Thursday, August 04, 2016 2:44pm /Cordros Capital
Despite 15% y/y revenue growth, NESTLE reported 21% y/y EBITDA decline and lost after tax (the first in the company's recent history) in the second quarter. The key drivers were (1) elevated cost pressure and (2) foreign exchange losses.
These two factors are systemic in nature and will further impact performance, albeit to a lesser extent, in the remaining half of 2016FY. Consequently, we look for 2016FY EBITDA and PAT declining by 14% and 72% respectively.
Firstly on cost, subsequent depreciations in the Naira (NGN) exchange rate against the Dollar (USD) portend downside risk for margins. Reference here is to the potential impact on (1) input cost of raw sugar and milk which are still wholly imported and (2) import duties which has a direct link with the official LCY exchange rate.
Secondly, we would expect the pass through impact of the hike in petrol price on transportation cost -- which management also attributed to the cost inflation experienced in Q2-16 -- to linger for the rest of the year.
Broadly, NESTLE is at about the limit of domestic raw materials input substitution, and short of further, sizeable price increases across principal products, the cost cutting measures being considered by the management will be of less impact on margins.
The scope for further forex losses has widened following the full floating of the LCY. With the NGN having already lost over 14% from end June level, amid further declines, it is not unlikely that NESTLE's net forex losses will reach (or breach) our target N18 billion for 2016FY. Interest expense on USD borrowings should also expand accordingly.
On revenue, the selective price increases effected YtD (MILO 15% average, GOLDERN 7% average and MAGGI 15% average) have been the major driver of growth. Whilst noting the tendency of management adjusting prices to fairly reflect costs in H2-16, the decision should be tough, considering the risk of losing grounds to competitors (as in the experience of MAGGI in Ghana). Price increases in 2017 are more realistic, and we expect some recovery in margins accordingly.
The stock recovered from the YtD low in April to accumulate 38% gain at the end of June, supported by some optimism following Q1-16 results and the general speculation that drove local equities prices higher. NESTLE is currently trading on a consensus 12M FPE of 26.6x, at 7% and 36% premium to its SSA and EM peers.
While we continue to have strong conviction on the company, we believe that risks remain on the downside and that the stock is overvalued. SELL.