August 02, 2019 /02:20PM / ARM Research
Competition gradually blighting the Food business
Central to the Q2 19 earnings of Nestle and Unilever is the telling impact of increased competition in the food business and improved input cost management. For Nestle, EPS grew 4.3% YoY to N16.90 due to gains from increased local sourcing of raw materials and higher sales. On the flipside, having restated its Q2 18 financials, Unilever reported 30% YoY decline in EPS to N0.35 reflecting increased input and finance cost following exchange rate differentials relative to prior year.
Over the rest of 2019, we expect normalization in margins for both companies while we expect the competition from other brands to remain drag on sales. However, after adjusting for the improved cost management over H1 19, we raised our NESTLE FVE to N1,447.39 which translates to an OVERWEIGHT rating. Nestle trades at a 2019P/E of 23.01x, relative to Bloomberg MENA peers of 15.49x. Elsewhere slow recovery in revenue guides our downward revision of Unilever FVE to N31.95 (previously: N35.82), which translates to UNDERWEIGHT rating. Unilever trades at a 2019 P/E of 26.1x relative to Bloomberg MENA peers of 16.1x.
Food business faces increasing challenge
Amidst flat pricing, competition in food business from smaller seasoning brands (Ginomax, Terra cubes, Onga cubes) became more apparent over Q2 19, with both companies recording low to mid-single digit growth in revenue, relative double digit recorded in prior years. To begin, Nestle’s revenue from the food business grew by just 1.6% YoY over the review period. However, support from its beverage business drove the 4.6% YoY expansion in its overall revenue.
Elsewhere Unilever’s revenue recovered from a downbeat in Q1 19, with food business expanding by 6.3%, following the measures put in place to drive topline. To clarify, we recall management’s guidance during its Q1 19 conference call to drive sales by partnering with banks to provide liquidity to its distributors. However, persistent struggle in the HPC segment drove overall revenue lower by 1.7% YoY to N23.4 billion.
Expect margin normalization
Over the review period, Nestle booked lower cost of sales over Q2 19, which was further magnified by N1.0 billion impairment recorded in Q2 18. On the raw materials, domestic maize prices fell by 4% YoY while palm olein dropped by 1.5% YoY. Consequently, cost of sales dipped by 4.4% YoY to N36.3 billion, driving a 483bps expansion in gross margin to 48.8%.
On the flipside, Unilever’s input cost expanded by 4.7% YoY which we believe mirrors convergence of NIFEX&NAFEX rates coupled with increased pricing of its HPC1 inputs. In its Q1 release, the company highlighted that it now sources FX within a range of N360/$ - N365/$, compared to the prior year wherein it was sourced within the range of N320/$ - N330/$. Consequently, gross margin dipped by 416bps to 31.9% in Q2 19 (H1 19: 26.6%). Over the rest of 2019, we expect a normalization in Nestle’s margins as the base effect from impairment charge ended with the half year result.
That said, we expect gross margin for FY 19 to print at 46% (+322bps YoY). Elsewhere, while we expect a recovery towards Q4 19, given the NIFEX and NAFEX convergence occurred in the later part of last year, full year margin will remain lower relative to prior year. That said, Unilever’s gross margin for FY 19 is expected to print at 28% (238bps YoY).
Following the increased receivables (+N3.2 billion) and a reduction in its trade payables (-N9.4 billion) over Q2 19, Nestle’s operating cash position declined to N33.3 billion over H1 19, compared to N53.5 billion recorded over H1 18. Unilever at the other end reported negative cashflow from operations (- N16.0 billion) mirroring the N20.5 billion increase in the company’s receivables over first half of 2019. For us, while this reflects the Unilever’s aggressive stance to drive sales, we remain worried about its cash collection as receivable turnover printed at 1.84x as at H1 19, compared to 3.21x at the end of 2018.
We are positive on Nestle
Nestle still posted a modest performance notwithstanding the tensed environment, due to savings from its cost. Elsewhere, exchange loss worth N219.5 million, recorded in Unilever’s finance cost coupled with input cost pressure drove earnings lower.
In coming quarters, we expect the competitive environment to remain unchanged, albeit with a normalization in gross margin. That said, gains from improved sales and lower cost is expected to support growth in Nestle FY 19 EPS by 26.5% YoY to N68.7. On other hand, Unilever’s EPS is expected to decline by 22.9% YoY to N1.23 due to struggling sales, impact of currency convergence on its input cost and less shield from its finance income, given its lower cash balance.
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