Tuesday, February 14, 2017 4:15 PM / ARM Research
In keeping with the theme of Valentine’s Day, we beam our strategy searchlight on one name struggling to find love. In recent weeks, Nestle Nigeria Plc has shed 23% YTD to near five-year lows underperforming the broader NSEASI.
Naira weakness exposes earnings Achilles heel
Over the last decade, Nestle delivered consistent earnings growth and increasing cash payouts to shareholders. Earnings expansion flowed from a combination of strategic product portfolio positioning to the Nigeria’s demographic and economic dividend, with improvement in middle class incomes and population translating to double digit topline growth.
Furthermore, Nestle’s largely domestic raw material sourcing and better pricing power meant that unlike other FMCG names, the company avoided the volatility associated with international commodity prices.
That said, one item that always caught the eye was Nestle’s unusually large FX share of loans which held out the potential for earnings compression in the advent of naira weakness. Accordingly, Nestle booked
N19.4 billion in FX losses over 9M 16 with PBT sliding 74% YoY. Exacerbating the earnings picture was the jump in tax rates (effective taxes 91%) which drove the collapse in PAT to N474million. Overall, our consumer goods analyst, Amaka Ukoha estimates that Nestle is on track to record its softest EPS number since 2007.
Consequently, the perfect storm of a steep plunge in global crude prices and a loss of currency stability which hit the Nigerian economy catalyzed the supposedly distant FX risk in 2016. Accordingly, Nestle booked N19.4 billion in FX losses over 9M 16 with PBT sliding 74% YoY. Exacerbating the earnings picture was the jump in tax rates following the expiration of tax concessions on its Flower gate factory in Q3 16 (effective taxes 91%) which drove the collapse in PAT to N474million. Overall, our consumer goods analyst, Amaka Ukoha estimates that Nestle is on track to record its softest EPS number since 2007. Looking at a price and EPS chart of Nestle, one could infer that markets seem to pricing the prospects of a sharp drop in EPS.
Reduced foreign activity on the domestic bourse amplifies bearish patterns
Aside fundamental concerns over its earnings trajectory, a derivative of the deadbeat economic climate and deterioration in FX market liquidity is the switch in investor profile on the domestic bourse. Specifically, foreign portfolio investors pulled back from the Nigerian equity market – leaving local investors at the helm for the first time in six years.
The development is of notable importance to Nestle which was a key portfolio constituent in FPI Nigeria exposures on account of its earnings track record and good corporate governance.
Potential dilutive concerns
Beyond the fundamental concerns, our weak currency outlook for 2017 with a base case of N400/$ implies earnings trajectory should remain subdued unless Nestle moves to break the FX link as with Guinness and Lafarge in our coverage universe.
For these two companies, Diageo has moved to convert its FX loans into equity via a rights issue and while Lafarge claims its debt to quasi-equity conversion is non-dilutive – the possibility exists.
Whether Nestle decides to or otherwise, markets are unlikely to be abreast until post FY 16 results release.
Thus, given the negative equity move, we think a lack of clarity over how Nestle intends to deal with FX loans has stoked further bearish sentiments on the stock. Accordingly, we see limited scope for local investors to shower attention on the stock as dilution concerns add to soft earnings prospect
Reiterating our SELL rating on Nestle
Having been largely bearish on Nestle in recent years, we think the confluence of earnings compression to multi-year troughs, shift in investor sub-set and uncertainty over treatment of its FX loans are catalysts for strong price retrenchment in 2017. Hence, ahead of the FY 16 results scheduled for the first week in March 2017, investors are best advised to take cognizance of the possibility of further downside. We have a SELL rating on Nestle with FVE of
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