Nestlé India Ltd will soon be included in the Sensex. Index inclusions tend to happen after a stock has rallied sharply, and often results in underperformance relative to the market after the inclusion.
As it turns out, the Nestlé India stock has had a massive rally, rising about 37% in the past year. This has raised the stock’s valuation to a staggering 59 times one-year forward earnings.
While the company is growing at a faster rate than many of its peers, growth rates are nowhere near where valuations suggest they should be.
“We expect topline and earnings CAGR at 11% and 16% over CY18-CY21," said SBI Capital Markets Ltd in a recent client note. CAGR stands for compound annual growth rate.
Besides, some risks have recently surfaced. Nestlé India’s baby food formula contributes significantly to its revenues, but competition is nipping on this segment.
“We see heightened competition from players like Danone, Abbott and Reckitt Benckiser which are sidestepping advertising hurdles in the online channel. With competitors having rolled out products across price points, we forecast a sales growth CAGR for Nestlé of 7% and 8% in the dried baby food and milk formula categories, respectively, over the next three years," said Goldman Sachs India in a recent note to clients.
Besides, the margins in Nestlé India’s businesses are tapering off. Gross margins slipped by 220 basis points year-on-year in the third quarter, largely due to higher inflation in milk and milk-based derivatives. The company is said to be increasing prices for its products selectively to counter the recent rise in milk prices.
But while a price hike could mitigate margin pressures, the market is concerned that it could impact demand. It would also mean that Nestlé India would have to increase spends on advertising and promotions to fend off competition.
To be sure, the company has seen market share gains in its flagship product Maggi in the last 18 months. Besides, new product launches have also driven growth. But analysts see limited room for an improvement in the growth trajectory. “We have already built the strong growth momentum into our forecasts, and expect the pace of market share gains for Maggi to slow down," said the Goldman Sachs report.
Of course, the disconnect between growth rates and valuations are somewhat an extension of what’s happening on a broad scale in the Indian markets, where equity indices are touching new highs, despite gloomy economic news. When the trend reverses, Nestlé India’s valuations can be expected to retreat as well.