Nestle India: No instant remedy

The clamour over safety standards of Maggi instant noodles has sent the stock of its maker Nestle India tumbling. From the all-time high at ₹7,499 that the Nestle stock hit in March this year, it has lost 20 per cent so far.

Still, Nestle India’s trailing 12-month price earnings multiple is at 47 times currently, above its three-year average of 45 times. It’s also higher than the FMCG index’s 40 times, and valuation of peers GSK Consumer Healthcare and Hindustan Unilever in the FMCG basket.

Nestle faces a tough few quarters ahead and can find it hard to meet the expectations built into the valuations. Investors in the stock can book profits in their holdings. Here’s why.

For one, both the sales ban and Nestle’s own decision to temporarily take Maggi noodles off store shelves will directly hit the company’s sales in at least the June and September 2015 quarters. It isn’t clear how long Nestle will hold Maggi off the market.

But the bigger problem is the blow to the brand’s image and trustworthiness, which can impact sales over the long term. Maggi is the brand under which Nestle markets other products in its prepared foods segment — sauces, instant pastas, masalas, and so on. It’s therefore not just instant noodles sales that can suffer. Even if the outcome of the tests and the various lawsuits Nestle faces does turn in its favour, the brand has already been hit. There is also the danger that distrust could spill over into Nestle’s baby foods and milk products segment.

Second, prepared foods and milk products are the two segments on which Nestle rides and where it holds the greatest pricing power. Prepared foods and milk products contribute 29 and 45 per cent of the revenue respectively, and are the company’s growth drivers in the past two years.

For the January-December 2014 period (Nestle follows the January-December financial year), revenue grew 7.9 per cent, below the 9.3 per cent and 11.8 per cent in the two preceding years.

The deceleration is in line with the overall slowdown in consumer discretionary spending. Nestle’s net profit, however, grew 6.5 per cent in 2014, better than the 3.7 per cent in 2013 due to savings in interest costs.

Prepared foods managed 10 per cent growth in fiscal 2014, while milk products grew 12 per cent. Sales in Nestle’s other two segments — confectionery and beverages — have moved in the opposite direction. Confectionery sales dropped 3 per cent last year, sharply below the 10 per cent growth in 2013.

Beverages clocked virtually no growth last year.

Third, Nestle has thus far managed growth primarily by increasing product prices; while underlying volume growth is poor. Volumes grew just 4 per cent in prepared foods in both 2013 and 2014, below 8 per cent in the years before. Volumes in milk products and confectionery have been shrinking for the past three years. Beverage volumes tanked 11 per cent in 2014 after briefly recovering in 2013.

Muted volumes point to wary consumers. Good volumes are also necessary if sales growth has to sustain. With consumer discretionary spending still sluggish, low volume growth may persist. Four, Nestle has lesser room now to hike product prices and keep up sales growth. Price of milk, the chief raw material, has stabilised for now.

Other inputs such as wheat, palm oil, and vegetables have already corrected. The blow to the Maggi brand will also hurt pricing power.

Five, for Nestle to repair the damage to its brand, it will have to step up its advertising and promotion spend. Currently, compared with peers, Nestle’s adspend forms a comparatively low 4.6 per cent of sales. The cost of recalling products across the country, since they are being removed from stores, will also lead to a temporary spike in costs.

All this can pressure operating profit margins, which had begun to revive on lower raw material prices. For the March 2015 and December 2014 quarters, operating margins were around 22 per cent, up from the nearly 20 per cent in the year-ago periods. And while Nestle holds 80 per cent of the instant noodles market by value, competitors GSK Consumer Healthcare (Foodles), ITC (Yippee) and Hindustan Unilever (Knorr) can step into the gap and take advantage of the current scenario.

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