Nestle Nigeria Plc - A compelling but expensive growth story


Wednesday, March 14, 2018 /6:15 PM /ARM Research 

Following a dismal 2016, when earnings fell to an eight-year low of N7.4 billion, Nestle Nigeria Plc (Nestle) returned strong in 2017, with earnings rising to a record N33 billion, a four-fold increase from the prior year. The big question now is, what happens next and are the drivers of 2017 earnings sustainable to deliver another sturdy earnings in 2018? In this note, we update our views on Nestle as well as revise our forecasts on the company.

Going into 2018, we remain broadly positive on Nestle and expect the company to sustain earnings growth, albeit at a much slower pace than 2017. Specifically, we see volume induced revenue growth and lower FX losses as key drivers of earnings in FY 18. Irrespective, downside risk to earnings will likely emanate from a subsisting input cost pressure which will hurt margins and, by extension, earnings. In addition, a further rise in operating expenses, particularly administrative expenses also pose downside risk to earnings in 2018.

In terms of equity market performance, Nestle is down 10% Year-to-Date (YTD), weaker than the return on the food sub-segment (-1.8% YTD) and NGSE All Share Index (+12.6% YTD). On our 2018 numbers, Nestle trades at a forward P/E of 26.4x relative to Bloomberg Middle-East and Africa peers of 20.5x. We retain our SELL rating on the stock with our revised FVE estimate of N998.21 (Previous: N879.62).

Lower effective tax offset cost pressures on Q4 earnings
Full-year 2017 earnings rebounded to its strongest level on record underpinned by improved operating performance and lower FX losses. However, we saw a deviation to the downside in Q4 17 despite a 44% YoY expansion in earnings to N12.3 billion. For context, while PBT declined 23% YoY to N10.3 billion, lower effective tax of 13% in the period (versus 53% in Q4 16) supported the expansion in earnings. Parsing through the numbers indicates earnings pressure stemmed from the mix of input and operating cost pressures as well as lower finance income. 

First off, despite a 12.4% YoY expansion in revenue in Q4 17, gross profit rose mildly by 6.8% YoY with related gross margin contracting by 220bps to 42% (below 5-year Q4 trend level of 43.5%). The margin pressure reflected a faster increase in input cost (+16.8% YoY) which stemmed from unfavourable price movements for locally sourced raw materials particularly Salt (+25% YoY) which is a major input in the production of its popular brand – Maggi. On topline, the slower rise in topline reflected the tapering out of the low pricing base. Like the prior quarter, the beverage segment was the primary driver of Q4 revenue with a YoY increase of 21% underpinned by volume, in our view. Over 2017, the company optimized its route-to-market as well as automated its sales force to make them more efficient in a bid to protect volume growth during periods of price hikes. We believe this investment also benefited the food segment which rose 7.8% YoY and accounted for the largest share (62.7%) of Q4 revenue.

Further down, the company reported a faster increase in operating expense (+17.3% YoY) relative to sales with both selling & distribution expense (+11.3% YoY) and admin expenses (+49.2% YoY) rising double-digit during the period. The sharp increase in admin expenses was due to an upward review in staff salaries, reflecting the strong union to which its staff belong to. Consequently, operating expense to sales ratio rose 89bps to 21%. This, combined with weakness in gross margin, led to a 309bps contraction in operating margin to 21.4%. Further down, although net finance expense of N263 million was much lower than N6.4 billion reported in Q3 17, it paled in comparison to net finance income of N3.2 billion reported in Q4 16. The foregoing combined with margin contraction on both gross and operating level underpinned the 23% drop in before-tax earnings.

Softer FX losses guides to earnings growth
Going into 2018, as with most consumer companies, Nestle’s management guides to sustained investment in its route-to-market and innovative marketing strategies to drive volume growth particularly for its leading products – Maggi, Milo and Golden Morn. This is coordinated with our view that volume led strategies will take center stage farther out given the unsustainability of the price-led revenue growth of 2017. Specifically, for revenue, we look for a growth of 9.2% YoY to N267 billion in FY 18, supported by the food segment through Maggi which has retained its leading position in Nigeria’s seasoning market. Over our five-year forecast horizon, we project revenue CAGR of 8.2% (vs. 16% in the five years ending December 2017).

In terms of input costs, according to FEWSNET, cross border demand for cereals remains above average although, the impact is being offset by robust market supplies from the dry season harvest. This, in our view should ensure price stability for Maize and Sorghum in H1 18. However, in the early months of H2 18, which is typically the lean season, we expect the combination of regional demand for local grains and limited market supply to put an upward pressure on cereal prices which we expect would ease in Q4 18 due to the peak harvest season. The aforementioned coupled with our view of currency stability over FY 18 underpins our expectation for an expansion (+109bps) in FY 18 gross margin to 42.4% relative to prior year (5-year average: 42.5%). We also project a slowdown in COGS (CAGR: +7%) over our forecast horizon as the transitory nature of food inflation wanes.

On finance expense, we envisage tamer finance expense in FY 18. To add, Nestle is expected to pay $33 million in FY 18 which we estimate is valued at around N370/$ on its books. Our view is for the currency to range between N360/$ and N370/$ in 2018 hence, we foresee minimal FX losses in the preview period. Overall, we project net finance expense of N2.8 billion (-69% YoY) in 2018.

Net impact of these revisions translates to PBT and PAT of N61 billion (+30% YoY) and N41.5 billion (+23% YoY) respectively with the later translating to an EPS of N52.31. We project a 5-year EPS CAGR of 12% (vs. 8% in the five years ending December 2017) as finance expense moderates further over our forecast horizon.

On our 2018 earnings, Nestle trades at a current P/E of 26.4x vs 20.5x for Bloomberg Middle East and Africa peers. We have a SELL rating on the stock with our revised FVE of N998.21 (Previous: N879.62).

Proshare Nigeria Pvt. Ltd.

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