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Will Nestlé change its focus on margins?

Will Nestl change its focus on margins?

Nestlé India Ltd tackled concerns about slowing volume growth at a recent analyst meeting. A slide in its presentation illustrated the dilemma it faces, showing weighing scales with sales growth on one side and margins on another. Of late, its priority has tilted towards margins. However, investors may prefer more balance between the two.

The decline in volume growth is visible in categories such as milk and nutrition, and chocolate and confectionery. But the portfolio mix is just one part of the problem. Nestlé also blames lower economic growth for a slowdown in sales. Many of its products are discretionary purchases by nature, and sales get affected in a slowdown.

But the situation gets worse when prices are hiked sharply. Pricing alone added 2.6 percentage points to Nestlé’s profit margins, though the net increase in margins was lower as costs increased too. The economic slowdown, discontinued products and price increases appear to be the company’s main problems at the moment.

The effect of discontinued products on sales growth will diminish as the base effect recedes. The prospects for a revival in economic growth in 2012 or even early 2013 seem bleak. The outlook for demand, therefore, should be dim. The ability to hike prices further would be diminished, and the effort should be to stoke demand through a more attractive pricing strategy.

But the current economic scenario may have come at an inopportune time for Nestlé. It is in the middle of a massive capital expansion plan, of which it has spent 1,730 crore in 2011 and has existing commitments of 510 crore for 2012. Viewed from one angle, it is readying for a massive sales push in almost all its major categories. That is a plus point.

But this is also affecting profit and asset utilization ratios in the interim. Consumer companies take pride in sweating their assets. But large plants take time to ramp up, not only due to operational reasons, but also because the market has to be ready to absorb higher volumes. Margins get hit as a result, initially.

Nestlé’s return on invested capital has fallen to 38% in the first half of 2012 compared with 58% in the year-ago period. That should be no surprise, as its capital base has risen sharply. This may explain why the company is not willing to tolerate lower margins for higher growth. It wants to have a more profitable product mix, discontinuing those with low profitability, thereby allowing it to earn more despite doing less.

Now, Nestlé faces a situation where capacity has risen, at a time when demand is likely to stay slack. It can choose to hold on to the price-product mix bandwagon, which will certainly mean its volume growth will underperform. Or, it can choose to become more competitive, and regain ground by cutting prices and offering attractive promotions.

The company’s expanded capacity should give it scale benefits, progressively limiting the negative impact on margins. That would mean a complete shift from its current strategy. Nestlé’s investors have the difficult task of guessing if that will happen. Rising food prices are a growing risk to this shift in strategy, however.

We welcome your comments at marktomarket@livemint.com

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