rs 10 and so on, may make price increases difficult.

This could mean that Nestle may now have to absorb some of the swings in commodity prices into its profit margins. With commodities such as coffee, cocoa and milk solids making up its raw materials basket, input prices for the company can be quite volatile, which could make for choppy earnings.

Infant foods: Seeking new channels

Third, a wide-ranging ban on advertisement and promotion of infant foods and milk substitutes, which took effect from January this year, has forced Nestle to look for alternate distribution channels for the business — hitherto its key cash cow.

The company has embarked on a revamp of its distribution. But given the wide-ranging restrictions on promotions and even point-of-sale displays, pushing sales growth in this category may prove a challenging task. In the past, a steady mop-up of shares by the company by way of buyback and a rising promoter's stake have kept valuation levels for the Nestle India stock high.

However, with the multiples for many frontline FMCG companies being corrected downwards, the stock could be more susceptible to downside risks.

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