Silver linings, some clouds for Nestle

Nestle India Ltd shares closed 3% higher on the NSE on Thursday, even as the company’s earnings for the June quarter (Q2CY22) missed analysts’ estimates. What gives? Multiple reasons: decent sales growth, rural upswing, acquisition of pet food company and launch of infant food brand.

The company follows a fiscal year from January to December; So the June quarter is his second. Total operating income increased 16.1% year-on-year in the second quarter to nearly 4,037 crore, driven primarily by domestic sales. Domestic revenue, which accounted for 95% of operating revenue, grew 16.4% year-on-year. For perspective: Domestic growth in the first quarter was 10.2%. Domestic sales growth in the second quarter is broad-based with a healthy balance of pricing, volume and mix.

“Management’s comment on broad-based growth across all categories and an uptick in the rural market in Q2CY22, coupled with the announcement of entering the fast-growing, high-margin pet care category and launching the Gerber brand in India, was an element of surprise , which led to mounting excitement,” said Naveen Kulkarni, chief investment officer, Axis Securities.

Nestle India acquires Purina Petcare India’s pet food business for 123.5 million. Purina’s sales for the year ended March was 36.08 million. These levels are too low for the needle to move in the near term, but the outlook is bullish. The company estimates the size of the pet care category at around 4,000 crores.

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According to Nestle India, pet adoption is increasing in the post-pandemic world and the pet food business is expected to register a compound annual growth rate (CAGR) of 50% in 2022-2026 compared to 39.4% CAGR in 2018-2021 .

Sachin Bobade, analyst at Dolat Capital Market, said, “The pet food business is high-margin and that will likely be a positive factor in overall margin improvement over the long term.”

Separately, the launch of the Gerber brand in the infant nutrition segment offers products to accelerate growth in this category. Kulkarni said, “Nestle India has recently seen increased competition from Abbott’s Similac and PediaSure. By launching the Gerber brand in India, Nestle can now protect itself from other companies.”

While these developments are encouraging, cost pressures have been unrelenting across industries, and Nestle has not been immune. The company said there have been unprecedented headwinds in commodities and that inflation in 2022 was five times the 3% compound annual growth rate recorded in 2018-2020. Accordingly, Q2 EBITDA shrank a whopping 409 basis points (bps) to 20.3%, at least the lowest level in the last 10 quarters. That’s due to a 304 basis point decline in gross profit margin to 54% as raw material costs increased as a percentage of sales. The increase in raw material costs is due to higher inflation, particularly for cooking oil, milk and milk products, and packaging materials. This was partially offset by better realizations.

Nestle India shares are down 3% so far in 2022. It is gratifying that the cost pressure is easing. “We are observing the first signs of softening in some raw materials such as cooking oils and packaging materials. Fresh milk, fuel, grain and green coffee costs are expected to remain stable as demand and volatility continue to rise,” the company said.

Needless to say, potentially stable or lower commodity prices will improve margin prospects. Expectations of normal monsoons and higher crop yields should boost rural demand. However, given that valuations are expensive, any significant upside could be capped in the near term. Based on Dolat Capital estimates, Nestlé shares are trading at 60.5 times 2023 EPS.

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